Tax Due Diligence in Serving Clients in the Marijuana Industry

Further exasperating the federal crime-related ethical concerns of serving MRBs is the uncertainty of dealing with tax rules unique to MRBs, as well as general rules and procedures that apply differently for these businesses. These rules are complex or without sufficient guidance, or both. Most notably, a federal tax rule—Section 280E of the Internal Revenue Code (I.R.C.)—greatly limits the offsets to revenue to derive taxable income. This increases the need for practitioners to understand well the nature of the operations and types of income and expenses of an MRB client, and to have a strong understanding of the tax laws and procedures, as well as accounting and recordkeeping.

This article begins with sample fact patterns to illustrate tax issues and possible ethical concerns that can arise in serving MRB clients due to both the tax rules and the federal crime reality of the client’s product. Next, due diligence lists are provided to help tax practitioners reduce their ethical issues, including avoiding tax penalties, when working with MRBs. Finally, suggestions are offered for reducing risks for tax practitioners, particularly given the reality that the growing number of MRBs calls for a growing number of tax practitioners willing to serve them.

Sample Tax and Ethical Issues Facing Tax Practitioners

It will be increasingly difficult for tax practitioners to ignore considerations of dealing with MRB clients. The Justice Department’s “Cole Memo,”² along with laws in over half of the states allowing some use of marijuana, together create a growing number of MRBs. A majority of states allow marijuana use for medicinal purposes.³ After the November 2016 election, eight states (Alaska, California, Colorado, Maine, Massachusetts, Nevada, Oregon, and Washington) and the District of Columbia, representing about 21 percent of the U.S. population, allow recreational use of marijuana. Practitioners are likely to find existing business clients expand into marijuana operations, clients investing in MRBs, and potential MRB clients seeking tax assistance.

The examples below focus on tax and ethical issues relevant to a nonattorney tax practitioner, such as a certified public accountant (CPA).

A tax practitioner assisting Ken needs to be aware that state law may limit the type of entity Ken may form and whether a profit can be generated. Beyond tax assistance, Ken needs assistance of a lawyer familiar with the federal and subnational laws governing all aspects of marijuana operations. State and local statutes, regulations, and guidelines for the production, sale, and limited use of marijuana tend to be lengthy, multifaceted, and complex. These rules intersect with other laws, such as corporate, agriculture, banking, tax, zoning, employment, advertising, and more. A nonattorney tax practitioner should confirm that the client has adequate legal representation to ensure the client is familiar with these laws and to provide added assurance to the tax practitioner that the client is operating within all relevant laws and reducing the possibility of federal crimes, such as money laundering or mail fraud.

Tax advice for Ken includes application of I.R.C. section 280E. This rule, enacted in 1982, provides:

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.

In computing federal income tax, the only reduction to gross receipts allowed for an MRB is cost of sales (COS). Informal, nonbinding guidance from the IRS states that inventory rules in existence in 1982 (rather than ones added in 1986 that would be more favorable for an MRB) govern the determination of COS.⁴

If an MRB has operations related to but separate from marijuana, it should aim to have them be treated as separate businesses for tax purposes so that only the MRB one is subject to deduction and credit restrictions. A tax practitioner experienced with the tax law in this area can help Ken navigate these rules from the start of his operations.

Ken also needs assistance complying with state and local tax rules including sales tax registration, business license tax, and special taxes applicable to MRBs. Due to federal banking laws, an MRB likely has only cash and no bank account or credit card activity. Ken will need assistance on how to pay taxes (income, employment, and sales) when he cannot do an electronic funds transfer or payment by check or credit card. The tax adviser will want to ensure that adequate records exist to verify income and expenses, as there will be no third-party documentation such as credit card or bank statements.

The IRS has never issued regulations for I.R.C. section 280E. A few informal IRS rulings and court cases exist, but certainty of application is lacking, further adding to the ethical (and tax penalty) concerns of a tax practitioner assisting Ken. Issues that exist include whether special rules for reduced tax rates, accelerated depreciation (such as for equipment used to produce goods), and income deferral apply to MRBs despite I.R.C. section 280E. Tax practitioners may face similar issues with state and local tax compliance to determine if the state conforms to I.R.C. section 280E, and dealing with special taxes for which little guidance may exist.

The IRS has issued guidelines to its examiners on whether an offer in compromise may be given to an MRB operating within state law.⁵ Generally, the IRS allows it without any public policy concern. The IRS does provide some modifications to the normal procedures though. A practitioner should determine if any restrictions exist for MRBs wanting to use the state procedures.

In using a nonattorney tax practitioner, a client has no privilege. Use of a Kovel arrangement should help both parties, but should be considered in advance because the federal crime aspect and strict state and local laws increase the likelihood of legal issues.⁶

Is there any concern if most of a practitioner’s business consists of MRB clients, making the practitioner’s profitability and livelihood tied to an activity illegal under federal law? Certainly, MRBs need tax assistance, and the government has not prohibited return preparers from assisting them. Clarification of advertising and revenue generation limitations (if any) in state licensing rules and those of professional organizations would be helpful.

Licensing rules and rules of professional conduct for many tax practitioners prohibit or sanction disreputable conduct. These rules include conviction of a crime or assisting a client in violating the law. American Institute of CPAs (AICPA) Rule of Professional Conduct 1.400.001 provides that “a member shall not commit an act discreditable to the profession.” Guidance is needed in all states to help CPAs understand any limitations or actions in serving MRBs or hiring/retaining employees who use or profit from marijuana, even where allowed under state law.⁷ Practice issues of serving MRBs include the possibility that a CPA might be denied reciprocal practice rights in another state.

Due Diligence Considerations for Accepting and Serving MRB Clients

Beyond the normal due diligence a tax practitioner exercises for business clients regarding compliance, planning, and controversy work, MRB clients warrant added steps to reduce the practitioner’s risk of violating ethical and licensing rules and nontax laws, and incurring tax penalties. Following are some suggested actions in (1) accepting MRB clients, and (2) serving MRB clients.

Prior to accepting any MRB client or retaining an existing client expanding into marijuana operations, a tax practitioner should consider the following actions.

• Review the rules of conduct pertaining to your license(s).
• Review your umbrella, malpractice, and other relevant insurance policies.
• Ask your malpractice insurance carrier what concerns and limitations it may have.
• Consult your legal counsel to learn more about relevant state laws and how to limit risks. Read these laws and regulations first to gain a sense of the depth of rules MRBs are subject to. Ask what ethical concerns and guidance attorneys in your state have in serving MRBs. This can provide insight into their due diligence and added concerns you should have (or perhaps not have).
• Check the prospective client’s understanding of the federal, state, and local laws governing marijuana. Determine if the client has experienced legal counsel to assist in understanding and complying with these laws.
• Perform expanded due diligence prior to accepting a client. In addition to usual questions and actions, consider asking for a legal opinion from the potential client that the client is in compliance with state and local laws, as well as the Cole Memo.
• Only take clients that have a bank account, as it may increase the likelihood of compliance with state law. Financial institutions are reluctant to provide services to marijuana businesses due to provisions of the Bank Secrecy Act. However, in February 2014, the Financial Crimes Enforcement Network (FinCEN) of the Treasury Department issued guidance for these institutions that may alleviate some concerns (FIN-2014-G001). If this is not possible, verify that the client tried and learn why the client could not find a bank to take its business.
• Implement the due diligence suggestions of FIN-2014-G001. While this FinCEN guidance is for financial institutions, the due diligence suggestions are appropriate beyond that purpose. They include verifying the business is properly licensed and registered, reviewing the license application, and learning about the business such as expected activity and the nature of the products sold.
• Consider the possible impact on your firm’s reputation and your existing client base.

Should a tax practitioner decide to service MRB clients, additional due diligence ideas follow.

• Engagement letters should state that the client is expected to follow applicable laws and use a bank account for all transactions (if possible). Ensure clients know of the limited privilege for tax work (IRC section 7525 and in general) and that no privilege exists for nontax or criminal tax information (such as if the CPA learns the client sold marijuana beyond the state limit). If the practitioner is only assisting with income tax compliance, the engagement letter should note that other state and local tax compliance services are not covered.
• Follow normal billing practices ensuring that fees are not related to client profitability (no contingent fees).
• Consider whether some tax planning services or solicitations should not be extended to the client.
• Repeat the initial due diligence annually (see list above) and be sure the client knows this will occur.
• Some MRBs do not keep records, thereby raising issues for tax advisers in performing their due diligence in ensuring proper tax compliance. Help clients with recordkeeping, working with their attorney should there be a concern about keeping records with customer names. Tax agencies use various means of reviewing records. A sales tax hearing in California revealed that the tax agency used a customer review website to obtain an estimate of how many customers an MRB likely had.⁸
• Give greater consideration than usual to use of IRS Form 8275 (Disclosure Statement) for interpretations taken involving I.R.C. section 280E given the lack of guidance for this rule. Such disclosure can avoid tax penalties for the client and preparer.
• Be alert to any actions or comments of the client that indicate the client may be in violation of any laws or not concerned with proper compliance.
• Keep up to date on law changes and new regulations regarding tax and nontax rules relevant to MRBs. Watch for changes at the Department of Justice and the status of the Cole Memo with the change in administration. Look for discussion groups and conferences that can help in keeping up to date.

Legalization of marijuana may cause some illegal operators to come forward to take advantage of the new laws. These individuals might have delinquent tax filings and payments. The due diligence suggestions above are even more important for such clients, and consideration of assisting them using a Kovel arrangement with their attorney is important.

Looking Forward

Tax practitioners need more detailed, official guidance on the application of federal tax rules to MRBs. They also need assurance from the IRS and state tax agencies and licensing bodies that no penalties or censure applies in serving MRBs. The IRS Advisory Council’s public report for 2014⁹ recommended that the IRS publish guidance to clarify that tax professionals would not be viewed as unethical, singled out for exam, or treated as in violation of Treasury’s ethics standards (Circular 230) for serving MRBs where legal under state law. No guidance has been issued though.

Tax practitioners should consider working with professional organizations, the IRS, and state tax agencies and licensing bodies to obtain clarification on ethical standards for serving MRBs and related activities possible in states that allow use and distribution of marijuana. They should also push for official guidance on application of tax rules for MRBs.

In the meantime, practitioners should proceed with extra caution relative to other business clients. ◆

Endnotes

1. Cannabis is a Schedule I controlled substance. Per the U.S. Drug Enforcement Administration (DEA), such drugs “have no currently accepted medical use in the United States, a lack of accepted safety for use under medical supervision, and a high potential for abuse.” Controlled Substance Schedules, DEA, https://www.deadiversion.usdoj.gov/schedules/ (last visited Apr. 19, 2017).

2. Memorandum from James M. Cole, Deputy Attorney Gen., to All U.S. Attorneys, Guidance Regarding Marijuana Enforcement (Aug. 29, 2013), available at https://www.justice.gov/iso/opa/resources/3052013829132756857467.pdf; see also Consolidated and Further Continuing Appropriations Act, 2015, Pub. L. No. 113-235, § 538, 128 Stat. 2130, 2217 (2014) (prohibiting the Department of Justice from using funds provided by that law “to prevent [32 specified states and the District of Columbia] from implementing their own State laws that authorize the use, distribution, possession, or cultivation of medical marijuana” for the applicable budget period).

3. See State Medical Marijuana Laws, Nat’l Conf. St. Legislatures, http://www.ncsl.org/research/health/state-medical-marijuana-laws.aspx (last updated Apr. 21, 2017).

4. I.R.S. Chief Couns. Adv. Mem. 201504011 (Jan. 23, 2015).

5. I.R.S. Small Bus. Self-Employed Div. Mem. SBSE-05-0416-0016 (Apr. 28, 2016).

6. In a Kovel arrangement, an attorney retains a nonlegal professional to provide technical advice that enhances the attorney’s ability to provide informed legal advice to his or her client. See United States v. Kovel, 296 F.2d 918 (2d Cir. 1961).

7. A few states have provided limited guidance. See AICPA et al., An Issue Brief on State Marijuana Laws and the CPA Profession (2016), available at https://www.aicpa.org/Advocacy/State/DownloadableDocuments/MarijuanaCPAsIssueBrief.pdf.

8. In re Just for You Caregivers, Inc., No. 854794 (Cal. State Bd. Equalization 2016), available at http://www.boe.ca.gov/meetings/pdf/hearingsummaries/2016/C_Just_for_You_Caregivers_Inc_854794_Sum_.pdf.

9. Available at https://www.irs.gov/pub/irs-utl/2014-IRSAC-Full-Report.pdf