California Sales Tax and Cannabis

This installment of the Tax and Vice Blog will focus on a recent California Sales Tax and Cannabis Tax case heard by the California Office of Tax Appeals (OTA). The OTA sided with the CDTFA and ruled against the Taxpayer in Appeal of Sacramental Native American Church (SNAC).  While there was nothing particularly groundbreaking about the OTA’s opinions in the SNAC case, the case does highlight some of the issues all California businesses (not just cannabis businesses) may encounter when the CDTFA finds businesses records are inadequate.

As always, we run our general disclaimer regarding this blog series. We are not here to judge or condemn those who choose to partake in activities such as the use of cannabis products. At the same time, we do acknowledge that activities, such as cannabis use, can be problematic for some, and we urge those who feel they may have a problem to seek professional help. We must also state the possession, use, sale, or distribution of cannabis are illegal under Federal Law.

The Taxpayer in this case, Sacramental Native American Church (SNAC) was doomed from the onset of this case. SNAC had no sellers permits and was attempting to argue it did not make taxable sales of cannabis products, but rather received “tithes” or “donations.”  This argument went over like a lead balloon with the OTA. Even if we are to assume SNAC and its “parishioners” had genuine and sincere religious beliefs, SNAC did not meet the narrow and strict requirements for the charitable organizational exemption to California sales tax. Among other things, SNAC would have had to have had a welfare exemption and it would have been engaged in the “relief of poverty and distress” to qualify for the charitable organization exemption.

Where this case gets interesting is how the CDTFA calculated SNAC’s sales tax bill as SNAC had inadequate business records. The CDTFA estimated SNAC’s taxable sales by counting the number of people who entered the business on a Friday over a four-hour period. It then used the number of people it counted entering SNAC’s place of business over that four-hour Friday time to calculate the average number of customers SNAC would receive on an hourly basis.  Using SNAC’s normal business hours, CDTFA calculated the number of customers SNAC would have had over the audit period, which spanned more than 2 years. The CDTFA then looked to Yelp reviews to estimate how much each SNAC customer spent. The CDTFA used these figures to arrive at a $239,336 assessment.

There are of course serious problems with the CDTFA’s methodology. Among other things, the CDTFA assumed every customer that entered the premises made a purchase. The CDTFA made no allowance for people merely browsing or people accompanying a friend making a purchase. The CDTFA did not directly observe any of the customers making purchases nor did it observe how many customers left SNAC’s business with SNAC merchandise. The CDTFA counted customers on a Friday, which is one of the busier days of the week for businesses like SNAC. The CDTFA used observations over a single four-hour window to extrapolate an average that covered a period of over two years. The OTA seems to recognize  the CDTFA’s methodology is far from perfect, but nevertheless sided with the CDTFA because the taxpayer had poor business records.

While SNAC was far from a model taxpayer, other taxpayers may suffer a similar fate during a California Sales Tax Audit if their records are inadequate. The CDTFA will often employ creative methods to find under- reported taxable sales if it believes a taxpayer’s records are inadequate. We offer the following suggestions to minimize a business’ exposure at a CDTFA audit.

1. Point of Sales (POS) system. Your business should have a good point of sales system that records all sales. The CDTFA will usually honor good POS data and will be less likely to employee creative methodologies to find unreported sales.
2. Receipts for Nontaxable sales. Make sure you keep receipts for any nontaxable sales like wholesale transactions. Make sure the receipts have all the required information. For example, receipts for wholesale transactions must have information such as the purchaser’s CDTFA account number on the receipt.
3. Your Numbers Need to Add Up. The CDTFA aggressively pursues unreported sales. You do not need to needlessly feed that aggression by making obvious clerical errors. For example, the amount of sales reported on a sales tax return should be consistent with the 1099-Ks, income tax returns, and other information the CDTFA may have at its disposal. Additionally, if your credit card processor issued a 1099-K reporting $200,000 in gross receipts for a given period, it would generally be a bad idea for the business to report well under $200,000 of gross receipts.

At RJS LAW, we help California businesses navigate California Sales Tax Audits as well as audits before other taxing authorities. Give us a call for a free consultation if you have any sales tax audit questions or want to learn more about California Sales Tax and Cannabis.

Written by Joseph Cole, Esq., LL.M.