By Debora Peters
A dilemma retailers will face is how to set up your retail space to efficiently serve your customers and maximize tax deductions. As we know, paraphernalia is not a controlled substance and therefore does not fall under the same regulations as Internal Revenue Code Section 280E.
An important fact to remember is that just because a business incurs an expense it still may not be deductible on the federal return. IRC Section 162(a) defines that in general, the expense should be routine and directly related to the business activity. Ordinary does not require habitual or made often; the court only requires that the expense is one that is ordinary and necessary for that business. When you are considering the deductibility of an expense, six different elements are required to be met:
- That was paid or incurred (if using accrual method of accounting) during the taxable year;
- In carrying on (excludes start-up expenses, which are deducted differently);
- A trade or business activity.
To translate, this means that a retailer for tax purposes is actually conducting two separate activities under the same business. The first is selling cannabis products, and deductions are limited to only Cost of Goods Sold. The second activity is selling paraphernalia, which all qualified ordinary and necessary expenses are allowed to be deducted.
So how do we handle this challenge? The answer is very carefully. When a retailer is setting up their store, you should consider the square footage you are dedicating to selling cannabis products and the square footage you are dedicating to selling paraphernalia. I have visited a number of retailers and it appears that most stores have dedicated a larger portion to paraphernalia due to the fact it takes up much more space than cannabis.
Once those determinations are made, a review of all facts and circumstances need to be considered prior to a conclusion of how to record the stores expenses. The first method is based solely on square footage. If the store’s total space is 1,000 square feet and 80 percent is allocated to paraphernalia, then 80 percent of all operating expenses, such as rent, utilities and insurance, can be expensed against the paraphernalia activity. For the remaining 20 percent of space that is allocated to cannabis, no deduction would be allowed unless the expense can be considered as cost of goods sold.
The second method is that of gross revenues. When two activities are operated under the same business and are financially dependent upon each other, this method must be considered as well. If the store’s annual income is $1,000,000 and $900,000 of that comes from cannabis products, the calculation would be as follows: 10 percent of rent, utilities and insurance can be expensed against paraphernalia activity and the remaining 90 percent will be allocated to the cannabis activity. Once again, unless the expense can be considered as a cost of goods sold, no deduction would be allowed.
I have heard many comments made that there is no way to make a profit in the state of Washington in the cannabis industry. I disagree; with proper planning and pricing of your product, there is still a profit to be made. As complicated as these issues seem, the key to success is planning and understanding the tax issues. I would recommend you seek professional guidance to help get you on the path to profitability. In next month’s issue, I will be addressing the federal rules and regulations for employment tax issues as well as 1099-MISC filing requirements. Regardless of whether you are a retailer or a producer/processor, it is important to understand these federal filing requirements and the record retention rules.
Debora D. Peters, of Peters Tax Solutions LLP, is an accredited tax preparer who has represented hundreds of clients under federal and state audits. She obtained her Enrolled Agents License in 2009.