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.