Tax season in the cannabis industry comes with a unique set of hurdles. Of course, while challenging, preparing tax returns for dispensary owners is not impossible.
As every dispensary owner knows, cannabis laws are continuously evolving. Each change presents its own set of issues to handle.
Additional regulatory, legal, and financial scrutiny adversely impact cannabis businesses, impacting what can be deducted from taxes. The limitations placed on cannabis businesses’ deductible expenses make tax season frustrating, especially for those just breaking into the cannabis industry.
With this being the case, diligence and preparation are essential for navigating tax season successfully. However, a dispensary accountant can facilitate the process.
In this guide, we’ll cover tax deductions and what to expect while operating in the cannabis industry.
Deducting Business Expenses
Regardless of the industry, the Internal Revenue Service allows self-employed individuals to deduct a plethora of business expenses. A lot of times, these deductions are made dollar for dollar, enabling business owners to subtract every dollar spent from their taxable income.
To deduct business expenses, you’ll first need to calculate your gross income. IRC 61 defines gross income with several items, including (but not limited to) the following:
Compensation for services, including fees, commissions, fringe benefits, and similar items;
Gross income derived from business;
Gains derived from dealings in property;
Income from life insurance and endowment contracts;
Income from discharge of indebtedness;
Distributive share of partnership gross income;
Income in respect of a decedent; and
Income from an interest in an estate or trust.
Once you know your gross income, you’ll have to determine all of the ordinary and necessary expenses paid or incurred over the taxable year resulting from your trade or business. IRC 162 defines these deductions more in-depth, showing the general deductions you can use as tax write-offs.
For more information regarding applicable business expenses, make sure to check Pub 535 published by the IRS.
The 280E Tax Code prevents a business that traffics Schedule I or Schedule II-restricted substances from deducting business expenses. However, deductions are permitted if the costs are directly related to COGS, or the cost of maintaining your inventory. While creative accounting is sometimes utilized to define the COGS, strict enforcement of 280E tax law can result in back-taxes.
Since cannabis businesses cannot obtain federal tax deductions, some find themselves forced to pay more than twice as much in taxes. This is why most cannabis businesses should avoid incorporating as an S-corp.
As an S-corp, cannabis businesses generate a “phantom income” that can cause double taxation. To lessen your corporate tax burden, it’s better to incorporate your business as a C-corp. C-corporation business owners’ taxes are based on their own salary and/or dividends.
Also, the C-corp is currently the only structure that protects business owners for 280E. If the company can’t afford to pay taxes, the government can go after the owners if not C-corp.
How To Avoid 280E
The right 280E strategy will save you money. Whether you choose to bring on a 280E management company to handle the corporate structures for your cannabis businesses or conduct research yourself, a little preparation will go a long way.
The financial terrain resulting from 280E can be tough to navigate. However, some strategies, other than incorporating as a C-corp, will help you bypass 280E.
One of the smartest moves to avoid 280E is to split your cannabis business. This is where you’ll split the business in half and run two entities under the same roof. The first business handles business expenses. This includes the cost of owning or renting the building, providing transportation, and paying for storage. The business also provides employee benefits, handles maintenance services, and hosts company events. The first business also sells non-cannabis products. However, this is not so cut and dry, as observed in the Harborside case.
The second business handles cannabis directly. This business handles growing, curing, and packaging cannabis. Distribution to consumers is also a part of this business. Through the second business, you’ll have as little of the total business overhead as possible, ensuring most of this business’s expenses are composed of inventory. These expenses can be included in the COGS.
Another strategy is to be prepared for an audit. Since the IRS openly admits it’s specifically looking for errors in cannabis business taxes, it’s safe to say this organization will strictly enforce 280E. If your business isn’t prepared for an audit, the IRS could reject your tax returns, demand back-taxes, and charge large penalties and fees. Again, as observed in the Harborside case, preparing by keeping excellent accounting records is essential to ensure that you can avoid paying penalties during an audit.
In IRS Code Section 471 and IRC 263A, small business taxpayers would no longer have to cope with the IRS’s complex inventory accounting provisions. However, 263A does not apply to taxpayers operating cannabis businesses.
One argument is that companies under $25m/year in average sales for three years can operate on a “cash basis,” deducting everything as it’s incurred. This is different from GAAP/accrual accounting in which things are placed on the inventory balance sheet. But businesses still have to consider the potential risks of taking on a position like this as it could be challenged during an IRS examination.
The new Section 471(c) is especially attractive to taxpayers who have been subjected to the harsh deduction disallowance provisions that came with Section 280E for cannabis-touching enterprises. This, of course, includes dispensary operators.
This addition to IRC 471 is significant because before, the IRS had power over inventory accounting methods. Through a Supreme Court case, Thor Power Tool v. Commissioner, the IRS was granted broad discretion under Sections 446 and 471 to make taxpayers adopt another accounting method. With the application of Section 471(c)(1)(A), the IRS can no longer cite Thor Power, giving taxpayers the ability to utilize whichever inventory accounting method is best suited for their audit.
Section 471(c)(1)(B) can provide small business taxpayers with some powerful protection, as well. This protection comes in the form of treating inventory as non-incidental materials and supplies or changing its accounting method change to meet its applicable financial statements or, if no applicable financial statements exist, the books and records will suffice.
If the taxpayer is subject to Section 280E, it’s challenging to treat inventory as non-incidental materials and supplies. With this being the case, these expenses could be treated as current deductions, meaning they’re disallowed under Section 280E.
With Section 471(c)(1)(B)(ii) in place, the IRS cannot force small business taxpayers with a method of accounting that’s reflected in its applicable financial statements to change their accounting method. Dispensary owners and other cannabis taxpayers subject to IRC 280E can adopt a method of accounting to allocate expenses, regardless of whether direct or indirect, to the cost of goods sold (COGS). These expenses lessen taxable income, and the IRS cannot do anything to prevent this from happening.
How A Dispensary Accountant Can Help
Dispensary accounting professionals understand what it takes to prepare your dispensary for taxation, beginning with cannabis business formation. The key here is to have your business situated for tax season long before you’re even on the IRS’s radar.
Cannabis accounting will provide you with the financial or legal guidance you need. Whether it’s through a dispensary organizational chart or a simple consultation, a knowledgeable cannabis accountant will analyze all available corporate structures for cannabis businesses to determine what will work best for your unique situation.
Do you need financial or legal guidance for your dispensary? Contact us today for a friendly consultation.
Opening and running a cannabis business in one of the legal states involves a unique set of obstacles and challenges. As any cannabis business owner knows, the ever-changing tapestry of cannabis laws can make it hard to stabilize the finances. There is a constant stream of new requirements for packaging, labeling, location, production, and now taxation. The current hubbub in the cannabis business world is Tax Code Section 280E.
You may have heard this term floating around related to panicking cannabis business owners facing a doubled tax burden. Don’t panic! Section 280E is an interesting legacy law from the 80s. Currently, it is a sticking point between federal and state cannabis businesses’ legality. It’s going to be a challenge, but the cannabis industry is already developing ways to work around the increased expense from Section 280E enforcement.
What Is the Section 280E Tax Code?
Tax Code Section 280E originates from a 1981 court case. A cocaine dealer tried to claim a tax deduction on business expenses for his cocaine selling business. As a result, Section 280E prevents any business that trafficks in a Schedule I or Schedule II-restricted substance from deducting any business expenses.
The only tax deductions permitted under Section 280E are those directly related to the “Cost of Goods Sold” which means the cost of maintaining your inventory. This can sometimes result in creative accounting to define the cost of goods sold. However, strict enforcement may create back-taxes for those who try.
Section 280E denies cannabis businesses the right to federal tax deductions. With these limitations, a cannabis business can be charged more than double the tax burden. So it’s easy to see why the industry is on alert about this enforcement.
How 280E Impacts Cannabis Businesses
So how, exactly does Section 280E impact a cannabis business? The rules are very specific to ensure that it is enforced fairly and in line with the constitution. However, strict adherence cuts both ways. The IRS has made it clear that they plan to very precisely audit cannabis tax deductions to ensure that only the cost of goods sold is included.
Any business that trafficks (creates or sells) a federally controlled substance (cannabis) cannot file for any tax deductions other than the direct cost of sold inventory. The cost of sold inventory can include growing, curing, and packaging.
All other tax deductions including wages and benefits, facility and utilities, and business overhead are barred and full taxes must be paid because the business itself trafficks in cannabis.
State Laws Caveat
It should be mentioned that state taxes do not apply under Section 280E because 280E is part of the federal tax code. States each have their own approach to taxing a cannabis business and some don’t have any special rules or restrictions at all. Your federal taxes will need to be managed with 280E in mind. However, your state business taxes and income taxes will need to be calculated based on the state laws where you are located. Every state is different.
Strategies to Manage 280E Cannabis Taxes
Fortunately, the cannabis industry isn’t taking this increased tax burden lying down. Enforcement of Section 280E has created an interesting financial terrain for cannabis businesses, but there are ways around bearing the brunt of the restrictions. Discovered by other cannabis businesses and similar industries with controlled substances, these strategies can allow your business to thrive despite the financial burden.
Split Your Business in Half
With a corporate lawyer to consult with, the cleverest move is to split your cannabis business right down the middle and run two entities under one roof. Business number one handles all the business expenses. Business One owns or rents the building, it provides transportation and storage. Further, Business One provides employment benefits, maintenance services, and hosts company events. It also sells all non-cannabis products like pipes and t-shirts.
The second business works directly with cannabis. Business Two grows, cures, and packages the cannabis if you cultivate. Business Two bud-tends and sells the cannabis directly to the customers. Further, Business Two includes as little of the total business overhead as possible, so that the mass of Business Two’s expenses are the inventory itself and, thus, included in the “Cost of Goods Sold”.
Done correctly with legal guidance (and in accordance with your state laws), the two-business approach is a court-approved way run one non-cannabis, non-280E business that can file normal tax returns, and one highly focused cannabis businesses with limited expenses to match its limited deduction capabilities.
Incorporate as a Corporation
Most cannabis businesses are inclined to incorporate as an S-corp or an LLC. These are most suited to small businesses and usually include generous allowances for tax deductions. However, due to the unique restrictions of a cannabis business under 280E, the “phantom income” that is generated by the S-corp and LLC is then double-taxed.
In order to reduce your corporate tax burden, it’s smarter to incorporate your business as a C-corp. A C-corporation owner is taxed on their own salary and/or dividends. It’s a different structure that changes and reduces the way your cannabis business will pay taxes. But remember, you may only need a C-corp for the second business in a split pair.
The IRS has openly said that they will be picking over Cannabis business taxes with a fine-tooth comb. The intent to enforce 280E as strictly as the law allows, which means they intend to reject many tax returns and demand back-taxes for any cannabis business that does not perfectly pass inspection.
So be ready to perfectly pass inspection. Have a lawyer and other necessary consultants on-hand. Build your business structure carefully and, most importantly, keep meticulous records.
Calculate the Exact “Cost of Goods Sold”
The first step is to calculate very precisely what your “Cost of Goods Sold” is. Determine how much acquiring, packaging, and selling your products has cost the business and create a receipt-record of that cost. You can deduct small related costs, but they have to be directly related. The final number will equate your total tax deductions for the cannabis business.
Be Precise With Job Task Tracking
Second, track job tasks very closely. If an employee does things related to “trafficking” cannabis, these hours need to be tracked separately. Many cannabis business owners who use the split-business trick actually hire their employees with both businesses and pay them from each. Your employee’s time cultivating, producing, or selling cannabis can also be included in the cost of goods sold.
Are you ready for Section 280E enforcement? Do you need financial or legal guidance for your cannabis business? Thus, contact us today for a friendly consultation and your financial plans for the future.
Every entrepreneur’s dream is to grow a successful business. For most, that means steadily increased sales and profits, with a healthy balance of income and expenses. As an LA-based distributor, increased sales and momentum comes with a catch—the more sales you get per month, the more complicated the tax requirements of your cannabis distribution company become. That’s why it’s essential that you get acquainted with the ins and outs of tax requirements for a Los Angeles Cannabis distributor.
In order to begin running a legal and compliant cannabis distribution business, you need to receive
A business license. This is standard for all businesses to legally operate.
A seller’s permit from the CDTFA
A cannabis tax permit from the CDTFA
A distributor license from the BCC (Bureau of Cannabis Control), a sub-agency of the California Department of Consumer Affairs
A seller’s permit is required if you sell any physical cannabis plants or products within the state of California. As a distributor, you are likely selling products to retailers or fellow distributors or microbusinesses. There are a few instances where you may not be required to obtain a seller’s permit. In those cases, you still need official documentation from the CDTFA clearly stating that your business is exempt. Learn more about the Seller’s Permit here.
The cannabis tax permit requires you to regularly file tax returns. For a business that is fully-operational, that can mean reporting every month on the last day of the month, during which the transactions you are reporting took place.
Filing Monthly Tax Returns
This is where things can get complicated.
However, as you become well-versed in LA cannabis tax laws, you will be able to develop an SOP (standard operating procedure) for efficiently and thoroughly documenting all of the necessary information needed in every transaction for your monthly tax returns. Incidentally, this is a major factor in the decision of many cannabis distributors to hire or outsource CFO services.
As a fully operational cannabis distributor, CDTFA requires you to do the following in order to file for monthly tax returns:
Collect cultivation tax
Collect cannabis excise tax
Document all transactions with an official receipt or invoice for the tax records of businesses you are collecting either of the above taxes from
File your Sales and Use tax with the CDTFA, pay the amount due, in addition to the above cannabis tax returns
Calculating and Collecting Cultivation Tax
Cultivation tax is collected from any cultivators or manufacturers of any harvested cannabis products that you purchase. Cultivation taxes are calculated based on the weight and the state of the cannabis plant at the point of the transaction.
As for rates, the CDTFA will begin accounting for inflation by annually adjusting cultivation tax rates on the first day of this coming new year. Cannabis businesses will receive notices of every adjustment directly from the CDTFA.
Dry cannabis flowers: $9.25 Dry cannabis leaves: $2.75 Fresh cannabis plant, where the weight is recorded within two hours of harvesting: $1.29
When you are documenting the amount of cultivation tax you received, be sure to record the category and exact amount of cannabis you purchased.
Calculating and Collecting Cannabis Excise Tax
The cannabis excise tax is collected from cannabis retailers you sell or transfer cannabis plants or cannabis products to. This is a 15% tax that’s “imposed upon all purchasers of cannabis or cannabis products sold at retail.”
There are three categories of purchases that deem this tax applicable or not:
Arm’s length purchases indicate that the transaction is taking place between two consenting parties who have no relationship outside of that transaction. So the lounge on .. street purchases a supply of cannabis oil, or a batch of recreational marijuana, from you, you deliver, and the story ends there. Perhaps they are regular customers, but neither one of you receive any further benefits from your relationship aside from the transaction of the goods.
In these cases, the calculated tax is the whole cost of the product, plus the 15% markup. This would be an example of the standard market price.
Non-arm’s length transactions, also known as arm-in-arm transactions, are, as you can imagine, the opposite. Perhaps the transaction is between family members. Or perhaps it is done between two companies that have the same shareholders or umbrella company. In this case, the cannabis excise tax is calculated based on the retailer’s gross receipts, with no fixed markup. This transaction does not reflect the market price of the product.
You are also not responsible for collecting cannabis excise tax in cases where you are selling products to another distributor or microbusiness. These transactions should be documented to clearly state the following, as indicated on the CDTFA’s website:
The selling distributor’s name and license number,
The purchasing distributor’s name and license number, and
A statement that no cannabis excise tax was collected.
California Cannabis Track-and-Trace Metrc System
The state of California requires that all compliant distributors implement the track-and-trace Metrc system by using the Wholesale Manifest for each transaction with a retailer. This means recording the wholesale cost of each unit the retailer has to pay, and as of January 1st, 2020, this includes the cost of transportation.
Sales Tax and Resale Certificates
As a distributor, you are required to collect sales tax when selling products to retailers. But, given the nature of your business, most if not all of your transactions with retailers will be resales. In the state of California, sales tax is not required for products that have been resold. So be sure to obtain valid resale certificates from retailers you supply to, declaring that you did not receive any sales tax.
This, among other reasons, is why it’s crucial that you only engage with other licensed businesses, you need this official documentation to present to the CDTFA when declaring monthly tax returns so that you won’t be penalized.
Keep in mind that, even if all of your transactions are resales, you’re still required to file your sales tax returns, stating that you have not collected any sales tax.
Reap the Rewards of Running a Compliant Business
There’s no doubt that running a compliant cannabis business is challenging. Keeping your finger on the pulse of current regulations and tax policies, maintaining a rock-solid paper trail, and developing a business model and budget that accounts for tax increases is no simple task.
That is why we do recommend having a go-to for all your tax-related questions. Top financial advisors like the team at Northstar that specialize in the cannabis space can give the best financial advice on how you can run a business that is both successful and compliant.
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.