By Todd Arkley
Creating the financial accounts for your cannabis business can be confusing, especially with the restrictions of Internal Revenue Code 280E. Below are some simple strategies to ensure that your financial records are not only compliant for federal tax purposes, but will also provide you with relevant and useful financial data.
Don’t get too complex. One of the biggest mistakes small business owners make is setting up too many different accounts when installing and establishing their accounting software. If every single item you purchase has a separate line item on your financial reports, not only will it take much longer to prepare your books, but also your financial data will be much less useful.
The best way to think about this is to start at the macro level — one account is Revenue and the other account is Expenses — and slowly add more accounts as you review your business plan and operational structure. The primary reason to add more accounts is to provide you relevant information to understand the profitability of your business. Tied in with this, as we will discuss later, is the ability to track the tax treatment of certain expenses.
For example, a cannabis retailer will need to keep very detailed records of each individual product that they are buying and selling. Where should you monitor this? Your inventory software will keep records of the stock you have purchased, down to the individual product. Your point-of-sale software will keep detailed records of what you have sold, down to the individual product. But in your accounting software, it is not necessary to have an inventory account for every single item. A handful of accounts — Flower, Edibles, Concentrates, for example — will likely suffice. For detailed financial analysis, you will be using your inventory tracking and POS software, in conjunction with your accounting software. Don’t make the mistake of thinking that your accounting software is the only data analysis and collection tool you have in your toolbox.
Another example: for your grow, it might be a good idea to have separate expense accounts for soil and nutrients, but it would be unnecessary to have separate accounts for each and every type of soil or nutrient you purchase. The question you should ask yourself when looking at your soil account is “Am I spending too little, too much, or just enough on soil?” If the answer is “too much,” then you dig into the one soil account further to locate the problem. It isn’t necessary to have 10 separate soil accounts to locate this information.
Regardless of the amount of accounts you set up, make sure to keep an electronic or paper copy of every expense receipt for easy retrieval, and include plenty of narrative description in your accounting software when inputting the expense. By doing this, it will be much easier for you to find and examine the specific expenses needed for more detailed analysis. In addition, if you do decide to split an account up in the future (for example splitting a single Internet/phone account into separate accounts), maintaining detailed records will make that process much easier to manage.
IRC 280E compliant accounts
Because of IRC 280E, you will be adding/modifying accounts that would not be necessary in a typical small business. After creating your basic expense accounts, take a step back and review your chart of accounts. Each account should be able to go into one of two categories: Cost to produce/acquire your product, or cost to sell your product. If it is a cost related to acquiring/creating your product, then it will likely be an allowable deduction on your federal tax return. If it is a cost related to selling your product, it will likely not be allowed as a deduction on your federal tax return.
By doing this analysis, you should be able to get a rough estimate of what your deductible expenses will be on your federal return and thus, what your taxable income will be. I do recommend that you have an experienced bookkeeper or CPA review your analysis of these accounts and assist with implementing the detailed mechanics to set up these accounts in your accounting software, as you will be using more asset/inventory accounts than usual. But for your back-of-the-envelope calculations, thinking of costs in this manner — produce/acquire vs. sell — will give you an approximate idea of your federal tax burden.
In some situations, you may need to split an account into two categories. For example, if you are a grower, most of your rent payments will be related to growing cannabis, but some of your rent will likely cover administrative offices as well. In this situation, it would be wise to have two rent accounts — Rent: Growing Facilities and Rent: Administrative Offices. Broadly speaking, the rent related to your grow would be tax-deductible under 280E and the rent related to your administrative offices would not be deductible. However, if the offices are used to monitor the grow, some of that rent could possibly be deductible. On the other hand, if the offices are only used to track and monitor sales, then that rent would probably not be deductible.
The most important part when splitting any costs into deductible vs. non-deductible categories is to document your methodology for determining the split. It is crucial that you can justify to the IRS your allocation of costs if you happen to be audited. Create processes and standards for allocating expenses and follow them. Keep a file that documents how you treat each expense category. Not only will this keep you compliant on your federal tax return, it will also create accounting standards to be used by all employees within your business.
Staying compliant with IRS regulations is crucial and to do so, you need to keep detailed financial records. It would be a mistake to assume that staying compliant with IRS regulations does not affect your bottom-line. The same data that is needed by the IRS can also be utilized by you to improve your overall profitability. View these restrictions as a challenge and those of you who can survive, in spite of these restrictions, will be much better positioned if and when tax reform occurs at the federal level.
Todd Arkley, CPA, is the owner of Arkley Accounting Group, which provides financial management for small businesses and the cannabis industry. He also serves on the board of the Coalition for Cannabis Standards & Ethics.