“Preparation time is never wasted time.” Anonymous
Penalty is not a glamourous word- neither is pain, usually. We attempt to avoid both at all consequences. However, if taxes are one of the inevitables in life, then penalties may also closely follow. Our articles are intended to prepare and educate operators, CFO’s, controllers, and adjacent professionals in the cannabis industry rather than to drive fear and sometimes therefore avoidance of such a topic.
This article follows a series entitled “The IRS and Cannabis- 2021 and Onward” describing the tax enforcement process, from beginning to end. In this series, we covered the following topics:
Introduction – Federal Tax Procedure
Part I – Resolution Efforts
Part II – Appeals and Tax Court
- First, this is the third anniversary of the legalization of recreational cannabis in California (Prop. 64, effective January 1, 2018). For calendar-year businesses which filed their 2018 federal returns in 2019, the period of limitations for assessing deficiencies on these returns will start to close as early as the start of 2022 (i.e., “within 3 years after the return was filed,” IRC 6501(a)). While this statute of limitations (SOL) may be longer in certain cases, our experience is that the IRS significantly ramps up audits during the third year after a new rule comes into effect, in order to avoid losing revenue. Thus, we expect a lot of our cannabis clients to be hearing from the IRS soon. We hope this series will help you understand and be comfortable with that process.
- In a March 30 report, the Inspector General for the Treasury Department (TIGTA) issued a report entitled “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.” Among other things, TIGTA recommended that the “IRS develop a comprehensive compliance approach for the marijuana industry, including a method to identify businesses in this industry and track examination results,” and that it “leverage publicly available information at the State level and expand the use of existing Fed/State agreements to identify non-filers and unreported income in the marijuana industry.” Thus, it is prudent to expect that the IRS will continue to take cannabis audits seriously.
- Even if you never get audited, you should know a little about the enforcement process, because it explains the advice we give you every day. Our profession operates in the “shadow of the law:” even though only a tiny fraction of cases ever goes to trial, we apply the rules from those cases 100% of the time.
We’ll begin at the end of the process, with the possible penalties if you lose your case. A century ago, Oliver Wendell Holmes, Jr. advocated for the “bad man” theory of the law—that is, starting from the assumption that citizens are moved solely by the prospect of punishments and rewards. If you prefer, you can turn this around, and think of the penalties in the Internal Revenue Code as describing the Tax Virtues. Just as a Boy Scout is “Trustworthy, Loyal, Helpful, Friendly,” etc, a virtuous taxpayer is one who avoids behaviors which incur penalties and interest, as follows:
- Timely Filing and Payment.
Ever notice how your tax professional is a little more perky around January 15 (4th-quarter estimated tax); February 28 (1099s); March 2 (farmers & fisherman); March 15 (pass-through info returns); April 15 (calendar-year tax due; returns for individuals, C Corps, trusts; 1st-quarter estimated tax; FBAR); June 15 (2nd-quarter estimate tax); September 15 (pass-through info return extended; 3rd-quarter estimated tax); and October 15 (Extended Individual Tax Returns & FBARs).
That’s because the most basic Tax Virtue is to timely file and pay taxes. For example, take an individual taxpayer. Assume his actions are not “fraudulent,” but that they nevertheless lack “reasonable cause.” If he is late to file his personal income tax return, he will owe an additional 5% x [the amount required to be shown on the return, reduced by taxes paid], for each month, up to 25%. Even if the taxpayer has paid all his taxes, such that this equation equals zero, he will still owe a basic penalty of $330. See Rev. Proc. 2019-44 Sec. 2, citing IRC 6651(a).
- Failure-to-Pay and Late Payments
Failure-to-pay penalty is charged for failing to pay your tax by the due date. The late payment penalty is 0.5% of the tax owed after the due date, for each month or part of a month the tax remains unpaid, up to 25%.
You won’t have to pay the penalty if you can show reasonable cause for the failure to pay on time.
Late payments are also subject to interest, at the underpayment rate, compounded daily. This rate is a function of the short-term federal rate, and is currently 3%.
For the vast majority of taxpayers, these are the only things they have to worry about. That’s because the United States tax system is based on “voluntary compliance.” Unless the IRS receives an information return (e.g.: W-2, 1099, partnership return) which contradicts the information on your tax return, it will assume that the amount of tax which you paid and self-reported is correct.
- “Accuracy” and “Fraud”
For the same reason (i.e., because our tax system is based on voluntary compliance), the IRS holds out stiffer penalties for taxpayers who take frivolous tax positions. There are roughly a dozen of these penalties, and they fall under the general label, “accuracy-related and fraud penalties.”
For individuals and businesses, the most common pitfalls are listed below. In each case, the additional tax is imposed on the portion of the underpayment attributable to the bad behavior. Except as otherwise provided, the rate of tax for each item is 20%, and it is a complete defense if the taxpayer can show he acted with “reasonable cause” and without “willful neglect.”
- Negligence or disregard of rules and regulations. “Negligence” includes a failure to make a reasonable attempt to comply with the tax law. “Disregard” may be intentional, reckless, or merely careless.
- Substantial Understatement of Income Tax. For an individual, this refers to the amount of understatement exceeding 10% times the amount required to be shown on the return. This penalty is avoided if the position had (i) “substantial authority,” or (ii) “reasonable basis” plus adequate disclosure in the return. To meet these requirements, clients sometimes seek a formal opinion from a tax professional. The client prefers the substantial authority opinion because it avoids the need for extra disclosures.
- Substantial valuation misstatement under Chapter 1. This is where you exchange property and underreport the property’s value (or over report its basis) by 150%. The penalty becomes 40% if the misstatement reaches 200%.
- Transaction lacking economic substance. This refers to transactions which have no meaningful purpose aside from achieving tax benefits. If the relevant facts about the transaction are not adequately disclosed in the return, the penalty increases to 40%. Beware: If you satisfy the elements of this penalty, there is no defense—not even reasonable cause.
- Reportable Transaction Understatement. There are some transactions with such a high risk of abuse, that the IRS defines them as “reportable transactions.” Any underpayment relating to these transactions is subject to penalty, unless the taxpayer can satisfy a stringent set of excuses.
- Fraud. Understatements attributable to fraud are subject to a 75% penalty. A Boy Scout does not do any of the things on this list, but especially not fraud.
- Assessable Penalties
To keep things interesting, there is also a miscellaneous hodgepodge of “assessable penalties.” For example:
- What if, instead of underpaying your taxes, you pay the full amount and then request a refund? If the IRS rejects your refund request, it will impose a 20% penalty, unless your request had “reasonable cause” and was not related to a transaction lacking economic substance.
- You can be penalized for failing to file a return relating to your interest in a foreign partnership, corporation, or trust.
- If an employee provides incorrect information on his W-4 (Employee’s Withholding Certificate), without reasonable basis, he shall owe a $500 penalty. To the age-old question, “Why can’t I claim nine dependents?”, the answer is IRC 6682.
- Your tax preparer can also be subject to penalties. They may be protected by the same “reasonable basis” and/or “substantial authority” written opinions mentioned above. For this reason, when your preparer says “I think you should get a tax opinion,” they mean it.
If your tax matter takes on criminal dimensions, you will need a lawyer who specializes in criminal tax defense. Until then, keep two things to keep in mind.
- First, just because an act triggers civil penalties does not also mean that it triggers criminal liability. Most criminal tax rules require a heightened standard of wrongdoing, such as “willful,” “fraudulent,” or “corrupt” behavior.
- Second, a criminal conviction also requires a heightened standard of proof. In contrast to tax court, where the taxpayer bears the burden of proof by a preponderance of the evidence, in a criminal proceeding the burden is on the government and it must prove its case beyond a reasonable doubt. You also have the right to remain silent.
If you get a notice from the IRS, you can take comfort knowing that you made your decisions and prepared your taxes with the help of professionals who understand all these rules. The audit may come as a surprise to you, but we have been planning for it every day.
An audit is simply an examination. It is tedious, expensive, and nerve wracking, but in the vast majority of cases it is simply your opportunity to show the IRS that you have been doing everything right. That’s exactly what they’re hoping for too.