Typically, state tax authorities will let cannabis businesses know if they have not paid enough sales and use taxes. However, will they notify you if you’ve paid too much? The odds are slim. The possibilities are so unlikely that cannabis owners and operators often hire tax experts to perform reverse audits to identify overpayments so they can request refunds.
Understand the Available Tax Exemptions
It is essential for cannabis businesses to understand the sales and use tax exemptions available to them. For example, most states offer companies exemptions from sales tax on machinery, supplies, and tools used to manufacture products. Generally, state tax laws also do not require businesses to pay taxes on the utilities and materials used in the manufacturing process. Cannabis businesses may be able to take advantage of some of these sales and use tax exemptions. Operators need to understand their state’s specific tax laws and claim the proper available exemptions; otherwise, exemptions to which you are entitled may be missed.
Traditional businesses often utilize sales and use tax compliance software to safeguard against overpaying; however, there are limited systems designed specifically for the cannabis industry to alert businesses of overpayments related to manufacturing. Overpaying can result from many reasons, including staff turnover, business expansion or downsizing, and human error mistakes, and can have significant consequences.
Review Broad and Historical Data
Reverse audits typically reach every department within the cannabis businesses and date back to the statute of limitations on state tax reviews. To ensure a reverse audit is accurate and effective, the auditor should review as much historical data as possible. For example, if a state auditor can review financial records for the four years preceding the audit, the reverse audit should comprise the same timeframe.
Common Types of Tax Overpayments
Two prevalent types of tax overpayments are on components of manufactured products and on the equipment used to make the products. Other areas where overpayments may occur, depending on state laws, include:
- Manufacturing equipment,
- Pollution control equipment and supplies,
- Safety equipment,
- Warehouse equipment,
- Software licenses,
- Maintenance fees,
- Protective clothing, and
- Service transactions.
If you believe your cannabis organization has overpaid on sales and use taxes in these and other areas, it is essential to clearly understand your operations. For example, to ensure that you are receiving maximum benefit from industrial processing exemptions, you must know where your manufacturing process begins and ends.
The Process – and Three Phases – for a Reverse Sales Tax Audit
Phase One: Feasibility Study
The first phase in a reverse sales tax audit is to perform a feasibility study, which analyzes various financial and accounting functions within a cannabis business. The results of a feasibility study help operators identify and estimate the potential sales/use tax refund opportunities. Depending on the size of the company, this may require up to two days of review. This first phase of the reverse audit typically reviews a fixed asset listing, chart of accounts, accounts payable detail for selected reports for a sample period, and invoices. If available, the auditor would also review an electronic download of all invoices and accounts payable activity. The feasibility study may only cover a certain period, where the results are projected over all time periods within the statute of limitations. Then, the auditor would estimate the potential refund. Depending on the results of this phase, the auditor will determine the next steps to take in phase two, the validation phase.
Phase Two: Validation
If the auditor identifies an overpayment in phase one, ‘the feasibility study,’ the primary focus of the validation phase is to compile the documentation required to prepare and submit the claim for a refund. The auditor will usually meet with the department managers who are most familiar with the items purchased, i.e., plant supervisors or buyers, to provide descriptions of the claimed items. If the reason for the exemption would not be evident to the state’s claim reviewer, department managers may be required to submit summary explanations. Once the proper documentation is compiled, the final step during the validation phase is to present the entire refund claim package to the company for review and approval.
Phase Three: Coordinating with the State and Ensuring the Refund is Issued and Received
Once the cannabis business approves the refund claim package, it is submitted to the state. It is common for state representatives to respond with questions and requests for copies of invoices. Accordingly, phase three includes responding to the state’s requests and ensuring that the refund is issued and received by the cannabis business. Similar to the final step when mitigating an exposure, it is crucial that department managers and other company personnel are trained to capture the exemptions that resulted in the prospective refunds.
Save Now and Later
Although the reverse audit process is time-consuming and complex, the end result can produce a significant financial gain for cannabis businesses. Each state’s rules and regulations for sales and use tax refunds are complicated. However, an experienced cannabis tax advisor can properly prepare a cannabis owner’s refund claim before they are officially submitted to the state for review.
Since 2009, Bridge West has assisted cannabis operations with reverse audits and successfully helped clients reap tax refund rewards now. We also work closely with owners and operators to update compliance systems and implement tax minimization strategies. Reach out, we’d love to talk.