Knowing what expenses your cannabis company can claim on your tax return can be overwhelming due to IRS Code 280E. Internal Revenue Code 280E states that businesses who engage in the sale of Schedule I or II controlled substances, like cannabis, cannot deduct business expenses from their taxable income. Meaning, unlike ordinary businesses, a cannabis business cannot deduct the following expenses:
- Employee payroll and benefits
- Rental and utility expenses
- Advertising and marketing expenses
- Repairs and maintenance expenses
- Office administrative expenses
However, there is an exception that will help your business subject to the Code 280E provision. This exception allows for the deduction of costs of goods sold (COGS). For a cannabis business, the COGS involve costs associated with the production of products. That means costs for seeds, soil, and nutrients are deductible. Likewise, expenses related to cultivating and harvesting cannabis fall under COGS as well.
This is an important distinction to take note of. Many cannabis companies aren’t aware of these exceptions. Having a team of financial experts to point them out can save you big bucks on your IRS tax return.
Because of this provision, a cannabis business ends up paying taxes on their gross profit, which could create a significant tax burden. In fact, they often pay two to three times more taxes than an ordinary business. But, with expert accounting advice and proper compliance, you can minimize the effect of 280E on your taxes.
The following examples can help reduce your federal tax burden:
1. Separate Your Cannabis Business Activities
A business that is subject to 280E, can divide its business into two parts to help reduce taxes. The first business can be responsible for producing and distributing cannabis. This business would file a tax return with COGS as the only deduction.
The second business would perform business activities not subject to 280E. This way, you can take business deductions on your tax return, like payroll, rent, and marketing expenses. When combined, these two companies pay fewer taxes than a company operating as a single entity. This 280E strategy may sound complicated. But, partnering with a company like Northstar, can give you more insight into the nuanced rules and guidelines of Code 280E. And thus, it can help you save more money in the long run.
This 280E tax strategy is legal under the 2007 Californians Helping to Alleviate Medical Problems (CHAMP) federal court case. But, before you establish a second company, you must be able to state the business’ real purpose and revenue. Again, this is another time when consulting an expert is helpful. Otherwise, you might face the risks of tax penalties and violations (as was seen with Harborside).
2. Use Smart Corporate Structuring
Before determining the corporate structure for your cannabis business, consider the benefits and drawbacks of each entity option. Your three options include a C-Corporation, S-Corporation, and Limited Liability Corporation (LLC).
For a large scale cannabis business, legal advisers and CPA’s generally recommended setting the business up as a C-Corporation. Since a C-Corp is a tax-paying entity, the corporation itself pays taxes on the company’s gross profit and the business owner only pays taxes on salaries or dividends.
3. Track Employee Time by the Individual Activity
Certain hours worked by employees are deducted under COGS if those tasks relate to cannabis production. This means that accurately tracking time could make a big difference in your COGS number. To make this process easier, consider installing a time tracking system. It should allow the employee to record time by individual activity.
For instance, if an employee works as a budtender, their hours should be recorded under that activity. Employees involved in inventory, packaging, or cultivation would record their time as such. Accounted for correctly, time spent cultivating, packaging and in inventory management is deductible in COGS under Code 280E.
4. Be Prepared for a Possible Audit
As a cannabis business owner, your company is more likely to be audited because you’re selling a federally illegal (Schedule 1) substance. Hence, audit preparation is key. This is why staying organized, well-versed on tax laws and tracking employee hours is so important.
Also, did you know, Section 280E of the IRC requires your business to document all gross receipts and expenses? This includes revenue numbers for products sold in-store and online. It also includes cultivation expenses, marketing, seeding, inventory management, etc.
The IRS expects you to keep receipts for all transactions, to show as evidence on your tax return. Every bit of revenue and expense, no matter how small must be accounted for. Since 280E only permits the deduction of COGS, this number is often the most scrutinized by the IRS. If the deduction is incorrect, your business may be subject to a fine.
5. Work with an Experienced Cannabis Accountant
Section 280E applies to federal tax treatment for legal cannabis businesses, but that still leaves state taxes in question. State and local taxes vary depending on the state you operate in. This means it’s up to you or a reputable tax advisor to understand and adhere to state laws. This is just one more reason to work with an experienced cannabis accountant.
Expert accountants in the cannabis industry know the laws better than anyone else. They understand the ins and outs of Section 280E and how to correctly minimize your taxes. They can help ensure your tax return is filed accurately and has the proper supporting documentation. This kind of specialized service mitigates the likelihood of being audited and can ensure better cash-flow. Expert accountants can also offer expert advice on what’s allowable under COGS and what’s not.
For example, they know that businesses may deduct electrical bills for designated inventory spaces, but not for electricity used in sales spaces. And in some cases, the shipping costs related to the cannabis product can be deducted as well. Only experts have this information at hand.
Companies like Northstar Financial Consulting Group offer this expertise. They can provide your cannabis business with a full-service Accounting and CFO solution while helping to lower your 280E taxes. And they work diligently to ensure your tax return is correct.