Wondering how to avoid 280E? You’ve come to the right place!
The cannabis industry is a rapidly growing market. We have helped many cannabis businesses reach financial success and grow exponentially. Even though there are exciting success stories, the cannabis industry and cannabis business owners are still facing massive challenges specifically related to their niche market.
Many challenges to the cannabis industry involve unique complicated accounting and tax laws. For instance, federal income taxes are based on a simple equation: start with gross income, subtract business expenses to calculate taxable income, and then pay taxes on this amount.
Unlike most traditional businesses, the cannabis industry is subject to Section 280E of the Internal Revenue Code. Section 280E is a federal statute that forbids businesses dealing with Schedule I or II controlled substances, such as cannabis, from deducting ordinary business expenses from their taxable income.
Simply put, unlike most businesses, cannabis businesses are likely paying a substantially higher effective tax rate just because they cannot take normal deductions associated with selling cannabis, such as employee wages, accounting, systems, rent, and more.
With that being said, our most common question from clients is: Okay, how can we avoid 280E?
Well, you can’t.
At least not entirely. There are a few things you can do to significantly reduce your tax costs while staying within the 280E regulations if you just keep on top of your game. Many cannabis companies aren’t aware of these exceptions. Knowing what to do, what you’re looking for, and having a team of financial experts to point them out, can save you big bucks on your IRS tax return.
How to calculate “Cost of Goods Sold” (COGS) under 280E
Section 280E does not prevent cannabis businesses from deducting the cost of goods sold. Identifying whether deductions can be allocated as COGS can make a significant impact to minimize the tax on your cannabis business.
If you are a cannabis cultivator, examples of COGS are raw materials and supplies, including seeds, clones, and fertilizer; indirect product costs, such as equipment maintenance, utilities used to grow cannabis, wages of supervisors; and quality control and inspection costs. Labor-related COGS could be deducted for cleaning, trimming, curing, packaging or inventory.
For businesses that are exclusively a dispensary, COGS are limited to the cost of the product and the costs of acquiring the merchandise. This can include transportation costs to purchase wholesale cannabis. Deductions may also be claimed for electric bills for designated inventory areas. Virtually everything else, such as employee salaries, marketing, advertising costs, rental fees for facilities, and more, are subject to 280E limitations in a retail environment.
Having an accountant who specializes in cannabis businesses can help you go over all of your expenses and determine what items can be considered deductible. It is worthwhile to have someone with this experience so that they may guide you to maximize your potential deductions.
Loving this article? Make sure to check out our other post that offers 280E tax code information you’ll enjoy, too.
Does your cannabis business perform another function?
The tax court lets businesses separate cannabis sales from other types of business transactions. If you have other parts of your business that isn’t directly related to cannabis and it generates real income, then this could be an option. This means the second business can deduct business expenses as usual for non-cannabis business activities. This will require “proof” that the non-cannabis part of the business could stand on its own, separate from the cannabis business itself. That means separating out payroll, operating costs, etc. that are specifically for the “second business”.
The separateness and business expenses must be documented because there is a likelihood of an audit. Your financial professional should be able to assist you in separating out the expenses.
Accurately track employee timesheets for COGS
Hours worked by employees doing tasks related to cannabis production are deducted under COGS. Therefore, employee time spent cultivating, packaging, and doing inventory management is deductible under Code 280E.
Accurately tracking time could make a big difference in your COGS number, so you want to pay close attention to this. To help facilitate the process try using a time tracking system. The time tracking system should be customizable and allow employees to record time by individual activity.
Understand corporate structures
Choosing a structure for a company is an important decision. This decision must be well-researched and strategically thought out because it could either help or harm your business. For a cannabis business, you generally are choosing between a C-Corporation, S-Corporation, or Limited Liability Corporation (LLC).
For larger-scale cannabis businesses, CPAs and legal advisors usually recommended setting the business up as a C-Corporation. Under United States federal income tax law, a C-corporation refers to any corporation that is taxed separately from its owners. A C-corporation is different from an S-corporation because an S-corporation is generally is not taxed separately.
Since a C-Corp is a tax-paying entity, the corporation pays taxes on the company’s gross profit. That means the business owner only pays taxes on salaries or dividends.
Keep your accounts updated and in order
The IRS requires you to keep receipts for all transactions as evidence on your tax return. This means all revenue and expense must be accounted for, no matter how small. Since 280E only permits the deduction of COGS, the IRS generally goes through these numbers with a fine-toothed comb. If there are mistakes or inaccuracies in your deductions, your business may be subject to a fine.
As a cannabis business owner, your company is more likely to be audited. Cannabis is considered a federally illegal substance and is subject to more scrutiny than other products. This is why staying organized, well-versed on tax laws, and tracking employee hours is so vital for the survival of your business.
Local and state taxes vary depending on where your business is operating. You will be responsible to know and adhere to all of your local state laws or finding a reputable tax advisor to help you.
Expert accountants in the cannabis industry are familiar with the laws better than anyone else. They understand all the details and tricks of Section 280E, what is considered a COGS and what isn’t, and how to correctly, and legally, minimize your taxes. They can help ensure your tax return is filed promptly and accurately, provide required supporting documentation, and help you avoid an audit.
This might all sound very overwhelming, but it could save you a lot of cash. Contact us today for a free consultation, and find out how we can help you significantly improve your cash flow.