A Lesson on How NOT to go through an IRS Audit in the Cannabis Industry

The Raymond Chico and Ruby Chico v. Commissioner of the IRS court case filed September 16, 2019 is a prime example of how not to run a cannabis business. The case also highlighted the fact that poor recordkeeping can result in steep penalties during an IRS audit. In all reality, these lessons are applicable to multiple industries, but due to the greater likelihood of cannabis businesses being audited, the stakes of getting it right are much higher.

This link https://ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=12051 will take you to the full court case, but the basic summary is as follows:

  • Raymond and Ruby had four business activities during the years in question:
    • Residential Rental to a third party. This activity was reported on Form 1040 Schedule E.
    • Doobtubes- a company that marketed, manufactured and sold marijuana cigarette containers. This activity was reported on Form 1040 Schedule C.
    • Lakewood Patient Resource Center, Inc. – A medical marijuana dispensary with additional services. This was a C Corporation until an S election was filed in 2011. Operations ceased in 2011. No tax returns were filed for 2010 and 2011.
    • Ray’s Tax Services- Tax preparation services. This activity was reported on Form 1040 Schedule C.
  • Once under audit, the taxpayer failed to comply with the document request list from the Internal Revenue Service. Subsequently, the agent summoned bank account information for the time period covered and performed a bank deposit analysis to determine if there was any unreported income.
  • The auditor found significant unreported income as a result of the bank deposit analysis.
  • The auditor requested substantiation for many of the deductions taken on the various businesses. The taxpayer would not provide the requested support and as such, these deductions were disallowed.
  • As there were missing returns for Lakewood, the auditor recreated them and included unreported income on the taxpayer’s returns.
  • Due to the taxpayer’s familiarity with tax preparation and the extensive errors discovered, the auditor assessed fraud and accuracy-related penalties.
  • The court ultimately upheld the audit assessment for the main reason that the taxpayer could not or would not provide proof.

Key takeaways:

  • The Taxpayer is required to maintain sufficient records to allow the IRS to determine the correct tax liability. This pertains to both income and deductions claimed.
  • If you do not provide the information requested during audit, the IRS may use indirect methods to reconstruct income. Once they have reconstructed income, the burden of proof belongs to the taxpayer to prove why it is incorrect.

When starting a cannabis business, bookkeeping and maintaining quality records can be an afterthought. This court case is an important reminder that the impact of having poor records is far reaching, so don’t delay in seeking accounting assistance early on.


Written by Jennifer Terbrack, CPA, a manager in Maner Costerisan’s Tax Department.