High Times?: Concerns, Risks for CPAs Working with Marijuana Businesses

in 1996 California voters passed Proposition 215, also known as the Compassionate Use Act of 1996 (CUA), which allows patients and their primary caregivers to cultivate or possess marijuana for personal medical treatment with the recommendation of a physician. In 2003, Senate Bill 420, commonly referred to as the Medical Marijuana Program Act (MMP) was enacted to establish statewide guidelines for Proposition 215 enforcement.

Under the MMP, qualified patients and their designated caregivers are entitled to "associate within the State of California in order to collectively or cooperatively to cultivate marijuana for medical purposes."

There are 23 states with some form of marijuana legalization for use, possession or distribution. In Colorado, Washington, Oregon, Alaska and Washington, D.C., laws to varying degrees have decriminalized the recreational use of marijuana. However, under federal law it's unlawful to manufacture, distribute, dispense or posses any Schedule I controlled substance (21 U.S.C. Sec. 801). Marijuana is classified as such under the Controlled Substance Act (CSA).

Possession and Trafficking of Marijuana

There are several federal statutory schemes that can be and are being used to regulate the growth of the marijuana business. Among them are the Internal Revenue Code and Bank Secrecy Act (BSA).

Internal Revenue Code

Though a marijuana business is illegal under federal law, it is obligated to pay federal income tax on its taxable income because IRC Sec. 61 (a) does not differentiate between income derived from legal and illegal sources. Income from manufacturing, distribution or dispensing of marijuana, as it is classified under the CSA, is an illegal source income for federal income tax purposes.

Generally, businesses are allowed to deduct ordinary and necessary expenses incurred in carrying on a trade or business under Sec. 162(a). However, Sec. 280E provides that "no deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act) which is prohibited by federal law or the law of any state in which such trade or business is conducted."

Since marijuana is a Schedule I controlled substance under the CSA, Sec. 280E applies to a marijuana business. In enacting Sec. 280E, Congress explained that the disallowance of deductions related to trafficking of illegal substances docs not preclude the adjustment to gross receipts with respect to effective cost of goods sold. The 1RS issued a Chief Counsel Advisory Jan. 23 on determining cost of goods sold for taxpayers subject lo 280E limitations.

Sec. 280E does not preclude the deduction of expenses attributable to a trade or business other than that of illegal trafficking in controlled substances merely because the taxpayer also is involved in trafficking in a controlled substance (see Californians Helping to Alleviate Medical Problems, 128 TC 173, 183).

Bank Secrecy Act

The Treasury Department's Financial Crimes Enforcement Network (FinCEN) and the Department of Justice issued guidance Feb. 14, 2014, with respect to marijuana related financial crimes.

The FinCEN guidance clarified how financial institutions can provide services to marijuana related businesses consistent with BSA obligations. FinCEN's guidance also specifically addresses the obligations lo file suspicious activity reports (SARs) for marijuana businesses as a "Marijuana Limited" SAR. The guidance provides "Red Flags" to indicate that a marijuana related business is operating in violation of state law or federal enforcement policy.

The Department of Justice guidance provides that provisions of the money laundering statutes, the unlicensed money remitter statute and the BSA remain in effect with respect to marijuana related conduct. Specifically, the Department of Justice explained that financial transactions with proceeds generated by marijuana related conduct can form the basis for prosecution.

As a result, federally insured banks are prohibited from processing funds from marijuana related business. Thus, most marijuana businesses can't open and operate bank accounts even if they are in compliance with state and local law. The result is that many then operate on a true "cash" basis.

FTB's Position

In a town hall meeting hosted by the California Board of Equalization (BOE), the FTB took the position that, for personal income tax purposes, California conforms with the IRC. Therefore, individuals reporting activities of a marijuana business under Schedule C are subject to the 280E limitations. On the other hand, the FTB announced that marijuana businesses operating as corporations are governed under California Revenue and Taxation Code, which does not have conforming legislation to the IRC. Therefore, 280E does not limit deductions for purposes of California corporate reporting.

BOE's Position

The BOE's position is that medical marijuana is tangible personal property, the sale of which is subject to sales tax in California (even though under the MMP, a marijuana business is not engaged in selling of marijuana, but rather collects reimbursement from members).

In February 2007, the BOE issued a special notice confirming its policy of taxingmedical marijuana transactions, as well as its requirement that businesses engaged in dispensing of medical marijuana hold a seller's permit. The dispensing of medical marijuana does not come within the definition of medicine excluded from sales tax. In addition, the BOE's policy is that any food product containing some form of marijuana, including cannabis extraction, is not excludable as a food product but rather is taxable as a supplement.

Ethical Considerations

The California State Board of Accountancy has not taken an official position for CPAs senicing marijuana businesses. The AICPA issued guidance July 24 (www.aicpa.org/ advocacy/state/downloadabledocuments/ marijuanacpasissuebrief.pdf).

Representing a client in violation of federal law is a personal and professional decision for each professional. Practitioners providing sendees to a marijuana business must consider the risks, including, but not limited to, the uncertainty surrounding enforcement of applicable federal laws and related IRC provisions. In addition, CPAs should consider whether representation is covered by his or her liability insurance policy.

Therefore, practitioners with clients operating under the CUA and the MMP must take precautions to ensure that representation does not result in aiding and abetting a criminal enterprise. To mitigate the risk, consider the following in choosing clients:

Duty of Due Care & Competence

Practitioners must first gain basic understanding on how a marijuana business may lawfully operate in California. Under the guidelines, qualified patients and primary caregivers may organize either as a collective, consumer cooperative or an agricultural cooperative. The MMP directs the California Attorney General to "develop and adopt appropriate guidelines to ensure the security and nondiversion of marijuana grown for medical use by patients qualified under the CUA." In 2008, the California Attorney General issued the Guidelines for the Security and Non-Diversion of Marijuana Grown for Medical Use (Guidelines). The Guidelines are not binding on the courts, but are entitled to "considerable weight." Furthermore, the Guidelines provide that cooperatives and collectives "should not purchase marijuana from, or sell to, nonmembers; instead, they should only provide a means for facilitation or coordinatingtransactions between members."

However, under the Guidelines, primary caregivers are allowed to be reimbursed for certain services (including marijuana cultivation) from members of the collective or cooperative. A dispensing collective or cooperative may credit its members for marijuana provided, which it may then allocate to other members. Members also may reimburse the collective or cooperative for marijuana that has been allocated to them. Any monetary reimbursement that members provide to the collective or cooperative should only be an amount necessary to cover overhead costs and operating expenses.

Choosing Clients

Practitioners must be inquisitive about their clients to determine whether the entity is indeed operating in compliance with state and local law, and accurately reporting for federal, state and BOE purposes. Consider:

* Ask the client's business attorney to obtain organizational documents to determine if the entity is in compliance with the MMP as a collective or cooperative.

* Visit the client business; observe daily operations; ask questions regarding standards and practices in the industry; observe inventor)' cycles; and review if the client maintains a point-of-sale system.

* Consider testing inventory and cash accounts to identify whether the client is reporting and recordkeeping accurately. Consider internal controls to detect fraud for inventory and cash.

* Review the slate of records to determine the accuracy of the books and records.

* Review the client's policy for reimbursement to and from members. Review the records related to accounting for reimbursement from members.

If you decide with the representation, then review your engagement letter to clearly identify the duties of the client to you as a professional. For example, the client has a duly to provide accurate records to the accountant for services, including bookkeeping, compilation/review of financials and tax preparation. Additionally, practitioners should provide that services are performed in reliance that client is truthful in its representation.

Performing Attestation Services

Consider whether evidence is available for testing purposes. Where records are incompetent, incomplete or inappropriate to support the issuance of an opinion letter, you must withdraw from the engagement or issue a disclaimer of opinion. Additionally, issued opinions must address the going concern issue due to the illegal activity under federal law.

Use of Kovel Agreement

Consider working through an attorney under a Kovel agreement to protect confidentiality and work product. Clients with representation maintain attorney-client privilege, which may encourage the client to be forthcoming and honest with their operations. In addition, audit representation of clients operating a marijuana business is a dangerous undertaking without proper guidance from an attorney. During audit representation, it's advisable to consult with an attorney to identify the possibility of an eggshell audit, during which time the taxingagency may be gathering information for criminal proceedings.

Tax Services

In preparation of income tax returns, businesses subject to 280E limitations may consider attaching a disclosure statement with Form 8275. The disclosure may provide that the taxpayer is operating in compliance with stale law, and has made an adjustment to account for 280E limitations applicable to the taxpayer. Transparency via disclosure may protect the client against penalties if selected for an audit in the future. In addition, proper adjustments for 280E with a disclosure statement may protect the tax preparer against penalties under section 6694.

Voluntary Disclosure

In the course of representation you may discover that your client's accounting and reporting- have been materially understated in prior years or during the current period.

If you discover that your client is engaged in activities that violate both stale and federal law, advise your client to cease activities. If your client refuses, you must withdraw from the engagement immediately. In addition, you must encourage your client to be forthcoming in making a voluntary disclosure with regards to federal and state taxing authorities. Consult with an attorney to determine the applicable voluntary disclosures for each taxing agency.

BY ANI GALYAN Esq., CPA, LLM

Ani Galyan Esq., CPA, LLM is a tax attorney at MillarLaw,a Professional Corporation. You can reach her at [email protected].