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

November 01, 2015

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. MMP is codified under California Health and Safety Code § 11362.7-11362.83.  Under the MMP, qualified patients and their designated caregivers are entitled to “associate within the State of California in order collectively or cooperatively to cultivate marijuana for medical purposes”. 

Currently 23 States have some form of legalization for use, possession, and/or distribution of marijuana under state law.  In Colorado, Washington, Oregon, Alaska, and Washington DC, laws to varying degrees have decriminalized the recreational use of marijuana.  However, under Federal law it is unlawful to manufacture, distribute, dispense, or posses any Schedule I controlled substance.  (21 U.S.C. § 801).  Marijuana is classified as a Schedule I controlled substance under the Controlled Substance Act (CSA). 


Federal:  Possession and Trafficking of Marijuana

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

  • Internal Revenue Code

Though a marijuana business is illegal under federal law, it remains obligated to pay federal income tax on its taxable income because IRC section 61(a) does not differentiate between income derived from legal sources and income derived from illegal sources. Income from manufacturing, distribution, or dispensing of marijuana, as it is currently classified under the CSA, is 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 section 162(a).  However, section 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, section 280E applies to a marijuana business. In enacting section 280E, Congress explained that the disallowance of deductions related to trafficking of illegal substances does not preclude the adjustment to gross receipts with respect to effective cost of goods sold.  On January 23, 2015, the IRS issued a Chief Counsel Advisory on determining COGS for taxpayers subject to 280E limitations. 


Section 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 (BSA):

On February 14, 2014, the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) and the Department of Justice (DOJ) issued guidance with respect to marijuana-related financial



The FinCEN guidance clarified how financial institutions can provide services to marijuana related businesses consistent with their BSA obligations. In addition, FinCEN’s guidance specifically addresses the obligations to 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 DOJ 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 DOJ 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 are unable to open and operate bank accounts even when they are in compliance with state and local law. The result is that many such businesses are forced to operate on a true "cash" basis.

FTB’s Position:

In a current Townhall meeting hosted by the State Board of Equalization (BOE), the FTB took the position that for personal income tax purposes, California is in conformity with the Internal Revenue Code.  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.   

State Board of Equalization’s (BOE) 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 taxing medical 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:

Currently California’s State Board of Accountancy has not taken an official position to CPAs servicing marijuana businesses.  On July 24, 2015, the AICPA issued guidance for CPAs in representing clients within the marijuana industry. 


Representing a client in violation of federal law may be a personal and professional decision for each professional.  Practitioners providing services to a marijuana business must consider the potential risks, including but not limited to the continued uncertainty surrounding enforcement of applicable federal laws and related provisions of the Internal Revenue Code.  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 pre-cautions to ensure that representation does not result in aiding and abetting a criminal enterprise.  To mitigate the risk, practitioners should 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[1], qualified patients and primary caregivers may organize either as a collective, consumer cooperative, or an agricultural cooperative.  Furthermore, the Guidelines provide that cooperatives and collectives “should not purchase marijuana from, or sell to, non-members; instead, they should only provide a means for facilitation or coordinating transactions 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 curious and inquisitive about their clients.  Asking the right questions will assist the practitioner in determining whether the entity is indeed operating in compliance with state and local law, and, furthermore accurately reporting for federal, state, and BOE purposes.  Consider the following when choosing a marijuana business as a client.


  • Identify whether the business is in compliance state and local laws.  Consult the business attorney of the client to obtain organizational documents.  Determine if the entity is in compliance with the MMP as a collective or cooperative.

  • Visit the client business site.  While on-site, observe the daily operations, ask questions regarding standards and practices in the industry.  Observe inventory cycles.  Review whether the client maintains a POS 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 state 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.


Once you have made the decision to move forward with the representation, as a practitioner you must review your engagement letter to clearly identify the duties of the client to you as a professional.  For example, the client has a duty 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:


In addition, practitioners should 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 current state of 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 is advisable to consult with an attorney to identify the possibility of an egg-shell audit, during which time the taxing agency 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 Taxpayer is operating in compliance with state law, and has made an adjustment to account for 280E limitations applicable to 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 either in prior years or during the current period.


If you discover that your client is engaged in activities that violate both state and federal law you must 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.


In addition, where client has substantial under reporting in prior years consider whether the client may participate in a voluntary disclosure.  Consult with an attorney to determine the applicable voluntary disclosures for each taxing agency.    




[1] 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, Edmund G. Brown, Jr., 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.”

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