Six ways to maximize deductions and stay compliant with tax regulations
Companies are known for exploring multiple product ideas and business opportunities before finding their sweet spot.
Most fast-growth companies are tasked with balancing a constrained budget, while providing the appropriate amount of funding to support product development, talent acquisition and a positive culture that aids in employee development and retention. However, in addition to funding challenges, cannabis companies and ancillary organizations supporting the industry are tasked with additional recordkeeping, tax exposure and financial obstacles.
The cannabis industry is growing at a rapid pace, yet companies continue to face the dichotomy of reporting illegal income at a federal level while reporting legal income at a state and local level. This causes an unfair disparity in tax burden, as well as differences in reporting between the federal, state and local levels. These differences are highlighted under IRS Internal Revenue Code Section 280E.
Section 280E requires the reporting of income from illegal sources at the federal level. Since the income tax liability at the federal level does not differentiate between income derived from legal sources versus income derived from illegal sources, all receipts of income must be recorded. However, since cannabis is still a Schedule I controlled substance at the federal level, most expenses related to the production, distribution and sale of cannabis are deemed illegal. This creates disparities in reporting and a much more substantial tax burden at the federal level. While cannabis companies must report all revenue to the IRS, Section 280E prohibits all deductions paid in the distribution, sale and production of controlled products.
In the simplest terms, companies that fall under Section 280E can only deduct expenses for the cost of goods sold (COGS). A Section 280E company is not permitted to deduct wages, rents or repairs, general business expenditures or marketing costs. Essentially, only the cost of growing the plant can be deducted.
Because non-cannabis companies can deduct all expenses related to the business, if the business incurs a loss, it will have no tax liability. However, if a cannabis company has a loss, it may still have a significant federal tax bill to pay. Furthermore, the company is required to use an accounting inventory method to be able to deduct the COGS.
In order to meet the requirements of Section 280E and to provide for solid tax, cash flow and financial planning, there are several ways a company can maximize its deductions and ensure compliance with the code:
- Understanding the implications of Section 280E and the short-term and long-term consequences of incorrect or “sloppy” records. While reporting expense deductions incorrectly in the short term may minimize current tax liabilities, it could result in substantial expenses in the long run, including increased tax liabilities, penalties, interest and significant legal costs. It is also imperative to understand the tax calculations as materially correct tax estimates must be factored into budgets, estimates and cash flow projections. A business may lose money from a profit-and-loss perspective, yet still incur a hefty tax liability, for which it will need the cash flow to cover.
- Ensuring the books and records are in good order and that cost-tracking methods are an accurate reflection of the activities of the business. Setting up a solid transfer pricing methodology that accurately reflects business activities from inception ensures the maximum allowable costs recorded as COGS and ultimately reduces the federal tax burden. Since many startups are cash-strapped, they skip the valuable step of getting their books and records set up properly. While it may save money in the short term, it typically results in significantly increased costs in the long term. Plus, a good set of books and records serve as the foundation for tax reporting.
- Preparing and maintaining separate books and records for Section 280E activities and non-Section 280E activities to provide for the maximum allowable deductions. Maintaining separate records for each business will allow the non-Section 280E business to accurately deduct all allowable expenses related to their activities. A good accountant or CFO can develop an appropriate allocation methodology to report costs among various business lines that are a true reflection of the economic activity. For example, if a company has multiple lines of business and employees who support each of the various lines, a good accountant can set up a time-tracking system to allocate employee expenditures appropriately. This will ensure accurate recordkeeping and a realistic solution for deductible versus non-deductible expenses.
- Maintaining and accounting for research and development expenses. All R&D expenditures fall outside of Section 280E. If an organization conducts cannabis activities and R&D, be sure to keep an accurate accounting of the costs of the R&D.
- Maintaining all costs associated with cultivation. Most costs around cultivation of the plant are part of COGS and can be deducted.
- Making quarterly estimated tax payments throughout the year to reduce the risk of penalties incurred and interest accrued when the tax return is due. Even if the company is showing a loss, potential tax liabilities must be regularly reviewed to determine the need for an estimated payment. In the event that tax liabilities are not paid throughout the tax year, penalties and interest may be assessed.
Good up-front planning, along with accurate and consistent recordkeeping from inception, can save a significant amount of time and money for any business. However, for a cannabis business, it is imperative to get it right from the start. Obtaining a solid understanding of the unique rules around cannabis companies and finding the right expertise can help ensure the health of an organization for the long term.
A little planning in the short term will go a long way toward avoiding a significant tax liability in the future.
Kim Gladkowski is a partner in New Agrariae, LLC, a full-service consulting firm committed to parity in the agricultural supply chain. The company provides equitable solutions from seed to shelf and can provide all aspects of consulting, including C-suite services, corporate social responsibility planning, fundraising, expertise and consulting in farming, research and development, regenerative agriculture, reduction in carbon footprint, vertical supply chain integration and all aspects of operations, production and sales. She is also the owner of EBalance, a full-service accounting firm, and can be reached at firstname.lastname@example.org.