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.