‘Tis the season! Tax season, that is.
And one thing that no one can argue with is that Cannabis tax laws are among the most complicated and intricate to comply with. With the unique-phenomena where cannabis is illegal on the federal level, but legal at the state level, there is an interesting dynamic with national bodies such as the IRS, and local governments.
Part of that interesting dynamic includes the less-interesting reality that cannabis regulations and cannabis business tax requirements are downright onerous. IRC 280E and the California’s recent cultivation tax hike are prime examples of the difficulties of the system.
As you are preparing for your annual tax returns, you, or your CFO, will probably be reassessing certain financial frameworks in place within your cannabis business. One of those questions that you might want to reconsider is whether you should be following an accounting method that’s cash-based, or accrual-based.
Let’s take a moment, first, to define the terms.
What Accounting Methods Are, and How They Impact Your Cannabis Business
Accounting methods are a chosen framework for your bookkeeping. These are predefined by tax laws, and each method has its pros and cons, as well as specifications that your business has to meet in order to be able to use a particular method. Those specifications are, generally, based on the level of your business—i.e. Your monthly income and business activities—as well as the classification that you chose when you first opened your cannabis business, like “corporation” or “LLC.”
Different cannabis accounting methods do not affect the amount your business made or spent, which you declare on tax returns. They don’t either affect how your business is subject to tax laws such as 280E.
So how does the accounting method you choose affect your cannabis business? It affects the timing of when certain transactions will be reported annually.
Now let’s get into the two basic accounting methods. Keep in mind that there are several other accounting methods out there, but they are, for the most part, modified versions of these two methods.
Cash-Based Accounting for a Cannabis Business
Cash-based accounting is the method of calculating monthly revenue and expenses based on the moment that you get cash or the moment it leaves your hands. This is the easiest form of accounting, because you are simply recording expenses and revenue as they come.
Accrual-Based Accounting for a Cannabis Business
Accrual-based accounting for a cannabis business is the method of recording your net earnings as they match up with your cash-in and cash-out, as well as the timeline of when your expenses, for example, are actually for. This is particularly relevant in cases where you pay rent ahead of time, or pay a lump sum for, say, insurance, instead of stretching it out into monthly payments.
This is more complicated, but does align your net monthly income more accurately.
How to Know if Your Business is Right for Cash Method Accounting
For a cannabis business that’s perhaps just starting out, or has yet to gain momentum, it makes sense that you’d want to keep it simple with your accounting methods. After all, as we pointed out earlier, there are enough complicated bookkeeping requirements in the cannabis industry, as it is.
Keep in mind, though, that there are a couple of requirements in order to be eligible for the cash-based accounting method:
- Your business must be licensed with a three-year average in gross receipts of less than $26 million as of the 2019 tax year, and/or
- You have a cannabis cultivation business, with daily operations that fall under the farming activities sector.
Note that cannabis producers and retailers, of course, can still choose this accounting method as long as they meet the first requirement.
Inventory Requirements While Using Cash-Based Accounting
Once you’ve discerned whether you meet the requirements of being able to opt-in for cash-based accounting, there are a couple of must-dos to implement in your accounting SOPs.
Keep careful stock of your cannabis inventory. Doing so classifies your inventory as “non-incidental materials and supplies.” For those that are new to accounting-jargon, this is as opposed to “incidental materials and supplies,” which are not tracked in an inventory-system. Depending on what your business’s SOP for inventory tracking is, you might do this by either recording how much of your inventory is sold or transferred, or by physically going through your stock regularly and recording what you currently have.
If you are a licensed cannabis cultivator, this may not apply to you. In that case, you might be eligible to use methods of tracking inventory for accounting purposes that are available to the agriculture sector, and farmers in particular.
Use the inventory procedure as specified in your applicable financial statement (AFS). If you don’t have an AFS, then follow the accounting and bookkeeping SOPs you do have.
The Timeline of Cash-Based Cannabis Accounting
If you are a cultivator of cannabis sativa or cannabis indica, the cash method can potentially hasten the process of when you can declare your operating expenses. It goes without saying, that there is quite the process that your business facilitates, lengthening the timeline of when you actually get the cash in your hands from those cannabis plants. It certainly is beneficial to not have to wait to declare your expenses until all of that inventory actually gets sold, particularly when you’re spanning from one tax year to the next. Not having to wait a whole extra tax year to declare your expenses is often ideal.
As a retailer or a processor, you can similarly benefit from cash-based accounting, though, of course, you won’t have the eligibility to the deductibles that a cultivator may have.
When it comes to accounts receivable, in accrual-based accounting, you have to declare that taxable income at the time of the transaction. With cash-based accounting, on the other hand, you don’t have to declare money owed to you, as long as it’s within a reasonable amount, until you’ve actually got the cash in your hands. If you do have a particularly large sum of accounts receivable, you may still have to declare it.
Is Cash-Based Accounting Right For Your Cannabis Business?
This is a question that is extremely particular to each and every business and situation. That’s why we recommend going to a top financial advisor in the cannabis industry. In which case, Northstar can help you.
Contact us now for a consultation, to learn whether cash or accrual-based accounting is right for your cannabis business. Call: +1.424.274.3188