Tax CDTFA includes CCT, CET, and Sales Taxes for Cannabis

by abizcannabis on April 20, 2019 Leave a Comment

Federal Legalization – Then What?

Federal Legalization – Then What? – It is fascinating to step back and observe how the mindset of many in the cannabis industry seems to work. Let’s think through a couple of scenarios and have a peek at the landscape in a post-legalization world. Let’s begin with the following:

STATES Act Becomes Law

The STATES Act passes in Congress, the President signs it and it becomes law which means that in the states where cannabis is legal:

Banking system becomes available to cannabis businesses.

IRC Sec. 280E is effectively repealed and cannabis businesses are no longer subject to the broad disallowance of expenses. [This result is dependent on the mark-up and amendments.]

[Note: while we don’t believe that anyone in Congress has proposed it yet, the Federal government could legalize cannabis for medical use [and perhaps for recreational use] and preempt many of the state laws. States could create more restrictive regimes, but could not authorize activities as permitted activities that federal law prohibited. Of course, federal prohibitions are limited by the Constitution. Such actions by the federal will create some very difficult paths because of policy distinctions arising from individual rights, public protections, commercial activities, health and safety, use of resources, etc.]

The Cannabis Trade Federation has published a white paper on the STATES Act that you can read here.

The STATES Act is a substantial improvement from the current situation but it does fully address:

Interstate commerce in connection sending cannabis product to [or “thru”] states which have not legalized cannabis.

The status of Indian Reservations and other similarly protected land has not been adequately addressed in the current version of the STATES Act which would subordinate tribal sovereignty to state law. [See The Murky Part of the STATES Act: Tribal Rights]

The substantial likelihood that Congress will enact a Federal Excise Tax on cannabis to both give the Federal government a “slice of the pie” and replace the revenue loss from the elimination of IRC Sec. 280E. A substantial excise tax of say, 20-25% without an exemption for medical use cannabis would create an additional financial disaster for those whose only interest in cannabis is for its benefit as a medicine.

The STATES Act is a “halfway approach that some will celebrate a victory, but many will be left out.” For a number of reasons, Congress must direct serious attention to whether a distinction should be made between medical and recreational use of cannabis.

Federal Legalization – Then What?

Removal of Cannabis from the Controlled Substances Act [“CSA”]

The broader solution that many advocates seek is either the removal of cannabis from Schedules 1 and 2 of the CSA or preferably the removal of cannabis from the CSA entirely. The removal or rescheduling of cannabis within the CSA could be accomplished via two different paths. The first and more conclusive would be through Congress legislation signed by the President. The second path would be the administrative action by the Drug Enforcement Agency [“DEA”] and its Diversion Control Division. We are not going to attempt to tackle the myriad policy issues of this alternative, but we do have some observations.

Once cannabis is removed from the CSA or rescheduled, cannabis will either become “medicine” or just another agricultural crop in the view of some people. The consequences of either may cause cannabis to lose much of its “special status” and become “just another plant”. However, it should be obvious to everyone that removing or rescheduling cannabis “isn’t that simple”. Cannabis is a drug with a lot of history.

We start our thinking with the question of how will any Federal regulations relating to cannabis be crafted? What agencies will have oversight at the Federal level? Will the mandate for the DEA be changed to oversee another special agricultural legal crop or a medicine? Will Federal legal cannabis be treated as if it is a type of prescription drug? Will the FDA become directly involved if cannabis becomes “medicine”? Will the IRS be given a new mandate to oversee and collect a new “Federal Cannabis Excise” tax? We regularly return to the maxim, “Be careful what you ask for because you may get it.”

The legalization of cannabis at the Federal level won’t directly do anything to change the licensing, regulation, or taxation of cannabis at the state level except to the extent it may have some preemptive impact. California’s cannabis regulatory agencies [CalCannabis in particular] must still revise, restructure and streamline their activities. Above all California’s agencies must simplify their licensing regimens. Licensing and reporting complexities are is the single greatest hurdle to reducing California’s flourishing underground cannabis industry.

We have written extensively about the critical need for restructuring and modification of the reporting and collection mechanisms utilized by the California Department of Tax and Fee Administration [“CDTFA”] for sales tax, cannabis cultivation tax [“CCT”] and cannabis excise tax [“CET”]. The most critical items include:

Legislation to add “responsible person” provisions for CCT and CET taxes.

Creation of a unique identifier for the reporting and remittance of tax payments from retailers, manufacturers, and cultivators to distributors to streamline the process of reconciling tax reporting and to permit CDTFA to rapidly identify and pursue non-compliant cannabis businesses [ See CCT – CET Collection Mechanics],

Mandate the use of segregated bank accounts [“trust accounts”] for cannabis taxes to better protect and preserve the funds that belong to the people of California [See CCT Collection Best Practices],

Federal Legalization – Then What?

We believe that there is a parallel urgent need for cannabis businesses to implement the technology and accounting infrastructure to develop, maintain and archive the records required by the myriad regulators. Our belief is that the single largest cause of the failure of cannabis industry businesses is going to be associated with failure to maintain those records, and remit proper amounts of cannabis taxes in a timely fashion.

The CDTFA audit process has the potential to be a bloodbath [ See Key to Success for California Cannabis Businesses – Managing Tax Liabilities]. We have yet to find a dispensary in California that is both properly calculating all of the cannabis taxes and presenting all of the required information on receipts [See Dispensaries Need Accurate Receipts].

Our recent posts have returned to a discussion of accounting/compliance platforms which include accounting software to maintain “books of account” [See Which Set of Books? ], point of sale systems for dispensaries, inventory management software, much more complex software for extractors, and a bridge to agency-level reporting under METRC See QBOnline-Boxstorm-METRC].

We have written a set of seven white papers that are available to the public to review. Our understanding is that many of our peers charge $5 – $7.5K for the same information. The subjects covered in the white papers are:

Brief Background of Legal Cannabis Regulation in California

Cannabis Business-Requirements for Books of Account, Transaction Recording, Method of Accounting and Record Retention for Federal Income Tax and California Cannabis Regulatory Requirements

Pass-thru Entities, Wages & Salaries, Non-Employee Compensation, Reasonable Compensation and IRC Sec. 199A Pass-Thru Entity Deduction

California Cannabis Distributor Responsibilities

A Methodology for Cost and Expense Allocations for IRC Sec.280E

California Cannabis Cultivation – Qualification as Farming

Inbound Investment Structuring

You can access the white papers to view here. We will be posting a procedure for registration to facilitate downloading copies. We have a special program for consultation with our professionals if readers have questions or would like assistance in implementation.

We find ourselves constantly reminding legal cannabis businesses that “legal” came with the conditions of “regulated” and “taxed” as the stimulus for government agencies to act. There is still much to be done to get kinks out of the regulatory and tax regimes. We intend to continue to publish our views and suggestions with respect to policy and operational reform.

At the same time, our experience and expertise are available to a cannabis business in California [and soon New York and Illinois] that would like to capitalize on it for the benefit of their own business. You can take the first step to work with us using the contact form below:

Federal Legalization – Then What?

by abizcannabis on April 17, 2019 Leave a Comment

California Cannabis Oil Tax

California Cannabis Oil Tax – this article is the companion to our article relating to the impact of taxes on the sale of cannabis flower. Our earlier article provided a simple illustration of the impact of taxes on the movement of flower through California’s commercial cannabis market. This article provides a simple illustration of the impact of taxes on the movement of cannabis oil through this market.

The following is a simplified illustration of the impact of the taxes that are directly and indirectly imposed on the movement of cannabis in the form of oil from a cultivator to consumers. The Taxes imposed on the commercial movement of cannabis in California are Cannabis Cultivation Tax (“CCT”); Cannabis Excise Tax (“CET); Sales Tax; City and County Cannabis Taxes; and California and Federal Income Taxes.

We have again prepared three Pie Charts to illustrate the impact of taxes on the division of the dollars generated from the movement of cannabis from cultivator to consumers in California in the form of oil. The Pie Charts below are based on the sale of ten kilograms of cannabis material by a cultivator to a single manufacturer. The manufacturer extracts and refines the oil. The manufacturer sells the oil to a single distributor. The distributor puts the oil in cartridges and sells the oil packaged for retail sale to a single dispensary. The dispensary sells the packaged oil cartridges to consumers. As compared to our flower article, the dollars collected from the consumers are now divided into five shares instead of four.

The total taxes imposed on cannabis oil will always be in the range of 45% when all of the taxes are taken into account. As a consequence, the Dispensary, Distributor, Manufacturer, and Cultivator will usually be competing for slightly more than ½ of the total dollars collected from consumers. The relative share of the total dollars each of the four businesses will receive after taxes will vary widely. As a general rule, the Cultivator will receive the smallest fraction.

For the purpose of illustration in the Pie Chart on the left, we have divided total dollars collected from the consumers between Taxes, Dispensary, Distributor, Manufacturer and Cultivator into five segments as follows: 45%, 15%, 15%, 15%, and 10%. The Pie Chart in the center illustrates the movement of cannabis material from a cultivator to consumers through an extraction, refinement and packaging process with specific dollar amounts. The Pie Chart in the center reflects the impact of Taxes other than the Income Taxes that will be incurred by the Dispensary, Distributor, Manufacturer and Cultivator based on the assumptions in the example. The Pie Chart on the right takes into account all Taxes including an estimate of the Income Taxes each of these business segments may incur

In the Pie Chart in the center, the Cultivator sells ten kilograms (10,000 grams) of cannabis material to a Manufacturer for $2,904.00, which includes the $968.00 of CCT associated with material ($0.2904 per gram total cost, including $0.0968 CCT). The Cultivator receives a payment of $1,936.00. The Manufacturer expressly assumes the $968.00 CCT liability of the Manufacturer.

The Manufacturer expends a total of $7,096.00 extracting oil from the material and refining the oil. The Manufacturer produces 1,000 grams of refined bulk oil which carries a cost to the Manufacturer of $10,000.00 ($7,096.00 + $2,904.00) including CCT of $968.00. The Manufacturer sells the refined oil to the Distributor for $12,000.00 plus $2,880.00 of CET. The Distributor assumes the Manufacturer’s $968.00 liability for CCT, as well as the liability for the $2,880.00 of CET attributable to the bulk oil.. The Manufacturer, receives a total payment of $11,032.00.

The Distributor packages the 1,000 grams of refined oil for retail sale in 2,000 tips of 0.5 gram each at a cost to the Distributor of $8,000.00. The Distributor marks-up the tips by an additional $4,000.00 and sells the 2,000 tips to the Dispensary for $12.00 each, a total of $24,000.00. The $24,000.00 price at which the tips are transferred to the Dispensary includes the $968.00 of CCT. The Distributor also adds $5,760.00 of CET which is collected from the Dispensary. The Distributor receives $29,760.00 in payment from the Dispensary. The Distributor owes $6,728.00 to the California Department of Tax and Fee Administration (“CDTFA”) for CCT ($968.00) and CET ($5,760.00).

The Dispensary marks-up the tips by $14,400.00. This is the mark-up assumed in the computation of the CET that the Distributor collected from the Dispensary. The Dispensary sells the tips to Consumers for $38,400.00 ($24,000.00 + $14,400). The total amount of Taxes the Dispensary collects from Consumers for the 2,000 tips is $13,800.00. These Taxes consists of: CET, $5,760.00 (15.0% x $38,400); Local Taxes of $3,840.00 (10% x $38,400.00); and Sales Tax of $4,200.00 (8.75% x $$48,000.00). The Dispensary collects a total of $52,200.00 from the Consumers. This amount converts into a purchase price per tip of $19.20 plus $6.90 of taxes.

The total taxes due to CDTFA and local governments from the Dispensary’s sale of these tips is $14,768.00 ($13,800.00 + $968.00). This amount does not include the California and Federal Income Tax that will be incurred by the Dispensary, Distributor, Manufacturer, and Cultivator. The Pie Chart in the center reflects the division of the $52,200.00 among Taxes other than Income Taxes, and the Dispensary, Distributor, Manufacturer, and Cultivator.

The percentage breakdown of the $52,200.00 illustrated in the Pie Chart in the center is taxes, 28.3%, Dispensary, 27.8%, Distributor, 23.0%; Manufacturer, 17.2% and Cultivator, 3,7%. Each of these businesses, Dispensary, Distributor, Manufacturer and Cultivator, must recover costs and make any profit from these fractions of the total dollars paid by consumers.

If we take into account an estimate of the Income Taxes that will be incurred by the Dispensary, Distributor, Manufacturer and Cultivator, the percentage of the $52,200.00 that is lost to taxes changes dramatically.

If we assume the Dispensary will pay income tax at a 40% rate on the full amount of the Dispensary’s $14,400.00 mark-up because of Internal Revenue Code (“IRC”) §280E, the Dispensary will have an Income Tax liability of $5,760.00. If we assume the Dispensary has operating expenses of $5,760.00, the Dispensary will have an after-tax income of $2,880.00, which is a 20% after-tax profit.

For the purpose of illustrating the impact of Income Taxes on the Distributor, Manufacturer and Cultivator, we will assume each of these businesses is also subject to a 40% income tax rate. We will also assume IRC §280E has no application to the Distributor, Manufacturer or Cultivator.

The Distributor will have an income tax liability of $1,600.00 and an after-tax profit of $2,400.00 based on operating expenses of $8,000.00, a mark-up of $4,000.00 and an income tax rate of 40%.

The Manufacturer has a cost of $7,096.00 and profit of $2,000.00 on the sale of the tips to the Distributor. The Manufacturer will have an income tax liability of $800.00 and an after-tax profit of $1,200.00.

The Cultivator will have an after-tax profit of $750.00 and an income tax liability of $500.00 under the same set of assumptions if the Cultivator’s operating expenses for the production of the cannabis material are $686.00.

Based on the preceding assumptions, the total income taxes imposed on the Dispensary, Distributor, Manufacturer and Cultivator will be $8,660.00 ($5,760.00 + $800.00 + $1,600.00 + $500.00) = $8,660.00). These assumptions regarding income taxes increase the total amount of Taxes due to various governmental agencies out of the $52,200.00 paid by consumers to the Dispensary to $23,428.00 ($14,768 + $8,660.00). The total amount left to be divided among the Dispensary, Distributor, Manufacturer and Cultivator after-taxes is $28,272.00 ($52,200.00 – $23,428.00). As the reader will immediately see, various governmental agencies will collect almost 45% of the $52,200.00 paid by consumers for this cannabis oil in Taxes.

When Income Taxes are taken into account based on the preceding assumptions, the percentage of the $52,200.00 allocated to taxes is 44.9%. The percentage of the $52,200.00 retained by each of the cannabis businesses after all Taxes are taken into account will be: Dispensary, 16.6%, Distributor, 19.9%, Manufacturer, 15.8% and Cultivator, 2.8%. Each of these businesses must recover their respective costs and take any profit from these fractions of the total dollars collected from cannabis consumers when all of the direct and indirect Taxes are taken into account.

As we have stated on multiple occasions, managing tax liabilities may well be the most important factor in the success of a California cannabis business. As we also regularly remind our readers, tax liabilities cannot be managed without financial record-keeping and tax reporting systems specifically designed for California’s cannabis industry.

California Cannabis Oil Tax

by abizcannabis on April 16, 2019 Leave a Comment

Key to Success for California Cannabis Businesses – Managing Tax Liabilities

Key to Success for California Cannabis

Businesses Managing Tax Liabilities

Key to Success for California Cannabis Businesses – Managing Tax Liabilities the key to the long-term success of every medical or adult-use cannabis business in California will be found in the management of tax liabilities. The usual reasons for long-term success in business – creativity, perseverance, experience, business acumen, and connections – are important. The management of the direct and indirect impact of the multiple taxes to which California cannabis businesses are subject, and the preparation and maintenance of the financial records required for the management of these tax liabilities, will, however, prove to be the single most important factor in the success of a California cannabis business in the long-term.

Do not stop reading this article based on the premise the above statement does not apply to you because you are a well-established cultivator and the bulk of the taxes on cannabis apply to dispensaries and distributors. Taxes impact the amount a cultivator will receive. All of the money that various governmental agencies take out of California’s cannabis industry is not available to pay costs and to provide profits. Cultivators, distributors, and dispensaries must split the money that is left after all of the taxes on cannabis are paid.

We are, of course, addressing the long-term success of fully-licensed, fully-compliant, fully tax-reporting California cannabis businesses. As anyone familiar with California’s cannabis industry is aware, most California cannabis businesses do not qualify as fully-licensed, compliant, tax-reporting businesses. The majority of California cannabis businesses are wholly or partially non-compliant. Many California cannabis businesses are trying to be fully compliant taxpayers, but it is not an easy course.

This article was prepared to illustrate the impact of the total tax load on California’s commercial cannabis industry. This article utilizes a simple example to illustrate the totality of the taxes that are directly and indirectly imposed on the commercial movement of cannabis in California from a cultivator to consumers. The totality of the taxes imposed on California’s cannabis industry are: Cannabis Cultivation Tax (“CCT”); Cannabis Excise Tax (“CET); Sales Tax; City and County Cannabis Taxes; and not to be forgotten California and Federal Income Taxes.

Key to Success

As is noted above, even for those California cannabis businesses that do not appear to be impacted by most of the taxes imposed on cannabis, an understanding of the effect of these taxes is critical to success. Taxes dramatically impact the prices at which cannabis is transferred between segments of the industry even if the taxes are not directly imposed on a particular segment.

We have prepared three Pie Charts to illustrate the impact of taxes on California cannabis businesses. The illustrations below are based on the transfer of a pound of flower by a cultivator through a single distributor to a single dispensary that sells the flower to consumers.

The Pie Chart on the left reflects a division of dollars between taxes, dispensary, distributor and cultivator based on an arbitrary percentage of the total amount paid by the consumers. In this Pie Chart, 40% of the total dollars collected from the consumers are allocated to taxes and the remaining 60% of the total dollars are divided equally between the Dispensary, the Distributor and the Cultivator. In reality, the percentage of the money collected from consumers from a sale of flower that will ultimately be paid over in taxes by a cannabis business will range from 30% to over 50%.

In all instances involving the commercial movement of cannabis from cultivator to consumer in California, the total taxes collected and paid over to governmental agencies in connection with a sale of flower will generally be around 40+% when all of the taxes are taken into account. Each of the Dispensary, Distributor, and Cultivator will receive 15%-25% of the money that remains from a commercial sale of the flower. In the Pie Chart on the left, we divided the remaining 60% of the total dollars equally between the Dispensary, the Distributor and the Cultivator. We made the divisions between the four segments of the Pie Chart broad in order to illustrate that there will always be a range to the share of the total dollars that will be received by a particular segment in a particular instance.

The Pie Chart in the center illustrates the movement of flower from a cultivator to consumers with the dollar amounts we have attributed to these transactions in our example. The Pie Chart in the center does not take into account the estimated income taxes that will be incurred by the Dispensary, Distributor, and Cultivator. The Pie Chart on the right takes into account the income taxes that we estimate will be incurred.

In the Pie Chart in the center, the Cultivator sells one pound of flower to a Distributor for $852.00 and the Distributor assumes the $148.00 of CCT associated with the pound of flower. The Distributor processes the flower into retail packages. The Distributor marks up the pound of flower by $600.00 and sells the flower to the Dispensary for $1,600.00. The $1,600.00 price at which the pound of flower is transferred to the Dispensary includes the $148.00 of CCT. The Distributor also adds $384.00 of CET which is collected from the Dispensary. The Distributor receives $1,984.00 in payment from the Dispensary. The Distributor owes $532.00 to the California Department of Tax and Fee Administration (“CDTFA”) for CCT ($148.00) and CET ($384.00).

The Dispensary marks-up the flower by $960.00. This is the mark-up assumed in the computation of the CET that the Distributor collected from the Dispensary. The Dispensary sells the flower to Consumers for $2,560.00 plus $920.00 of taxes (CET, Local Taxes, and Sales Tax) which the Dispensary collects from the Consumers. The total amount collected by the dispensary for the pound of flower is $3,480.00. The total taxes the Dispensary collects of from the Consumers for the pound of flower of $920.00 consists of: CET, $384.00; Local Taxes of $256.00 (10% x $2,560.00); and Sales Tax of $280.00 (8.75% x $3,200.00).

The total taxes due CDTFA and local governments from this sale of cannabis flower are $1,068.00 ($920.00 + $148.00). This amount does not include the California and Federal Income Tax that will be incurred by the Dispensary, Distributor and Cultivator. The Pie Chart in the center reflects the division of the $3,480.00 among taxes, Dispensary, Distributor and Cultivator without consideration of income taxes. The percentage breakdown of the $3,480.00 illustrated in the Pie Chart in the center is: taxes, 30.8%, Dispensary, 27.6%, Distributor, 17.2% and Cultivator, 24.4%.

Key to Success

If we take into account the estimated income taxes that will be incurred by the Dispensary, Distributor and Cultivator, the percentage of the $3,480.00 that is lost to taxes moves significantly above 40%. If we assume the Dispensary will pay income tax at a 40% rate on the full amount of the Dispensary’s $960.00 mark-up because of Internal Revenue Code (“IRC”) §260E, the Dispensary will have an income tax liability of $384.00. If we assume the Dispensary has operating expenses of $384.00, the Dispensary will have an after-tax income of $192.00, which is a 20% after-tax profit.

For the purpose of illustrating the impact of income taxes on the Distributor and the Cultivator, we will assume each of these businesses is also subject to a 40% income tax rate and achieves a 20% after-tax profit. We will also assume IRC §280E has no application to the Distributor or the Cultivator. The Distributor will have an income tax liability of $80.00 and after-tax profit of $120.00 ($600.00 x 20%), if its operating expenses are $400.00 and the income tax rate is 40%. The Cultivator will have an after-tax profit of $170.40 ($852.00 x 20%) and an income tax liability of $113.60 ($284.00-$170.40 = $113.60) under the same set of assumptions if the Cultivator’s operating expenses are $568.00.

Based on the preceding assumptions, the total income taxes imposed on the Dispensary, Distributor and Cultivator will be $577.60 ($384.00 + $80.00 + $113.60). These assumptions regarding income taxes increase the total amount of taxes due various governmental agencies out of the $3,480.00 paid by the Consumers to $1,645.60. The total amount left to be divided among the Dispensary, Distributor and Cultivator after-taxes is $1,834.40. As the reader will immediately see, significantly more than 40% of the $3,480.00 paid by the Consumers for the pound of flower will be paid by one of the three cannabis businesses in taxes to various governmental agencies.

When income taxes are taken into account based on the preceding assumptions, the percentage of the $3,480.00 allocated to taxes is 47.3%. The percentage of the $3,480.00 retained by each of the cannabis businesses after all taxes are taken into account will be: Dispensary, 16.6%, Distributor, 14.90% and Cultivator, 21.2%. Each of these businesses must recover their costs and make their profit from these modest percentages of the total dollars collected from cannabis consumers. Of course, if a California cannabis business, other than a dispensary does not make a profit, income taxes are moot. However, a dispensary may have an income tax liability even if it loses money because of IRC §280E under the present state of the law.

Can anyone interested in the successful operation of a cannabis business in California doubt that the management of the collection, reporting, and remittance of the many taxes imposed on California’s cannabis industry is critical to success?

Key to Success

We prepared the preceding as one of several articles we will publish to the significance of the impact of taxes on California cannabis businesses. The next article will be similar to the preceding. The next article will illustrate the impact of taxes on extracted cannabis oil.

Tax management demands professional expertise. Tax liabilities cannot be managed in the absence of financial record-keeping and tax reporting systems that are specifically designed for the industry and for the business function within the industry.

Key to Success

by abizcannabis on April 14, 2019 Leave a Comment

Lines We Don’t Cross

Lines We Don’t Cross – it is April 14 and we should have had a very smooth day with one day to go to the tax filing deadline. Unfortunately, we had an experience that was both disappointing and potentially harmful to everyone involved. Let’s begin by screaming at the top of our lungs “JUST BECAUSE CANNABIS IS LEGAL IN CALIFORNIA UNDER CERTAIN CIRCUMSTANCES, IT DOESN’T GIVE ANYONE A GET OUT OF JAIL FREE CARD!!!”. The simplest way to address this issue without turning it into a rant is for us to reiterate the rules proscribed by various agencies that regulate Circular 230 practitioners in California. [By doing so, no one that has seen this post, can ever say that they were not aware of the rules. We should be able to lay out sufficient bright lines with those rules such that we can avoid a discourse about the conduct of specific business owners or their advisors.

The reason we have chosen to frame the discussion by reference to the rules that govern Circular 230 Practitioners is that we seem to be getting a disproportionate number of questions about “is it ok to…” and finish the sentence with myriad forms of conduct that could land a business owner in prison and be a death penalty for a professional license. We have one very simple thought…we don’t have, have NEVER had, and NEVER will have a client that could offer us ANYTHING, let alone $$$ that would cause us to consider any form of conduct that might put reputation, let alone a professional license at risk…PERIOD.

The California Board of Accountancy [“CBA”] Regulations state

§ 58. Compliance with Standards. Licensees engaged in the practice of public accountancy shall comply with all applicable professional standards, including but not limited to generally accepted accounting principles and generally accepted auditing standards.

Note: Authority cited: Sections 5010 and 5018, Business and Professions Code. Reference: Section 5018, Business and Professions Code.

The CBA regulations effectively incorporate Circular 230, PCAOB, AICPA and CalCPA rules by reference.

AICPA and CalCPA have:

Acts Discreditable RULE 501. A member shall not commit an act discreditable to the profession.

The California Bar has the following rule for practicing attorneys admitted in California.

Rule 8.4 Misconduct (Rule Approved by the Supreme Court, Effective November 1, 2018)
It is professional misconduct for a lawyer to:
(a) violate these rules or the State Bar Act, knowingly* assist, solicit, or induce another to do so, or do so through the acts of another;
(b) commit a criminal act that reflects adversely on the lawyer’s honesty, trustworthiness, or fitness as a lawyer in other respects;
(c) engage in conduct involving dishonesty, fraud,* deceit, or reckless or intentional misrepresentation;
(d) engage in conduct that is prejudicial to the administration of justice;
(e) state or imply an ability to influence improperly a government agency or official, or to achieve results by means that violate these rules, the State Bar Act, or other law; or
(f) knowingly* assist, solicit, or induce a judge or judicial officer in conduct that is a violation of an applicable code of judicial ethics or code of judicial conduct, or other law. For purposes of this rule, “judge” and “judicial officer” have the same meaning as in rule 3.5(c).

The IRS Office of Professional Responsibility enforces – Circular 230 – Paragraph 51 – Incompetence and Disreputable Conduct –

(a) Incompetence and disreputable conduct. Incompetence and disreputable conduct for which a practitioner may be sanctioned under §10.50 includes, but is not limited to —
(1) Conviction of any criminal offense under the Federal tax laws.
(2) Conviction of any criminal offense involving dishonesty or breach of trust.
(3) Conviction of any felony under Federal or State law for which the conduct involved renders the practitioner unfit to practice before the Internal Revenue Service.
(4) Giving false or misleading information, or participating in any way in the giving of false or misleading information to the Department of the Treasury or any officer or employee thereof, or to any tribunal authorized to pass upon Federal tax matters, in connection with any matter pending or likely to be pending before them, knowing the information to be false or misleading. Facts or other matters contained in testimony, Federal tax returns, financial statements, applications for enrollment, affidavits, declarations, and any other document or statement, written or oral, are included in the term “information.”
(5) Solicitation of employment as prohibited under §10.30, the use of false or misleading representations with intent to deceive a client or prospective client in order to procure employment, or intimating that the practitioner is able improperly to obtain special consideration or action from the Internal Revenue Service or any officer or employee thereof.
(6) Willfully failing to make a Federal tax return in violation of the Federal tax laws, or willfully evading, attempting to evade, or participating in any way in evading or attempting to evade any assessment or payment of any Federal tax.
(7) Willfully assisting, counseling, encouraging a client or prospective client in violating, or suggesting to a client or prospective client to violate, any Federal tax law, or knowingly counseling or suggesting to a client or prospective client an illegal plan to evade Federal taxes or payment thereof.
(8) Misappropriation of, or failure properly or promptly to remit, funds received from a client for the purpose of payment of taxes or other obligations due to the United States.
(9) Directly or indirectly attempting to influence, or offering or agreeing to attempt to influence, the official action of any officer or employee of the Internal Revenue Service by the use of threats, false accusations, duress or coercion, by the offer of any special inducement or promise of an advantage or by the bestowing of any gift, favor or thing of value.
(10) Disbarment or suspension from practice as an attorney, certified public accountant, public accountant, or actuary by any duly constituted authority of any State, territory, or possession of the United States, including a Commonwealth, or the District of Columbia, any Federal court of record or any Federal agency, body or board.
(11) Knowingly aiding and abetting another person to practice before the Internal Revenue Service during a period of suspension, disbarment or ineligibility of such other person.
(12) Contemptuous conduct in connection with practice before the Internal Revenue Service, including the use of abusive language, making false accusations or statements, knowing them to be false, or circulating or publishing malicious or libelous matter.
(13) Giving a false opinion, knowingly, recklessly, or through gross incompetence, including an opinion which is intentionally or recklessly misleading, or engaging in a pattern of providing incompetent opinions on questions arising under the Federal tax laws. False opinions described in this paragraph (a)(l3) include those which reflect or result from a knowing misstatement of fact or law, from an assertion of a position known to be unwarranted under existing law, from counseling or assisting in conduct known to be illegal or fraudulent, from concealing matters required by law to be revealed, or from consciously disregarding information indicating that material facts expressed in the opinion or offering material are false or misleading. For purposes of this paragraph (a)(13), reckless conduct is a highly unreasonable omission or misrepresentation involving an extreme departure from the standards of ordinary care that a practitioner should observe under the circumstances. A pattern of conduct is a factor that will be taken into account in determining whether a practitioner acted knowingly, recklessly, or through gross incompetence. Gross incompetence includes conduct that reflects gross indifference, preparation which is grossly inadequate under the circumstances, and a consistent failure to perform obligations to the client.
(14) Willfully failing to sign a tax return prepared by the practitioner when the practitioner’s signature is required by Federal tax laws unless the failure is due to reasonable cause and not due to willful neglect.
(15) Willfully disclosing or otherwise using a tax return or tax return information in a manner not authorized by the Internal Revenue Code, contrary to the order of a court of competent jurisdiction, or contrary to the order of an administrative law judge in a proceeding instituted under §10.60.
(16) Willfully failing to file on magnetic or other electronic media a tax return prepared by the practitioner when the practitioner is required to do so by the Federal tax laws unless the failure is due to reasonable cause and not due to willful neglect.
(17) Willfully preparing all or substantially all of, or signing, a tax return or claim for refund when the practitioner does not possess a current or otherwise valid preparer tax identification number or other prescribed identifying number.
(18) Willfully representing a taxpayer before an officer or employee of the Internal Revenue Service unless the practitioner is authorized to do so pursuant to this part.
(b) Effective/applicability date. This section is applicable beginning August 2, 2011.
If you happen to become aware of a licensed professional that has violated any of these rules, REPORT THEM TO THAT APPROPRIATE REGULATORY AGENCY IMMEDIATELY. if you aren’t sure, REPORT THEM ANYWAY AND LET THE REGULATORS DECIDE.
The question of whether the legal cannabis industry in California succeeds or fails is going to be determined by compliance with tax and regulatory provisions going forward. Let’s not shoot ourselves in the head.

Lines We Don’t Cross

by abizcannabis on March 18, 2019 Leave a Comment

CCIA Policy Conference What’s Missing?

CCIA Policy Conference What’s Missing? – On Wednesday, March 20, 2019, the California Cannabis Industry Association (“CCIA”) will host its 4th Annual Policy Conference in Sacramento, California. The conference has a notable line-up of representatives from the legislative and administrative branches of California government, including Nicole Elliott, Senior Advisor on Cannabis, Governor’s Office of Business and Economic Development; Hon. Wendy Carrillo, Assembly, District 51; Hon. Reggie Jones-Sawyer, Assembly, District 59; Hon. Scott Wiener, Senator, District 11; Hon. Scott Wilk, Senator, District 21; Hon. Ricardo Lara, Insurance Commissioner; Lori Ajax, Chief, Bureau of Cannabis Control; Christina Dempsey, Manager, California Department of Public Health; Nicolas Maduros, Director, California Department of Tax and Fee Administration; and Richard Parrott, Director, California Department of Food and Agriculture.

The conference also has an impressive line-up of keynote Speeches, Presentations, and Sessions. There are keynote speeches from government representatives as follows: Hon. Ricardo Lara, California Insurance Commissioner; and Nicole Elliott, Governor’s Office. There is another keynote speech of particular interest to us for the reasons discussed below: Importance of Associations: Taking a Closer Look, Saphira Galoob, The Liaison Group.

There are a couple of Panels that are certainly timely in view of the description of California’s regulation of its cannabis industry by those who claim to be most knowledgeable regarding the cannabis industry as maladroit: State of Cannabis Regulations, moderated by Sean Luse, Berkeley Patients Group; and 2019 Policy Development & Legislation, moderated by Amy Jenkins, CCIA.

There are also a couple of Sessions that should prove interesting: Challenges and Opportunities in Cannabis Testing, moderated by Emily Richardson, CW Analytical Labs; and Distribution: The Gateway or Cog to Stability, moderated by Elizabeth Conway, Surterra Wellness.

There are four Workshops that should prove helpful for some attendees: Ensuring the Cannabis Industry, moderated by Stacey Jackson, Golden Bear Insurance; Compliance: An In-Depth Look at What You Need to Know, moderated by Henry Wyckowski, Wykowski Law; Branding – The Experts Weigh in on What You Need to Know, moderated by Robert O’Shaughnessy, The Higher Ground Agency; and The President Signed the 2018 Farm Bill, Legalizing Hemp – What Next for Cannabis Businesses?, moderated by Kristin Nevedal, International Cannabis Farmers Association.

The preceding summarizes the apparent coverage of CCIA’s 4th Annual Policy Conference. Most of our readers will have seen one or more advertisements for this conference so the preceding provides nothing new. We have written this note, however, to question why it appears so many significant policy issues for California’s medical and adult-use cannabis industry are not being addressed at this conference.

Let us start with some broad policy questions that we believe should be asked. Why has California’s roll-out of its regulatory structure been described as “maladroit” in s recent financial analysis of the cannabis industry? Why have so few individuals who have involved California’s cannabis industry prior to the first steps toward regulation not been able to become incorporated into a regulated industry? Why did California fail to collect millions of dollars in tax revenue that it projected it would collect? Why do California’s cannabis regulatory agencies so frequently appear to be working at cross purposes to California’s cities and counties? Why does it appear neither CCIA nor California’s cannabis regulatory agencies are interested in developing more effective coordination of the cannabis industry with California’s cities and counties?

There is a keynote speech – Importance of Associations: Taking a Closer Look – but both the interests of independent cannabis businesses and associations of California cannabis businesses appear to be unrepresented at the conference. Where is the California Association of Independent Dispensaries? Where is the Association of Los Angeles Dispensaries? Where is the Sierra Foothills Growers Association? Where is the California Growers Association? Where is the Southern California Growers Association? Where is the Association of Delivery-Only Dispensaries?

Let us return to the missing tax dollars. The simplistic answer given by many is that cannabis taxes are too high and California’s cannabis regulations are too onerous. The failure of the California Department of Tax and Fee Administration (“CDTFA”) to require financial record-keeping and tax return reporting that ties into such financial record-keeping is a far more significant cause of the failure of CDTFA to collect the taxes it should have collected from licensed businesses. California cannot reasonably expect to collect the taxes it should collect if it does not require California cannabis businesses to keep accurate and complete financial records. California has also made it unnecessarily difficult to become a licensed and regulated cannabis business. California cannot expect cannabis businesses to become taxpayers if it does not make it easy to become a regulated cannabis business.

Let us turn to another topic. Have California’s legislative and administrative policymakers forgotten that Proposition 64 preserved all of the rights granted to Californians under Proposition 215? [See Keeping the Promise of Proposition 215] Most of the policymakers who are molding California cannabis industry at the present time have forgotten, or never knew, that former Governor Brown very likely did more to shape California’s cannabis industry with his 2008 memorandum when he was Attorney General than any single policymaker. The principles expressed in that memorandum remain valid today. The Proposition 215 rights granted Californians were preserved in Proposition 64. Medical cannabis distribution will begin making a comeback in California as soon as the financial advantages of medical cannabis over adult-use cannabis again come to the forefront.

Let us close by positing a broad policy question that cuts across all of cannabis regulatory agencies and cannabis regulations that have created such confusion and turmoil throughout California’s cannabis industry. Did California’s cannabis regulatory agencies err in failing to follow two underlying principles in their approach to regulation? We believe California should have adopted the two principles that follow. First, California’s cannabis regulatory agencies should have deferred all issues relating to land use and public health and safety to local jurisdictions to the maximum extent possible. Second, to the maximum extent possible California’s cannabis regulatory agencies should have made it as easy as possible for California’s existing cannabis businesses that were locally acceptable to become California licensed cannabis businesses.

by abizcannabis on March 4, 2019 Leave a Comment

CDTFA Cannabis Tax Audits

CDTFA Cannabis Tax Audits – on February 28, 2019, we published [Dispensaries Need Accurate Receipts] to describe the financial records a dispensary must prepare and maintain as well as the receipts a dispensary must issue to

its customers to establish that it has complied with its tax reporting responsibilities. We published our [Which Set of Books?] note to provide every California dispensary with a guide for the preparation and maintenance of the financial records a dispensary needs in order to be prepared for the inevitable tax audit.

We are publishing this note to describe the how quickly, efficiently and accurately the California Department of Tax and Fee Administration (“CDTFA”) will be able to select cannabis businesses for compliance audits relating to CCT and CET. Many millions of dollars are missing from California’s coffers. We have described in other notes some of the reasons. CDTFA is under substantial pressure to collect the missing revenue or to explain that all of the tax revenue that should have been collected by California has in fact been collected. Anyone with minimal knowledge relating to California’s cannabis industry knows the latter is not true. Consequently, audits are coming, and they are coming quickly.

CDTFA bears some of the responsibility for lagging tax collections, although we doubt CDTFA will accept significant responsibility for the tax shortfall. CDTFA will concentrate on finding taxpayers that did not pay their full share while pointing out the Bureau of Cannabis Control (“BCC”), the California Department of Food and Agriculture (“CDFA”) CalCannabis, and the California Department of Public Health (“CDPH”) MCSB have disincentivized underground cannabis businesses from “becoming legit” through onerous regulations.

How will CDTFA proceed and what cannabis businesses should be most concerned? CDTFA will utilize Sales Tax and Sales Tax Examiners as the starting point for finding missing tax revenue. There are multiple reasons. Local governments that imposed cannabis taxes lack the staff and the experience required to effectively conduct audits. Both the Cannabis Cultivation Tax (“CCT”) and the Cannabis Excise Tax (“CET”) are newly enacted taxes. No one has experience with the auditing of tax returns reporting CCT and CET.

CDTFA has a substantial number of experienced Sales Tax Examiners. Dispensaries collect 90+% of the taxes imposed on California’s cannabis businesses. CDTFA will “follow the money.” CDTFA will begin its search for lost tax revenue with Sales Tax audits of dispensaries.

Sales tax audits are easy audits from the standpoint of tax audit efficiency. Sales tax audits of dispensaries are comparable to audits of bars. An experienced Sales Tax Examiner will be able to make an initial selection of those California dispensaries that merit a serious audit based on an in-office analysis of a dispensary’s Sales Tax returns and cursory in-person inspection of the dispensary’s activities. An experienced Sales Tax Examiner will first confirm that it appears substantially all of the sales by the dispensary are being entered into the dispensary’s records as retail sales. This confirmation will be based on customer traffic and average retail sale ticket.

The Examiner will then compare the reported retail sales for a couple of monthly periods to the dispensary’s inventory turn-over. The Examiner will generally compare the amounts for two separate months with the totals for the calendar year. If the amounts for the complete year and the two months that were examined fall within expected ranges, the Examiner will turn to another item.

An experienced Sales Tax Examiner will separately examine the dispensary’s record-keeping relating to the collection, accounting for, and remittance of all of the taxes a dispensary collects from consumers – Sales Tax, CET and local cannabis taxes. A California dispensary is required to collect CET from its consumers. In most instances, it will also collect local cannabis taxes. It is likely the preparation and maintenance of proper records that accurately account for the collection and remittance of all of the taxes collected from consumers will prove the downfall of most dispensaries. We have yet to encounter a dispensary with record-keeping practices that we consider adequate to successfully survive a Sales Tax audit.

There is another aspect of a Sales Tax audit of a dispensary that we must discuss. The Sales Tax Examiner will examine and secure copies of the dispensary’s payments of CET to distributors. There are two reasons the Examiner will examine and copy the records that tie the cannabis inventory purchased by the dispensary and the amount of CET paid to each of the distributors that sold cannabis products to the dispensary. The Examiner will, of course, use this information to determine the accuracy of the dispensary’s payment of the CET it collects from customers to distributors. This information will also be used as a foundation for spot-checking the accuracy of the collection and remittance of CET by distributors which will also be discussed in this note as the examination of distributors will also be an immediate focus of CDTFA and its stable of Sales Tax Examiners.

CDTFA will also focus on distributors in following the flow of money in California’s cannabis industry. We have already identified distributors as the location of the “three black holes” into which a significant portion of California’s missing tax revenue disappeared. We also have described the difficulties distributors face in preparing and maintaining financial records that will be adequate for a distributor to successfully survive an audit.

Distributors are responsible for collecting and paying over both CCT and CET to CDTFA. Distributors purchase cannabis inventory from cultivators without paying Sales Tax by giving the cultivators their Resale License numbers. A distributor is required to collect, account for, and pay-over to CDTFA the CCT associated with each purchase of cannabis inventory from a cultivator. A distributor is required to maintain inventories of its purchases and the associated CCT that is part of a distributor’s inventory costs.

A distributor adds processing costs to its cost of inventory. A distributor then sells separate portions of its cannabis inventory. With each separate sale from cannabis inventory, a distributor must account for the removal of the inventory at its inventory cost on its books and add CET to a sale price of the inventory. A distributor is required to collect CET from the purchaser of the inventory based on the California 160% mark-up of the sale price of the inventory by the distributor to assumed retail sale price. The inventory sold also has an associated CCT that is included in the sale price of the inventory and is due to the CDTFA. The distributor will also adjust its cost of inventory to reflect the sale of a portion of its inventory.

A distributor will secure a Resale License number from a dispensary in order to avoid paying Sales Tax on sales of inventory items. A distributor is required to file a Sales Tax return to report the sale as a sale exempt from Sales Tax. An experienced Sales Tax Examiner can easily determine whether it is likely a distributor has significantly underpaid either CCT or CET through an in-office review of the various tax returns a distributor is required to file with CDTFA. The sales revenue, associated CET and CCT, and inventory costs follow a pattern. The pattern for the flow of cannabis product through a distributor should match the flow of money reported in the various tax returns filed with CDTFA. If it does not, the Examiner will conclude the distributor merits in-depth examination even though there may be an explanation for the deviation.

The point of the preceding is that the returns that distributors file with CDTFA convey enough information to provide a guide for CDTFA to decide which distributors should be audited. California’s experienced Sales Tax Examiners rank among the best. CDTFA has two new taxes to collect and a strong incentive to utilize them.

The only individuals involved in California’s cannabis industry that have experience with the type of audits CDTFA will conduct relating to CCT and CET are individuals who have experience with bar audits or excise tax audits. Those individuals in California’s cannabis industry who have been involved with income tax audits by the IRS are ill-prepared for CDTFA audits relating to CCT and CET.

We must add that we believe most California distributors, like most dispensaries, lack adequate records to successfully survive an audit by CDTFA for CCT and CET.

Tax - CDTFA

Federal Legalization – Then What?

Federal Legalization – Then What?

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