IRS Audits and M&A Activity Escalate in the Cannabis Industry

Will You Be Ready When They Knock On Your Door?

CannaBlog by Cory Parnell, Chief Operating Officer, and Jim Marty, Chief Executive Officer of Bridge West

During 2020, we saw a significant increase in both IRS audits and Merger and Acquisition (“M&A”) activity for cannabis operators. At Bridge West, we believe that both IRS audits and M&A deals will escalate throughout 2021. Quite often, significant issues come to light when we are assisting cannabis operators with their IRS audits or with an M&A transaction. In fact, many of the issues are similar for either an IRS audit or in an M&A transaction.  In this CannaBlog, we will address the key issues that cause a significant increase in tax liability or cause a deal to not be completed.

To begin, we frequently review inadequate books and records that could either trigger an IRS audit or stand-out in M&A due diligence.  Below are some of the key areas that are often deficient:

• Recording Business Transactions. A good recordkeeping system includes a summary of your business transactions. Over 95% of Bridge West clients use QuickBooks to record business transactions and create journals and ledgers.   One nice feature with QuickBooks Online is the ability to attach supporting documents to transactions.  When onboarding new clients, we have seen instances where there is either no support for transactions, or the recorded transactions are lumped-in with multiple purchases.  Cannabis operators must keep records as long as they may be needed for the administration of any provision of the Internal Revenue Code.  Operators must keep records that support an item of income or deduction on a return until the period of limitations for that return runs out.
• Gross Receipts are the income the business has received. Operators should keep supporting documents that show the amounts and sources of your gross receipts. Documents that show gross receipts include cash register tapes, bank deposit slips, receipt books, and invoices. Also, the IRS or a potential buyer will perform a test to compare what is reported to the state on the monthly Sales and Use Tax returns. We have observed higher income on the financial statements than what is reported on the tax return. This ‘red flag’ will raise issues during an IRS audit or during due diligence in an M&A transaction.
• Inventory (Cost of Sales) is any item you either manufacture or buy which is then sold to a customer. If you are a cannabis manufacturer or producer, this includes the cost of all raw materials or parts purchased to manufacture the finished product.  Supporting documents should show the vendor that sold you the item and the amount paid. Documents reporting the cost of inventory include the following: canceled checks, cash register tape receipts, and credit card sales slips supported by the vendor invoice. These records will help determine the value of your inventory at the end of the year.  Your accounting records must be consistent with your financial statements and tax return.  It is also important to ensure that your inventory is based on either IRS Code Section 471a or 471c.  This includes plants that are still growing and harvested plants that are drying.  It is critical to have proper documentation regarding how your inventory complies with these IRS Code Sections.
• Selling, General, and Administrative Expenses are the costs you incur (other than the cost of inventory) to operate your cannabis business. Supporting documents should show the amount paid and document that the amount was for a business expense. Documents for expenses include canceled checks, account statements, credit card sales slips, supporting vendor invoices, and petty cash slips for small cash payments.
• Compliance with All Filing Requirements with the appropriate government agency is also important. Operators need to file all necessary forms for payroll, sales and use tax, personal property tax, and specific IRS reporting on a timely basis. We often see that the following IRS forms have not been filed: 1099-Misc, 1099-OID, 1099-Int, and Form 8300. Form 8300 is the filing that reports cash payments over $10,000 received in a trade or business. It applies to single transactions or a series of transactions over a 12-month period. We have observed where a seller did not file Forms 8300 and that terminated the deal negotiations.
• Financial Statements. Cannabis operators need precise records to prepare accurate financial statements. These include income statements and balance sheets. These statements can help operators manage their businesses and assist in relationships with your bank and/or creditors. At the end of each month, account balances on financial statements should be tied out to supporting documents.
• Federal and State Income Tax Returns. Cannabis operators need accurate records for tax return preparation. These records must support the reported income, expenses, and credits. These are the same records that are used to monitor your business and prepare your financial statements.

If one of your exit strategies is to sell to a publicly-traded Multiple State Operator (“MSO”) or a cannabis organization with plans of going public, you need to consider the items below. Most of the M&A activity in the cannabis industry has been performed by publicly traded MSOs, and they command the highest valuations in the marketplace.

• Inventory Observations should be completed at the end of the company’s fiscal or calendar year-end.  This is very important and time-sensitive.  It is also essential to maintain accurate inventory records, including cultivation yield results, conversion of yield into either finished goods or oils, and production reports of finished goods.  These production reports can be easily maintained on a spreadsheet where most operators track the production results.
• Inventory Production Information. It is important to maintain accurate inventory records like cultivation yield results, conversion of yield into either finished goods or oils, and production reports of finished goods.  These production reports can be maintained on a spreadsheet, as mentioned above.
• Financial Statements with Footnotes are important because footnotes will address all the accounting policies to ensure the financial statements are prepared in accordance with Generally Accepted Accounting Principles (GAAP). GAAP financial statements can be more complicated if the cannabis business has issued convertible debt, issued either warrants, stock options, or profit interests, completed a merger or acquisition, or issued various equity positions.

We have seen a number of M&A transactions terminated because the above ‘red flags’ were either not completed or it would have taken a significant amount of time to complete.

Be Ready, Be Prepared and Avoid Surprises

Bridge West recommends that cannabis organizations have all the above items to be prepared when the IRS or a potential buyer knocks at your door. Unfortunately, we have seen a lack of ‘auditable’ numbers as an M&A ‘deal killer’ – don’t let this happen to you!

If you are interested in discussing the issues addressed in this CannaBlog or any other matter, please contact Cory Parnell, COO of Bridge West at cparnell@bridgewestcpas.com and 651-287-6327 or Jim Marty, CEO of Bridge West at jmarty@bridgewestcpas.com and 303-651-0304.

Bride West is one of the first accounting firms to focus solely on the cannabis industry. Since 2009, the practice has expanded to more than 400 cannabis and hemp clients nationwide. To schedule a complimentary and confidential consultation with a member of our Leadership Team, please contact us.