What is the 280E Loophole?
If you are in the cannabis industry, you have likely heard about the 280E loophole. 280E excludes normal business expense deductions from federal taxes for companies operating in the cannabis space.
So, what is the issue here?
This exclusion limits profits and makes accounting for cannabis inventory more complex than other operations.
With limited access to deductions and credits, some cannabis businesses must deal with an effective tax rate of as much as 80%. It is easy to see why so many cannabis business operators are looking for a 280E loophole. But equally important to keep in mind is that many of the Section 280E strategies you might hear about online are as risky as they are aggressive.
Costly infractions can come as a result of incorrectly allocating expenses into cost of goods sold and putting costs to non-plant lines of the operation. Some cannabis companies find themselves in litigation over these practices, especially if they do not have a cannabis CPA handling their books on their behalf.
Managing Tax Liability and Attracting Investment
At Northstar, we optimize our clients' tax positions with a firm understanding of tax laws. This involves improving inventory accounting and finance functions.
We establish consistent methodologies, detailed reports, and documentation to ensure our clients are always ready for an audit. Current cannabis accounting practices lead our efforts.
Through this approach, we address the 280E challenge while establishing a solid foundation to support long-term growth. Without this organization and expert accounting practices, tax liability remains high and it is challenging for cannabis companies to attract investment.
280E Cost of Goods Sold FAQ
Business operators, including cannabis business operators, subject to Section 280E must check Sec. 471 to understand how to properly capitalize inventory and valuation methods, as well as how to allocate expenses and their impact on cost of goods sold.
What is deductible under 280E?
Under 280E, taxpayers are not allowed to make deductions for a trade or business in which the operations are involved in the trafficking of controlled substances. Since cannabis is still federally prohibited, the IRS does not want to see business deductions that are related to this federally illegal activity. The only offset to gross income is COGS.
Can dispensaries deduct expenses?
Section 280E of the Internal Revenue Code does not allow dispensaries to deduct most expenses. This is because these operations sell a federally illegal controlled substance. Expenses that come about in the production, distribution, and sale of cannabis are generally non-deductible, except those properly classified as COGS.
Does 280E apply to growers?
Every business involved in touching medical or recreational marijuana and its products throughout the supply chain is subject to 280E. This includes marijuana growers. While these operations might be operating in a state that has legalized cannabis, 280E still applies because of the federal classification.
280E Depreciation
Since Internal Revenue Service code section 280E keeps cannabis businesses from taking deductions, depreciation falls under this restriction as well. For instance, retail cannabis operations cannot deduct depreciation of cash registers, leasehold improvements, shelving and display cases, and other assets as a standard business expense. However, depreciation on production equipment may be includable in COGS for cultivators and manufacturers.
Accounting for Cannabis Inventory Valuation
For cannabis retail, inventory would be classified into primary categories (flower, concentrates, edibles), secondary categories (brand, potency, strain type), and tertiary categories (individual SKUs and batch numbers).
During inventory valuation, we methodically determine the total cost value of all products in stock at any point during the accounting period.
By assigning a dollar value to the goods in stock, we know what a portion of the company's current assets is worth. This comes in handy when handling financial statements and encourages better decisions when considering available funds.
Inventory sold gives the business more cash flow. This allows the company to replenish goods and maintain appropriate stock.
From there, we add the value of all sold inventory and all associated direct costs to get the cost of goods sold. Then, COGS subtracted from the total revenue offers the gross margin.
We track inventory metrics like gross margin because this offers a clearer assessment of company revenue and how much is available to cover operational costs. This also allows us to explore strategies to increase revenue as we work to maximize profits.
Inventory Costing Methods for Cannabis Businesses
There is no single inventory costing method that works for every cannabis business. We must identify which solution will work best for the company.
Cloud-based inventory management systems leave a lot to consider. However, with cannabis inventory typically having an expiration date, these three methods usually work best.
FIFO (First-In, First-Out). The first-in, first-out method considers the items that were first put into inventory as those which will be sold first. This technique is commonly used in the food industry and other perishable goods sectors.
Through this technique, businesses sell the goods purchased first before selling the newest stock. This method ensures remaining stock contains the most recently purchased goods, which are then accounted for at their purchase cost and give an idea of the current value of inventory.
With FIFO, perishable cannabis goods remain fresh, allowing operations to minimize waste from spoilage. This also allows cannabis operators to comply with state and local laws that regulate efficient seed-to-sale tracking and rendering of unsold products after expiry.
Since the cannabis industry is impacted by price volatility and its black market, the FIFO method also gives small operations the ability to report lower COGS and higher margins by selling lower-priced products first. But for scaled operations with higher-volume transactions, FIFO makes accounting for cannabis inventory more challenging, meaning the business may be better off using a simpler alternative.
LIFO (Last-In, First-Out). The LIFO method involves selling the most recently bought goods first and allowing older goods to stay in inventory for longer. This increases storage costs, spoilage risks, and the overall cost of goods sold.
However, LIFO has advantages. It is good for those looking to reduce their taxes by reporting higher COGS and lower profit margins. This also suits businesses with high inventory turnover that want to avoid the complexity of tracking individual purchase dates.
But cannabis businesses rarely use this solution. Since cannabis products are typically perishable and can expire before being sold, the LIFO method results in more waste and losses.
WAC (Weighted Average Cost). The WAC method is the most straightforward method for inventory costing. It calculates the average value of all inventory in stock regardless of when the items were purchased or will be sold. To calculate the weighted average cost per unit, divide the total cost of goods in inventory by the total number of units.
High-volume sales and volatile prices make this one of the quickest and most efficient solutions for cannabis. This facilitates inventory management in instances where multiple strains or batches are combined to make edibles or concentrates, since calculating individual item costs would be impractical. While using WAC, it is crucial to maintain seed-to-sale tracking for compliance.
Cost of Goods Sold Optimization
The first thing we recommend is setting up Inventory Control Standard Operating Procedures (SOPs). Initially, this involves checking to ensure there is enough inventory in stock to satisfy demand. However, it is crucial to avoid tying up too much money in stock.
Purchasing Cannabis Inventory SOPs
Every week, the person in charge of purchasing must check each product to determine which ones are low in stock. Then, they order approximately a month of supplies. Checking important inventory indicators should be included in this process to determine which products to order. If the products are aging or expiring, they should not be purchased, or those product purchases should be reduced significantly to minimize waste.
When making purchasing decisions, consider current sell-through rates, seasonal demand patterns, shelf life remaining for available products from suppliers, and any upcoming promotions or price changes from vendors.
Receiving Cannabis Inventory SOPs
For receiving inventory, staff should verify quantities match purchase orders, inspect products for quality and proper labeling, record all METRC tag information and batch numbers, update the inventory management system immediately upon receipt, and store products in their designated locations at the correct temperature.
Cannabis Storage and Control SOPs
Cannabis product storage is essential in this space. Products must be stored safely and at the right temperatures to ensure freshness. This is where a regular cycle count becomes important.
Each type of product should have an established cycle count schedule. This establishes whether you are experiencing inventory losses.
Poor inventory management policies typically contribute to inventory losses, such as inventory being lost, stolen, or expiring on the shelf.
For cannabis storage and control, a team member should perform a blind count of all inventory. Each product's stock should be documented.
Product inspections are equally important. This involves checking to see which products will expire the soonest. These products should be the first to sell. Any products that are expired should be disposed of and marked as a loss. Discrepancies should be reconciled and documented as a loss using the inventory system in place.
Cycle counts should happen weekly. A KPI should be in place to ensure inventory discrepancy remains less than 1%.
Security is equally important. Most of the time, security cameras and access controls are enough to prevent theft. But if an operation needs additional precautions, having all staff sign a theft policy outlining consequences can also discourage theft. Give your team the ability to anonymously report theft as well.
Cannabis Inventory Aging SOPs
We recommend analyzing cannabis inventory aging weekly. Cannabis business operators will often find that part of their inventory has aged beyond 60 days. This means cash is tied up in inventory, and this is not reflected in the Profit/Loss statement but is visible on the Balance Sheet.
An inventory aging report will help diagnose inventory issues. If products are 60 days or older or close to their expiration date, they should be discounted to speed up sales. If products are not selling fast enough, they should be removed from future orders or reduced in quantity.
Strategies for eliminating aging inventory include running promotions or bundle deals, offering staff education to push slow-moving products, partnering with delivery services for wider distribution, and marking down prices before products expire to recover partial value rather than taking a total loss.
Closing on Accounting for Cannabis Inventory
Inventory accounting is a crucial part of managing any cannabis operation. The right tools and processes should be used to ensure accurate tracking of all inventory levels, as well as aging reports that show what has been sold and the revenue generated from sales.
Proper inventory management SOPs combined with a strong CPA team help cannabis operations stay compliant, minimize waste, and maximize their COGS deduction under 280E.