California: Cannabis Client Due Diligence and Corporate Tax Return Preparation

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We normally create articles about ideas relating to economic management, specially with respect to tax management. Articles primarily based on abstract economic ideas are vital.

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

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We not too long ago 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 method prior to supplying our client an Engagement Letter in order to grow to be familiar with the dirt in which these bushes develop.

A CPA must In no way commence function for any client, specially a client operating in the cannabis market, with out 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 every thing in a single spot,[1] integrated:

  • Overview of the LLC Articles of Organization filed with the California Secretary of State.
  • Overview of the Information and 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 Type 8832 “Check the Box” Entity Classification Election.
  • Overview of the Bureau of Cannabis Manage [“BCC”] Cannabis – Delivery Dispensary kind.
  • Overview of City of Oakland Company License and Cannabis License.

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

  • Overview of the Typical 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, comprehensive investigation is important to ascertain that money is correctly accounted for each in gross receipts and in the assets of the business enterprise.

California’s underground cannabis market place is properly identified to all involved in the market. 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 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 commonly utilized in the market do not supply a Dispensary with a summary of total CET paid to every single Distributor. These deficiencies in record-maintaining make the method of auditing Distributors far much more problematic. These deficiencies also make a mechanism whereby underground operators can make use of arrangements with genuine licenses to buy 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 many operators relating to the verification and archival of facts relating to CET paid in connection with purchases. We have received a wide variety of responses.

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

  • Overview bank statements for the complete year and a single added 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 comparable style, maintaining in thoughts the special concerns that money poses.
  • Examine the Common Ledger totals for gross receipts with CDTFA quarterly filings for Sales Tax, and regional 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 correctly calculated on person delivery receipts, and on the quarterly filings.

As soon as we have completed our evaluation methods above, we can supply the client with an Engagement Letter and accept a client[3].

As soon as 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 supply solutions to the entity, regardless of whether as workers or independent contractors [which includes consideration of all that comes with AB 5], as properly 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, solution management and delivery solutions. Lots of of the service invoices and costs will track the activity of personnel for allocation of costs to management, overhead, and IRC Sec. 280E non-deductible “trafficking expenses”.
  • If officer’s spend requirements to be allocated to a variety of functions, we make positive 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 carried out, as we have created proprietary approaches that we deploy beneath the Cannabacus brand and we and other people have written extensively on the subject.

As soon as the expense allocations are completed, we are at the point that we start out placing the 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 constantly tie in.
  • We use Type 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 incredibly sturdy caution must be noted with respect to the bullets inside this caption. The author has just about forty years of knowledge 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 concerns are there for excellent cause and answering a single the incorrect way can “set off bells” when the return is processed. Make positive you Meticulously Study AND ANSWER Each and every 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 ideal. Accuracy in the simplest of products can save hours of time in the future.
  • As soon as the Federal Return is carried out, the California Franchise Tax Return must be somewhat simple with the exception of California enabling IRC Sec. 280E costs for corporations.

[1] We note that our Dropbox Company is supplemented and hardened with a tool from that tends to make it completely 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 post.

[3] We note that our evaluation 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 function necessary in these methods is such that we usually request a non-refundable retainer of $two,500-$three,500 when we undertake the due diligence methods.

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