In recent months, our firm has seen a significant increase in the Board of Equalization’s (BOE) audit activities as they relate to medical marijuana dispensaries, and even more specifically as they pertain to the Los Angeles area. The BOE audit staff has been targeting the local dispensaries in its sales tax audit activities and has been performing audits that are not being completed in accordance with the BOE’s established audit procedures. The result of the BOE’s renewed focus on medical marijuana dispensaries, in conjunction with their unorthodox and inappropriate audit procedures, is leaving many tax compliant marijuana dispensaries with undeserved, inflated liabilities and ample confusion regarding their sales tax reporting requirements.
It has long been a practice of the BOE to focus its audit activities on businesses that transact a significant amount of cash sales such as restaurants, bars, and convenience stores. The increase in popularity of medical marijuana over recent years, the passage of the recent legislation regarding marijuana, and the large volume of cash sales has led the BOE to pursue medical marijuana dispensaries now more than ever. In addition to the foregoing factors, BOE staff has also recognized that medical marijuana dispensaries frequently do not accept credit or debit cards as a form of payment, frequently purchase the majority of their inventory with cash, and frequently do not utilize a point of sale cash register which retains detailed sales information. The confluence of these factors results in medical marijuana dispensaries being an ideal business for the BOE to select for a sales tax audit. These factors also make it difficult for a BOE auditor to make sound judgments regarding the taxable sales of a marijuana dispensary. In addition to the auditor being unable to make sound judgments supported by evidence, the lack of verifiable records makes it difficult for an auditor to apply established audit procedures to marijuana dispensaries.
In the course of a normal audit of a cash based business, the auditor generally will apply one of two auditing techniques to verify reported taxable sales. The first audit method, often referred to as a “mark-up”, involves the auditor computing a ratio between the cost of goods sold of a business and its sales. Once the sales ratio is established, the auditor can apply it to the business’s cost of goods sold to compute a sales amount. If the taxable sales amount reported is less than the auditor’s computation, then the difference will generally be assessed as additional taxable sales. The second audit method involves the auditor computing a ratio of a business’s cash sales versus its credit and debit card sales, often by means of observing the business for three days. The auditor can obtain the credit card sales of the business from its merchant processor and then apply the credit card ratio established by their observation to these merchant deposits to determine the cash sales of the business. If the computed taxable sales amount is greater than the reported amount, the difference will generally be assessed as additional taxable sales.
Given that medical marijuana dispensaries frequently do not accept credit cards or maintain detailed purchase records, an auditor cannot utilize one of the two forgoing, commonly used audit methodologies to verify the sales of a medical marijuana dispensary. As a result, they generally must utilize a different audit methodology. Generally speaking, it is acceptable for an auditor to observe the operations of a business for three days, compute an average daily taxable sale amount from those observations, and then extrapolate that amount over the audit period. The auditor is required to have discussions with the taxpayer about changes that may have occurred to the business’s operations since the audit period so that they can understand and account for any material changes to the business that may have an effect on their computation of the taxable sales. In our recent experience, the audit staff has failed to perform its observation test over three full days and it has not been discussing changes within the economic landscape of medical marijuana dispensaries with dispensary owners prior to the issuance of their audit working papers.
Because many dispensary owners refuse the to let the auditor sit inside their establishment and observe the business, the BOE audit staff has instead been sitting outside of the dispensaries for one to two hour periods and observing how many individuals enter the dispensary. The audit staff will then apply an arbitrary average sales per patient amount, such as $40, to each individual entering the business during their observation. Based on a few observations, generally comprising of approximately eight to ten hours total, the auditor will compute what the daily taxable sales of the dispensary “should be” and then assume that this amount of sales occurred each day of business’ operations for the preceding three years. This approach is not an approved BOE audit methodology for establishing taxable sales. The BOE requires that when an auditor performs observation of a business in an effort to establish audited taxable sales that they must perform three full days of observation. A full day is defined as occurring on a single day for the entirety of the business’ hours of operation. The reason that this rule exists is because there is inherently a significant amount of variation from one hour to the next and it is impossible to determine if the one or two hour period in question represents a busy or non-busy period of time. The rule provides assurances to business owners that the observation will yield representative results.
In addition to the questionable reliability of the abbreviated observation tests, the audit staff also presumes that the sales activities of a dispensary are the same now as they were three years ago. In the Los Angeles area this is particularly troubling as Proposition D was approved by voters in Los Angeles in May 2013. Over the past four years, as a result of this passage, dispensaries that have been allowed to continue to operate have experienced tremendous growth due to the closure of over 800 dispensaries in the ensuing time period. Because dispensaries that have been allowed to continue to operate in Los Angeles have experienced tremendous growth, the assumption that sales have remained constant is invalid and results in the computation of audited taxable sales are accordingly being dramatically overstated because of this flawed assumption.
The combination of the abbreviated observation testing and the unsubstantiated presumption that dispensary sales are constant over the past three years has led to large asserted liabilities for medical marijuana dispensaries in the Southern California area. Owners and operators of medical marijuana dispensaries need to ensure that they are prepared for a sales tax audit by maintaining detailed records of their purchases and their sales in order to clearly demonstrate to Board of Equalization staff that their reporting has been substantially accurate. Often times this is a difficult endeavor, as medical marijuana dispensaries are not aware that the Board of Equalization would require such a detailed and substantiated record of the business activities of the dispensary. Further, many dispensary owners are leery of retaining such information for fear that it could result in Federal legal issues if they were ever raided. We understand these concerns and our firm has an established track record of dealing with these types of issues with the Board of Equalization. If you have any questions or concerns regarding any of the forgoing, please give us a call for a free, no obligation consultation.