One thing you never hear is, “I can’t wait to pay my taxes.” For those in the cannabis industry, it seems like you’re taxed to the hilt. Yet here we are, on the cusp of another tax season. The feds still consider cannabis illicit, but they are happy to take taxes from the industry — to the tune of $2.8 billion in federal taxes in 2018 alone — in figures estimated by New Frontier Data.
So between all the regulatory hoopla, from operational regulations to licensing fees to excise taxes to the lack of banking access, cannabis businesses already have an overwhelming list of tasks to execute to operate daily. Let’s cut through the clutter.
First and foremost, become familiar with IRS Code 280E. That’s one primary source of the cannabis business tax headache. Cannabis companies are required to pay tax on gross income, and that can be as high as 70 percent in some cases. The workaround? You can only deduct expenses directly related to generating a profit. Those are COGS (Cost of Goods Sold), and they are your golden ticket to authorized deductions. We’ll look at those in a bit.
In summary, IRS Code 280E was created in 1982, during the Reagan’s administration’s “war on drugs,” when a convicted cocaine trafficker boldly used federal tax laws to justify deductions on standard business expenses related to his drug enterprise.
280E prohibits companies from deducting business expenses for any gross income associated with the trafficking of Schedule I and II substances per the Controlled Substances Act. Because the feds still consider cannabis part of the Controlled Substances Act, the stipulations outlined in 280E still apply. That means state-regulated and compliant cannabis businesses are penalized through strict limitations on tax deductions. Funny enough, the feds always take your taxes, even if they deem the industry illegal.
Here are three essential tips to save your cannabis business money this tax season, and they’re all dependent on the other:
- Keep detailed records.
- Reduce your tax liability.
- Avoid audits.
1. Keep detailed records
Legitimate businesses have a paper trail, and that’s one thing that separates the black market from the legal cannabis industry. Keep detailed records. Use a software system (like Quickbooks) to track your income, expenses and assets. Then come tax-time, your accountant will be able to quickly identify if you’re eligible for additional tax deductions or steer you in the right direction for next year. Maintain your records throughout the year. Save receipts. Track where your cash is going. Having a solid paper trail and data integrity will be essential if you’re audited (more about that later).
2. Reduce your tax liability
Your tax liability is what you owe the feds once you’ve deducted everything allowable. For the cannabis industry, there’s one golden area to help reduce what you will owe, and it was mentioned earlier. We’re talking COGS. You can calculate COGS, and the deductions allowed by COGS, throughout the year, and it’s in places you might not expect.
Did you know that you might be able to deduct part of your rent as COGS? It’s true. If you have a dispensary that uses 30 percent of the square footage as a lobby (not deductible) and uses 70 percent as the sales floor (deductible), you can calculate a monthly deduction for the areas directly associated with cannabis business transactions. In other words, where sales happen, deductions happen.
Other COGS might include utilities. Keep your statements and track your bill payments and take that information to your accountant or tax professional for a proper deduction calculation.
Another golden way to reduce your tax liability is through the careful classification of employees on your payroll. For those cannabis businesses that have multiple licenses (like a producer that also has a retail location) or are vertically integrated, you have more COGS to consider. To do this, carefully (and accurately) document what each employee does for your business.
Write job descriptions that detail what your employees do, and what percentage of time they spend doing their primary job functions. For example, employees that cultivate cannabis are eligible for payroll deductions as COGS. However, employees that sell marijuana are not qualified for payroll deductions come tax-time — simply because their role is not considered ‘necessary’ to the creation of the goods sold, i.e., COGS.
3. Avoid audits
The number one thing most businesses want to avoid at all costs is an audit. They’re stressful, time-consuming and can be expensive. The first line of defense is to keep detailed records, as discussed earlier. Robust record-keeping can help you or your tax professional prove your case in the event of an audit.
The IRS scrutinizes payroll, so that’s where detailed job descriptions come into play. They also look at excessive deductions. Don’t play with fire and deduct 100 percent of your rent as COGS. That can trigger a penalty or audit. The average business audit rate is 1.4 percent. Still, data from MJBiz Daily shows that in 2015, when the industry was just getting started, that 6.3 percent of cannabis businesses were audited. That’s a huge gap. In an article on accountingtoday.com, Rachel Gillette, a partner and chair of Greenspoon Marder, a cannabis law practice, attributes the high audit rate to the lack of banking. The cannabis industry is a cash-centric one, and that leaves a gap in the paper trail that’s the norm for most other businesses. Again, that’s why keeping impeccable records is essential.
Since legalization has spread across the U.S., there are more and more Certified Public Accountants (CPAs) that serve the cannabis industry. They can help you navigate the intricacies of the provisions of 280E. Money spent on a CPA that specializes in cannabis is a solid expenditure. They can ensure that taxes are completed correctly and help guide your business on a path to continued growth. That peace of mind is priceless.
As the cannabis industry works to solve the banking issues and other barriers to doing business, the most successful may just become their own best advocate and keep things in-house. In a few years, well-known accounting companies that specialize in the cannabis industry (like GreenSpring LLC, New Approach, PriceKubecka PLLC, and The Canna CPAs, for example) might serve as a model and inspiration for cannabis companies to form their own accounting departments, with a focus on taxes and legal compliance.