CDTFA Audits Cannabis

California Department of Tax and Fee Administration (CDTFA) Sales Tax audits are never a walk in the park.  The recent California Office of Tax Appeals (OTA) decision in the Halo City Solutions matter, which involved a CDTFA audit of a Cannabis business, highlights just how a tax audit gone wrong can take place during a CDTFA Audit. 

The Taxpayer in Halo City Solutions was a retail cannabis business.  For reasons not stated in the opinion, the Taxpayer did not provide much documentation in the way of Point of Sale (POS) records or other records corroborating its sales during the audit period.  Like other cannabis businesses, the taxpayer could not use a federal bank.  As such, it had no bank records or credit card records available to corroborate the sales it reported on its tax returns.

The CDTFA, without much documentation to work with, decided to estimate the business’ sales by doing a turnstile audit.  Based on the business’ yelp page, the CDTFA determined the business was open 11 hours a day and seven days a week.  The CDTFA counted the number of customers that entered the premises during eight separate one-hour periods to determine an average of how many customers entered the premises per hour.  Five of the eight one-hour periods fell on a Friday. The CDTFA made a 5% adjustment to this average to account for customers that entered the premises but did not make a purchase.  The CDTFA also made a 12% adjustment to account for the fact foot traffic would be higher on Fridays.  The CDTFA assumed every customer that entered the premises purchased an eighth of an ounce of product and from there it made its estimates as to what the Taxpayer’s sales were during the audit period. 

Using this technique, the CDTFA estimated the Taxpayer owed over $250,000 in additional tax plus penalties.  The Taxpayer appealed to the OTA.  Despite the turnstile audit approach being highly problematic, the OTA upheld the CDTFA’s determination. 

The first thing that went wrong in Halo City is that the taxpayer did not provide the auditor with much in the way of records.  Cannabis businesses are at a particular disadvantage in CDTFA audits because they do not have bank records or credit card records to corroborate the sales reported on their tax returns.  However, cannabis businesses (as well as any other type of business) can and should record all their sales in a Point of Sale (POS) system.  If Halo City provided POS records, perhaps the CDTFA would not have had to resort to a turnstile audit.

Given that the CDTFA likes to use a turnstile approach to audit CDTFA businesses, perhaps the taxpayer in Halo City could have installed an actual turnstile to count the numbers of customers entering the business.  Rather than having to rely on the CDTFA’s flawed methodology in counting how many customers entered the business, the taxpayer could have used a real turnstile to collect data showing how many customers actually entered during any given period. 

Lastly, the CDTFA relied on Yelp to obtain information about the business’ operations.  Yelp and other social media do not always contain accurate information.  The Taxpayer in Halo City could have suffered thousands of dollars of loss if Yelp inaccurately reported its hours of operation.  For example, if the Taxpayer were only open six days a week, the assessment would be 16.7% higher than it should have been.  Businesses should be mindful, inaccurate information on social media can be used against them in audits.  Businesses should make sure their social media postings and information are accurate. 

Tax Audits are never easy.  At RJS LAW we help individuals and businesses who are under audit with the CDTFA, IRS, EDD, FTB, and other agencies.  If you or your business are under audit, or would like an assessment of your returns, please feel free to contact us at 619-595-1655 or via the web at RJS LAW for a complementary consultation. 

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