Fourth in a series on what 1,446 pages of IRS cannabis training materials reveal.

The first three posts in this series covered the IRS's internal statement about hemp's legal status changing, why METRC is not the accounting software the IRS wishes it were, and how the IRS maps your corporate structure before you even get the audit letter. This one is about something that may make cannabis industry experts chuckle: the IRS's training materials contain factual errors, outdated assumptions, and law enforcement language that reveal a significant gap between how the IRS understands the licensed cannabis industry vs. how the industry actually works.

I want to be clear: the IRS has invested real resources in building cannabis-specific audit tools, and much of the Audit Technique Guide is thoughtful. But some of what is in these materials proves that a useful starting point in any cannabis business examination may be educating the examiner on the realities of operating a licensed and highly regulated cannabis business. 

Let us start with botany. The IRS Audit Technique Guide states that "all marijuana goes through five cycles of growth: Clone, Vegetative, Bloom, Flowering, Harvest." "Bloom" and "Flowering" are the same stage, right? Most cannabis growers think cannabis has four primary growth phases, not five. But this is illustrative of the level of baseline knowledge your examiner may be working with. 

The Guide also instructs examiners to ask taxpayers "what they do with the non-THC portion of their harvested plants" and whether they "get taxable scrap income by selling to a customer that can use the non-THC parts of the plants." This might make sense for a sawmill selling wood chips, but in the licensed cannabis world, waste disposal is a state-mandated, documented destruction process. There is no secondary market for cannabis "scraps." The IRS is applying agricultural logic to a product whose leftover material must, by law, be rendered unusable and destroyed under strict regulatory rules.

Speaking of borrowed logic, the Guide cites DEA estimates that "a 1KW light and ballast module will produce 1 to 2 pounds of dried saleable product per harvest." That estimate comes from law enforcement interdiction guidelines developed for illegal grows using legacy HPS lighting. Modern licensed operations use LED systems, multi-tier racking, and controlled environments that make per-light yield estimates based on old ballast technology about as useful as estimating an electric vehicle's gas mileage. Yet this is the formula the IRS offers agents for independently estimating a grower's production and, by extension, its income.

The Guide's vocabulary is also revealing. Throughout the materials, every cannabis taxpayer is a "trafficker," every multi-entity structure is a "trafficking organization," and state licensing databases are tools to "reveal the full extent of a trafficking organization." These are state-licensed, publicly registered, and highly regulated businesses. They have passed background checks, obtained regulatory approvals, and submitted to ongoing state oversight. But in the IRS's internal vocabulary, they are described using the same terminology you would use for an illicit cartel.

On the lighter side, the Guide also lists "Weedmaps.com" as an "Internet/Intranet Source" for examiners conducting pre-audit research. There may be a legitimate investigatory purpose (checking advertised pricing or identifying unlicensed operators), but the image of an IRS revenue agent browsing Weedmaps as part of their homework is genuinely funny.

And my personal favorite framing choice: "In the wild, cannabis plants normally grow during the months of April to September." In the wild. This is a training document about auditing state-licensed commercial operators, not a nature documentary. We know nobody the IRS is auditing is growing cannabis "in the wild." Maybe they should, though, because black market sellers are getting a free pass as far as the IRS's enforcement of IRC 280E. Am I right?

The Guide also instructs examiners that "testimony that budtenders work both in the grow and the dispensary should be regarded with skepticism." The IRS is telling its agents, as a blanket matter, to disbelieve employees about their own job duties because the IRS finds it implausible that a retail worker might also do cultivation-related work. In smaller licensed operations, cross-functional roles are common, documented, and entirely unremarkable. But the IRS has decided in advance that it does not believe you.

The materials then ask examiners a rhetorical question about security cost allocation: "Would one expect security contractors to spend most of their time watching plants in the grow, or guarding cash, its transaction and transport to the bank or vaulting facility?" The intended answer is obvious, but in reality, cultivation security in regulated states involves perimeter monitoring, 24/7 camera systems, and access control protocols mandated by the state.

The Guide describes cannabis manufacturers as ranging from "a home-baker using THC 'budder' to make brownies" to large industrial operations. The home-baker framing might have been relevant in the early years. But by May 2021 (the date of the Guide), every legal state had strict manufacturing licensing requirements, facility standards, good manufacturing practices, and mandatory third-party testing for edibles production. The IRS is training agents with an image of cannabis manufacturing that predates the regulatory framework those agents are actually encountering.

While these things may be somewhat funny to an industry participant, IRS audits are no laughing matter. The stakes in a cannabis business examination can be enormous. The agency has invested real resources, and I respect its efforts to understand the cannabis industry.

What is clear is that there is a gap between the agency's institutional knowledge and the realities of the industry, and that can impact your IRS examination. When your examiner arrives with a five-stage plant life cycle, DEA yield formulas from the pre-LED era, and a vocabulary that calls your licensed dispensary a "trafficking organization," you don't just need to defend your tax return. You might also need to educate your auditor. Be prepared to do both.