ArchivesCannabis Taxation Archives — C. Lynn Northrup, CPA, CPIM
Managing and valuing inventories in cannabusinesses is the key to increasing cash flow and lowering taxes. Cannabusinesses are restricted to reducing gross revenues by the cost of goods sold because of IRS Section 280E. Section 280E was enacted in 1982 and provides that no deduction or credit is allowed for any amount paid or incurred in carrying on a trade or business consisting of the trafficking in controlled substances within the meaning of schedule I or II of the Controlled Substances Act. The only way cannabusinesses can reduce their tax burden is by maximizing cost of goods sold (COGS).
The tax laws and regulation associated with cannabusiness are complex. Understanding these complex laws and regulations makes the job of valuing inventories and determining COGS of cannabis businesses a challenge. This is compounded by the cannabis industry being a collection of complex processes and types of businesses.
Cannabusinesses include cultivators or growers that grow plants and then harvest the flower from these plants. In addition to selling flower, it can also be processed into a variety of marijuana infused products (MIPs). Marijuana infused products are created by extracting distillate which is then infused into other cannabis products such as vape cartridges, edibles, topicals, wax, and shatter. These products are then packaged and sold through dispensaries. The tax laws and regulations for determining COGS and inventory valuation for growers and MIPs are different for dispensaries.
Cultivation or farming of cannabis needs to track the flower yield from indoor and outdoor grows measured in grams to develop a cost for the harvested flower. Marijuana infused products are the result of process manufacturing operations creating multiple varieties of products requiring different types of packaging. Costs are developed based on the recipes for these products, including packaging.
These products are then sold and distributed to dispensaries for ultimate resale to the consumer. Dispensaries, in many cases, are required to inspect, repackage, and check the quality of products before they can be sold to the consumer.
Most cannabis businesses are using Quick Books to accumulate costs supplemented by spreadsheets to calculate yield and the cost of distillate. The costs of cultivation and marijuana infused products include direct labor, material, and allocation of overhead. Allocation of overhead should be based on guidance from Section 471 and Section 263A of the Internal Revenue Code. It is critical to determine any allocation of overhead to be included in COGS in compliance with IRS codes and regulation, but also to maximize costs that offset gross revenue.
Accounting for cannabis products needs to be accurate. In some cases, ERP (Enterprise Resource Planning) systems are being utilized by larger operations. Dispensaries determine cost based on the actual cost of products purchased and associated freight. Inventory tracking is required, and many dispensaries utilize point of sale systems and inventory management systems to control and manage activity.
Based on my experience, managing and controlling inventory costs and the associated investment is one of the most challenging and critical areas of cannabusiness. First, inventory investment requires a significant cash investment. This makes effective purchasing and inventory management vital. Second, accurate and maximum determination of COGS reduces the tax burden created by IRS Section 280E. This means that inventory costing and management should be a top priority for all cannabusinesses and their accountants.
Utilization of professionals who understand cost accounting and the unique taxation requirements of the cannabis industry represents the key component to success or failure.
The IRS recently published guidance to provide cannabis businesses insight regarding compliance with IRS regulations. Major questions have been raised regarding Section 471 (c) which allows small business tax payers with revenue under $25 million to adopt the cash basis of accounting and prepare the books and records in accordance with the taxpayer’s accounting records. This seemed to open the door to modifying how cannabis businesses recorded cost of goods sold to minimize the impacted of Section 280E. Changes in Section 471 (c) resulted from the Tax Cuts and Jobs Act of 2018.
Section 280E disallows all deductions or credits for a business that sells or otherwise traffics marijuana. However, Section 280E does allow businesses to reduce its gross receipts by properly calculating cost of goods sold. This means that advertising or selling expenses are not deductible.
The guidance under Section 471 (c) according to the IRS is that it is just a timing provision and would not permit a taxpayer to recover a cost that it would not otherwise be permitted to recover or deduct for Federal income tax purposes solely by reason of it being an inventory cost. We’re not sure if this works and there could a conflict with Section 471 (c). This is a new regulation and is the IRS opinion on the application of Section 471 (c). They are adding Internal Revenue Code “flush language” via a regulation which is the opinion of the Internal Revenue Service.
I work with multiple cannabis businesses and have spent a considerable amount of time dealing with Section 471 (c) and how to apply it. The regulations say that qualifying businesses may choose to treat its inventory as reflected in the taxpayer’s books and records prepared in accordance with the taxpayer’s accounting procedures. If a change in accounting was made to adopt the new regulations, a Form 3115 is required to be filed outlining the changes.
A taxpayer taking the Section 471 (c) approach contrary to the regulations should consider disclosing any position that could be inconsistent with the new regulations. A disclosure should be made by filing a Form 8275R with the tax return. Determining cost of goods sold for cannabis businesses can be complicated and should be based on cost accounting logic. Cannabis businesses and their tax advisors should consult with someone experienced in these areas when applying these regulations.
IRS guidance has indicated that the growth of the marijuana industry will warrant increased tax compliance efforts. Accordingly, extreme care should be taken when developing and preparing cannabis tax returns based on the recent IRS guidance.