California: Cannabis Client Due Diligence and Corporate Tax Return Preparation

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We commonly create articles about ideas relating to monetary management, particularly with respect to tax management. Articles primarily based on abstract monetary ideas are essential.

As a practicing CPA, on occasion 1 has to “get into the dirt” and “push the digits.”

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We lately had the chance to help a new client who is certified as a “cannabis equity business” with the City of Oakland, California. We undertook an comprehensive due diligence course of action prior to supplying our client an Engagement Letter in order to turn out to be familiar with the dirt in which these bushes develop.

A CPA should really Under no circumstances start operate for any client, particularly a client operating in the cannabis sector, with no conducting due diligence and getting an Engagement Letter signed.

Our initial due diligence on the business enterprise entity, which we requested the client upload to a single Dropbox folder so we have anything in 1 location,[1] integrated:

  • Critique of the LLC Articles of Organization filed with the California Secretary of State.
  • Critique of the Details Statements filed with the California Secretary of State.
  • Critique of an executed copy of the Operating Agreement for the LLC.
  • Critique of an executed copy of Type 8832 “Check the Box” Entity Classification Election.
  • Critique of the Bureau of Cannabis Handle [“BCC”] Cannabis – Delivery Dispensary kind.
  • Critique of City of Oakland Business enterprise License and Cannabis License.

When the due diligence was completed, we reviewed the policies and procedures for the operation of the business enterprise, like:

  • Critique of the Regular Operating Procedures [“SOPs”] for sales, marketing and advertising, merchandise handle, delivery practices, and personnel.
  • Critique of internal accounting controls more than the basic ledger, and gross receipts. These procedures will differ substantially if the LLC’s access to industrial banking is restricted.
  • In an instance in which an operating entity has restricted access to banking, comprehensive investigation is required to ascertain that money is effectively accounted for each in gross receipts and in the assets of the business enterprise.

California’s underground cannabis marketplace is nicely identified to all involved in the sector. We discovered initially-hand about some of these activities, particularly prior to the deployment of METRC on a widespread basis[2]. The point that may perhaps not be clear is that a Dispensary pays Cannabis Excise Tax [“CET”] on the cannabis and cannabis solutions it purchases from Distributors.

The record-maintaining systems typically utilized in the sector do not present a Dispensary with a summary of total CET paid to every Distributor. These deficiencies in record-maintaining make the course of action of auditing Distributors far extra problematic. These deficiencies also build a mechanism whereby underground operators can make use of arrangements with reputable licenses to acquire cannabis and cannabis solutions on which CET purportedly has currently been collected [and we presumably paid over to the California Dept. of Tax and Fee Administration [“CDTFA”] by the Distributor].

A California Dispensary has no direct reporting duty for CET at this time. We have queried several operators concerning the verification and archival of facts relating to CET paid in connection with purchases. We have received a assortment of responses.

Our subsequent methods involved a critique of gross receipts exactly where we:

  • Critique bank statements for the complete year and 1 further month on “both sides” with a view towards confirming that the deposits and other credits to the bank account tie to the Basic Ledger. Exactly where the entity lacks bank accounts, we use the money handle ledger to confirm money in a comparable style, maintaining in thoughts the distinctive troubles that money poses.
  • Examine the Basic Ledger totals for gross receipts with CDTFA quarterly filings for Sales Tax, and neighborhood jurisdiction [in this case Oakland] Gross Receipts Tax. Our concentrate is each on tying the total gross receipts in the quarterly filings to the Basic Ledger and on ascertaining that the taxes are effectively calculated on person delivery receipts, and on the quarterly filings.

When we have completed our critique methods above, we can present the client with an Engagement Letter and accept a client[3].

When we have accepted client pursuant to an executed Engagement Letter with a Cannabis Rider, we dig into the expense side of the entity.

  • Our initially step is to appear at persons that present solutions to the entity, whether or not as personnel or independent contractors [which includes consideration of all that comes with AB 5], as nicely as all of the employment tax and EDD filings and reporting and withholding for contractors.
  • We then concentrate on the allocation of payroll/contractor spend to functions inside the business enterprise for management, accounting/finance, safety, item management and delivery solutions. Numerous of the service invoices and expenditures will track the activity of personnel for allocation of expenditures to management, overhead, and IRC Sec. 280E non-deductible “trafficking expenses”.
  • If officer’s spend desires to be allocated to numerous functions, we make certain we do it on “white paper” statements that are appended to Type 1125-E.
  • We are going to leave the information of how the allocations described in the step above are accomplished, as we have created proprietary solutions that we deploy below the Cannabacus brand and we and other people have written extensively on the subject.

When the expense allocations are completed, we are at the point that we commence placing the facts on the tax return [Form 1120 – Corporation Tax Return].

  • We commence by creating certain that gross revenue per the basic ledger and tax return generally tie in.
  • We use Type 1125-A as the location exactly where we add “white paper” statements if there is something we need to have to add to the calculation of Price of Goods Sold {“COGS”].
  • We deliberately group all of the IRC Sec. 280E trafficking expense products on a “white paper” statement which seems on Schedule M-1 – [“ Reconciliation of Income/Loss Per Books with Income Per Return”] with linking references on other schedules inside the return exactly where 280E elements are broken out.
  • It is our view that a thorough job of highlighting and linking all of the products the IRS will appear for reduces the need to have forForms 8275 – Disclosure Statement and 8275-R Regulation Disclosure Statement as a consequence of disclosures inside the physique of the tax return.
  • A extremely robust caution should really be noted with respect to the bullets inside this caption. The author has virtually forty years of practical experience and “horse sense” about disclosure involving sensitive products connected to cannabis. A newer practitioner would be smart to seek the guidance of a CPA with an MST or a tax lawyer when facing disclosure choices as the presentation in a return establishes the manner in which the return is most likely to be audited.
  • A final point is in order…all of these yes/no checkbox inquiries are there for very good purpose and answering 1 the incorrect way can “set off bells” when the return is processed. Make certain you Very carefully Study AND ANSWER Just about every Query.
  • Make certain that exactly where you are asked for an identifier such as a social safety quantity, taxpayer identification quantity, Secretary of State Corporation quantity, and so forth., that you get it proper. Accuracy in the simplest of products can save hours of time in the future.
  • When the Federal Return is accomplished, the California Franchise Tax Return should really be fairly simple with the exception of California permitting IRC Sec. 280E expenditures for corporations.

[1] We note that our Dropbox Business enterprise is supplemented and hardened with a tool from Sookasa.com that tends to make it completely HIPAA compliant.

[2] We discovered fairly a bit about black marketplace scams involving these with Delivery Only Dispensary licenses, and that will be the topic of a separate write-up.

[3] We note that our critique up to this point has been to vet the client entity and its owners and to satisfy ourselves that there are no omissions of gross revenue. We note that the level of operate necessary in these methods is such that we generally request a non-refundable retainer of $two,500-$three,500 when we undertake the due diligence methods.

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