California: Cannabis Client Due Diligence and Corporate Tax Return Preparation

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

As a practicing CPA, on occasion a single 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 in depth due diligence procedure prior to supplying our client an Engagement Letter in order to come to be familiar with the dirt in which these bushes develop.

A CPA really should By no means commence perform for any client, specially a client operating in the cannabis business, without the need of conducting due diligence and getting an Engagement Letter signed.

Our initial due diligence on the company entity, which we requested the client upload to a single Dropbox folder so we have every little thing in a single spot,[1] incorporated:

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

When the due diligence was completed, we reviewed the policies and procedures for the operation of the company, such as:

  • Overview of the Common Operating Procedures [“SOPs”] for sales, marketing and advertising, merchandise handle, delivery practices, and personnel.
  • Overview of internal accounting controls more than the common 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, in depth investigation is important to ascertain that money is adequately accounted for each in gross receipts and in the assets of the company.

California’s underground cannabis market place is nicely recognized to all involved in the business. We discovered 1st-hand about some of these activities, specially prior to the deployment of METRC on a widespread basis[2]. The point that may well not be apparent is that a Dispensary pays Cannabis Excise Tax [“CET”] on the cannabis and cannabis items it purchases from Distributors.

The record-maintaining systems commonly utilized in the business do not give a Dispensary with a summary of total CET paid to every Distributor. These deficiencies in record-maintaining make the procedure of auditing Distributors far a lot more problematic. These deficiencies also generate a mechanism whereby underground operators can use arrangements with reputable licenses to buy cannabis and cannabis items 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 many operators concerning the verification and archival of information and facts relating to CET paid in connection with purchases. We have received a wide variety of responses.

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

  • Overview bank statements for the whole year and a single more month on “both sides” with a view towards confirming that the deposits and other credits to the bank account tie to the Common Ledger. Exactly where the entity lacks bank accounts, we use the money handle ledger to confirm money in a related style, maintaining in thoughts the exceptional challenges that money poses.
  • Examine the Common 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 Common Ledger and on ascertaining that the taxes are adequately calculated on person delivery receipts, and on the quarterly filings.

When we have completed our critique actions above, we can give 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 1st step is to appear at persons that give solutions to the entity, no matter whether as workers 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 company for management, accounting/finance, safety, item management and delivery solutions. A lot of 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 wants to be allocated to numerous functions, we make positive we do it on “white paper” statements that are appended to Kind 1125-E.
  • We are going to leave the specifics of how the allocations described in the step above are carried out, as we have created proprietary strategies that we deploy beneath 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 start out placing the information and facts on the tax return [Form 1120 – Corporation Tax Return].

  • We start out by generating positive that gross earnings per the common ledger and tax return usually tie in.
  • We use Kind 1125-A as the spot exactly where we add “white paper” statements if there is something we require 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 require forForms 8275 – Disclosure Statement and 8275-R Regulation Disclosure Statement as a consequence of disclosures inside the physique of the tax return.
  • A quite powerful caution really should be noted with respect to the bullets inside this caption. The author has just about forty years of expertise and “horse sense” about disclosure involving sensitive products associated to cannabis. A newer practitioner would be sensible 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 superior explanation and answering a single the incorrect way can “set off bells” when the return is processed. Make positive you Meticulously Study AND ANSWER Each Query.
  • Make positive 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 on., that you get it proper. Accuracy in the simplest of products can save hours of time in the future.
  • When the Federal Return is carried out, the California Franchise Tax Return really should be somewhat simple with the exception of California permitting IRC Sec. 280E expenditures for corporations.

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

[2] We discovered rather a bit about black market place 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 earnings. We note that the level of perform needed in these actions is such that we ordinarily request a non-refundable retainer of $two,500-$three,500 when we undertake the due diligence actions.

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