Vertices | Tax & Accounting

Accounting For Medical Marijuana Businesses Explained

Introduction

Working with many Medical Marijuana (MMJ) growers, processors, and dispensaries in Oklahoma, it has become abundantly clear that best business practices and accounting support for the cannabis industry are greatly lacking!

As I meet with business owners, the stress of the cannabis business is ever-present.

Many of the operators I have encountered completed 2018 with high hopes, only to discover the tax bill that awaited them was unlike anything they anticipated! Even those who engaged bookkeepers, accountants, and other “professional” help were caught unaware. As I searched for articles to share with those in the cannabis industry, I quickly realized most were written for peers, not business owners.

This article will detail the issue of accounting, record keeping, and taxation for cannabis companies, primarily focusing on dispensaries. A later article will spend time on processors and growers.

The Complexity of MMJ Accounting

Basis of the Issue: How Cannabis is Classified (Scheduled) Federally

Let’s start at the beginning, shall we? The causal factor for the cannabis conundrum rests in the fact that Marijuana is federally illegal BECAUSE it is listed as a Schedule I Controlled Substance. In layman’s terms, this means:

Schedule I Controlled Substances

Substances in this schedule have no currently accepted medical use in the United States, a lack of accepted safety for use under medical supervision, and a high potential for abuse.

Some examples of substances listed in Schedule I are: heroin, lysergic acid diethylamide (LSD), marijuana (cannabis), peyote, methaqualone, and 3,4-methylenedioxymethamphetamine (Ecstasy). (from https://www.deadiversion.usdoj.gov/schedules/ )

Because Marijuana is still listed as a Schedule I drug, its sale is illegal at the federal level. This is the basis of the conflict for legalization, which affects accounting, which rolls into taxation, and the discrepancy between the State and Federal Governments. Cannabis business owners are caught in the grind.

The Courts and IRS Law 280E

Prior to the state legalization of Marijuana, 280E was not an IRS rule many were familiar with! IRS 280E specifically deals with taxpayers who sell Schedule I or II drugs as a business and states:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted. (McElroy, “Taxpayers Trafficking in a Schedule I or Schedule II Controlled Substance — Capitalization of Inventoriable Costs”, 2015)

In essence, the Federal Government does not see the business as legal and does not allow for expenses (rent, salaries, utilities, etc..). Instead, the Government only allows for something called Cost of Goods Sold (COGS). Cost of Goods Sold, specifically, is the cost of what was purchased to resell (flower, edibles, etc…). For Dispensaries, this is the cost you paid for product (plus shipping, if applicable). No other costs are allowed to be used to reduce your income subject to tax.

There are other relevant tax code citations (IRS 471, IRS 162, IRS 263A), but let us suffice to say: these have all been tried and denied by the Courts. Digging deeper into these rules would not be beneficial to the purposes of this writing; make accounting and taxation understandable to a cannabis business owner.

Why are my Cannabis Business Expenses not Tax Deductible?

In plain English, 280E says that businesses who sell Schedule I or II drugs are not allowed to deduct any expenses (other than the Cost of Goods) from their business sales, in order to calculate income for the basis of Federal Taxation.

As detailed in Table 1 below, most businesses in the US would expect to pay income taxes on the Net Income (at the bottom of the table) of $4,500.00. The Net Income is (Net Sales – Cost of Goods Sold – Expenses).

Cannabis businesses ARE NOT taxed like other businesses in the US. Based on IRS 280E, they are NOT allowed to deduct any other costs other than the cost of their product (Cost of Goods Sold). Therefore, cannabis businesses will be taxed on Gross Profit (Net Income – Cost of Goods) of $50,000.00!!! A major difference in the tax liability! This difference in tax treatment results in taxes being charged on $50,000 versus on $4,500.

Business Setup - Can it Help?

There are a few ways to go about establishing (setting up) your company. It is important to know the difference between the corporate structures as well as the difference between state and federal designations.

State Designations

For Oklahoma, the types of business organizations may be found at https://www.sos.ok.gov/corp/organization.aspx (The Oklahoma Secretary of State website).

These business types are:

A Sole Proprietorship is one individual or married couple in business alone. Sole proprietorships are the most common form of business structure. This type of business is simple to form and operate, and may enjoy greater flexibility of management and fewer legal controls. However, the business owner is personally liable for all debts incurred by the business.

A General Partnership is composed of two or more persons (usually not a married couple) who agree to contribute money, labor, and/or skill to a business. Each partner shares the profits, losses, and management of the business, and each partner is personally and equally liable for debts of the partnership. Formal terms of the partnership are usually contained in a written partnership agreement.

A Limited Partnership* is composed of one or more general partners and one or more limited partners. The general partners manage the business and share full in its profits and losses. Limited partners share in the profits of the business, but their losses are limited to the extent of their investment. Limited partners are usually not involved in the day-to-day operations of the business.

A Limited Liability Partnership* is similar to a General Partnership except that normally a partner does not have personal liability for the negligence of another partner. This business structure is used most commonly by professionals such as accountants and lawyers.

A Corporation* is a more complex business structure. As a chartered legal entity, a corporation has certain rights, privileges, and liabilities beyond those of an individual. Doing business as a corporation may yield tax or financial benefits, but these can be offset by other considerations, such as increased licensing fees or decreased personal control. Corporations may be formed for profit or nonprofit purposes.

The Limited Liability Company (LLC)* and the Limited Liability Partnership (LLP)* are the newest forms of business structure in Oklahoma. An LLC or LLP is formed by one or more individuals or entities through a special written agreement. The agreement details the organization of the LLC or LLP, including: provisions for management, assignability of interests, and distribution of profits or losses. Limited liability companies and limited liability partnerships are permitted to engage in any lawful, for profit business or activity other than banking or insurance.

*Registers with the Secretary of State (as listed on https://www.sos.ok.gov/corp/organization.aspx)

Many of the cannabis businesses we deal with are setup as LLC’s. LLC’s work to limit the liability of the individual business owners.

IRS (Federal) Designations

In regard to taxation, there are basically two types of classifications; Taxable Entities and Passthrough Entities. There are also two types of Corporations: C Corporations and S Corporations. For the purposes of taxation, C Corporations are significant. A C Corporation is a legal entity that is separate and distinct from its owners.

All other entities are considered pass through entities (meaning the taxes pass through the entity and are assessed and collected at the personal level).

Generally, especially regarding legal liability, some form of a corporation offers personal protection for the business owners. If a business is started as a sole proprietor, the owner is the business and the business is the owner. In this circumstance, the owner has no separation of responsibility for legal issues arising from the business.

Initially, accountants and attorneys advised Cannabis Clients to set up as C Corporations. This was primarily due to the difference in tax rates between C Corporations and other types of tax entities.

Because cannabis businesses are paying taxes on such a larger amount (Gross Profit, not Net Profit), C corporations offered some advantage. The corporate tax rate is approximately 20% (actually 21%), while the highest personal tax rate is around 37%. Below is a demonstration of the tax differences between the two methods (I DO NOT RECOMMEND A C CORP FOR SMALL CANNABIS BUSINESSES FOR TAXATION PURPOSES, I RECOMMEND A S CORP, unless very large revenue is expected).

*Cannabis companies pay tax on Gross Income, not Net Income

**Table Assumes the cannabis income is the only source of income for the individual

***Dividend’s from C Corps are typically treated as Capital Gains and taxed at approximately 18.5%.

Recordkeeping and Accounting

Good Recordkeeping

The breaking point in the cases that have gone to trial have largely come down to poor record keeping. In business (ESPECIALLY TO THE IRS), if it is not documented, it did not happen!

From a ruling in Alterman V Commissioner, TC Memo 2018-83, the court noted:

Petitioner essentially reads our Opinion in CHAMP to hold that a medical marijuana dispensary that allows its customers to consume medical marijuana on its premises with similarly situated individuals is a caregiver if the dispensary also provides the customers with incidental activities, consultation or advice. Such a reading is wrong. Petitioner also has not established that the Vapor Room’s activities or services independent of the dispensing of medical marijuana were extensive. We perceive his claim now that the Vapor Room actually consists of two businesses as simply an after-the-fact attempt to artificially equate the Vapor Room with the medical marijuana dispensary in CHAMP so as to avoid the disallowance of all of the Vapor Room’s expenses under section 280E. We conclude that section 280E applies to preclude petitioner from deducting any of the Vapor Room’s claimed expenses. (Nitti, 2018)

The court viewed the lack of separation of separate services as an “after the fact” attempt to make one business look like two businesses! Good bookkeeping would have allotted revenue to each service, along with the expense (Cost of Goods) incurred to earn the revenue.

Good Record keeping costs more! It may require two sets of books, two business setups, and two tax returns, if the businesses are run separately. The extra costs MAY be very small compared to the benefits.

Regardless of the type of business you choose to setup, RECORDKEEPING is paramount with Audit Readiness!

An excerpt from an article in Forbes:

Recordkeeping, recordkeeping, recordkeeping. This should go without saying, but if you work in an industry in which the IRS has a tool at its disposal to deny ALL OF YOUR NON-COGS DEDUCTIONS, you had better be meticulous in your record keeping. As we discussed above, if you’ve got a (substantial) second line of business, treat it like one, separately recording revenue and expenses. But even if you don’t, you HAVE to maintain consistent, thorough, and defensible allocations of costs between G&A expenses (that are subject to Section 280E) and COGS (which are not). To argue that you have half-a-million in COGS without bothering to record opening or ending inventory is to set yourself up for a quick defeat. (Nitti, 2018)

Job Descriptions

Vertically Integrated Cannabis Businesses (those who own Grow and Dispensary, Grow and Processing, or Grow, Processing, and Dispensary) have some advantages over simply owning a dispensary (as will be discussed later).

However, in keeping with good record keeping, these companies need to invest the time (or money, if you would like to outsource it) to write good job descriptions. It will not be sufficient to say, “I have a person who works the dispensary, so I pay them for that. Also, they work in processing, so I pay them for that as well.” The IRS may well deem all the salary costs to the Dispensary, where labor IS NOT a part of Cost of Goods, therefore, not reducing the revenue of the dispensary.

Job descriptions as well as documented work hours, by job or process, will be of huge benefit during an audit.

Company Setup

It is possible to set up your company in many ways. Once company “can” enshrine all the aspects of a business (i.e. Grow, Processing, and Dispensary all under one Business Entity). It is NECESSARY to properly account for both expenses and incomes along each business unit. If not, the IRS may choose to classify the majority of the expenses to the Dispensary portion of the business, which is likely to be the highest revenue portion of the business, especially if all operations stay within the business only (if you were not selling to others via grow or processing).

A better approach, as it is easier to document the separation of incomes, costs, payroll, and COGS is to set each business up as its own entity. There are some legal benefits, as well (contact a business attorney for more information). While this will increase the cost of banking, accounting and bookkeeping, and tax filings, the savings can be quite significant! It CAN also make an audit much easier to navigate

How Expenses Work and Why it Matters for Cannabis

Expenses Vs Assets (General FYI, not specific to cannabis, but important)

For many business owners, an expense is an expense…anything they pay money for is an expense. In accounting, and therefore, in taxes; that is not always the case.

An expense is an immediate income reduction (sales – expenses = profit). Expenses are things like rent, utilities, payroll, marketing, etc.

Items such as inventory or buildings are not expenses, they are assets. Assets do not get charged off right away (example: if you purchase a vehicle, you do not get to write off the full $50,000 purchase price the first year. Instead, an asset is expensed as the asset is used up. If the vehicle is expected to last 5 years, the business would expense $10,000 / year for five years (this is an oversimplification and does not include some tax considerations and bonus depreciation programs, but you get the point).

This matters to dispensaries because dispensaries purchase inventory. Inventory is an ASSET, not an expense. It does not become an expense until it is sold. Inventory is taxable (if purchased with profit). If a business profits $100,000 and spends $50,000 on inventory, it now has $50,000 in cash and $50,000 in inventory. It owes taxes on $100,000. If a dispensary spends $50,000 purchasing inventory and sells half of the inventory in year 1, it still owes taxes on the remaining $25,000 in inventory it holds.

OpEx Expenses vs Cost of Goods (COGS) and Accounting

OpEx Expenses
There are two broad categories of expense for most businesses. Operation Expenses (rent, utilities, payroll, insurance, etc). Operation Expenses are expenses incurred during the operation of the business. They are specifically not part of a Cost of Goods Sold expense because they do not contribute to the making of or purchasing of inventory.

Cost of Goods Sold
Cost of Goods Sold are expenses directly related to the producing of or purchasing of inventory. For dispensaries, only the cost of the product plus any shipping necessary to get the product to the dispensary can be allocated as Cost of Goods purchases.

Why it Matters
If accounting is lackadaisical, it may lead to costly ramifications. In the following example, we will look at the difference in properly allocating inventory purchases to Cost of Goods Sold vs OpEx.

Table%203

Not properly categorizing COGS results in tax paid on $200,000, instead of $50,000!!!

Accounting and Taxation

Proper accounting is the gateway to proper taxation. Tax preparers utilize accounting to determine taxable income. Tax preparers are charged with assimilating data into a properly filed tax return, based on the information given them.

If COGS are incorrect from accounting, they will be incorrect on the Tax Return. For cannabis, accounting, simply stated, is a service you cannot afford to be without.

Knowing what items are allowed to be part of COGS for dispensaries is THE major hurdle to having proper and accurate accounting.

Only inventory purchases and shipping for inventory to your dispensary are allowed as COGS items for Dispensaries. Items not allowed under COGS for Dispensaries:
Rent
Salaries
Contract Labor
Storage
Display Cases
Utilities
Insurance
Professional Fees
Licenses and Fees

Audit and Audit Ready

The chance of a business getting audited in the US is approximately 1.5%. This number fluctuates from year to year, but remains relatively stable. For marijuana business operators, the chance of an audit has been reported as high as 10 to 15 percent . (CBPOK (“Taxes & Accounting for Oklahoma Cannabis Businesses” 2019)).

While getting audited can be intimidating, being properly prepared is key. If you have invested the time in choosing an accounting firm that is familiar with marijuana businesses, gives you sound advice on what you may and may not deduct, and prepares solid financials (thus, data for your tax return), you will come through the audit just fine! Again, preparation is key! Remember, of the major cases that have been tried, most noted poor bookkeeping and accounting as contributing factors to higher taxes, leading to penalties and interest costs!

New IRS 199A Risk vs Reward

The IRS has a new rule, 199A, which allows for specific entities to automatically reduce their Net Income by 20%, for Income Tax purposes.

One of the best synopsis I have read in regard to 199A reads as follows:

Under the new tax law, Section 199A grants owners of sole proprietorships, partnerships and S corporations a 20% deduction against the income earned from the business, dropping the top effective individual tax rate on the income of the business from 37% to 29.6%. So let’s say a marijuana facility is run through one of these “pass-through entities.” The income of the business will be high because of the application of Section 280E; does that mean the owner gets a 20% deduction against this post-Section 280E elevated income number?

The answer depends on whether the IRS views the owner’s Section 199A deduction as being subject to Section 280E. On the surface, it should NOT be, because the deduction does not belong to the business, but rather the owner, and thus the Section 199A deduction should not be considered as being “paid or incurred…in carrying on any trade or business…of trafficking in controlled substances.”

If that is the case, it would soften the blow of Section 280E for those owners who operate as a pass-through, because the Section 199A deduction would be based on the higher, after-Section 280E amount.

But if 35 years of case law has taught us nothing else, it’s taught us that we should not come to expect favorable tax treatment of a marijuana facility. It is not a stretch to see the IRS arguing that even the Section 199A deduction — while not a direct deduction of the business — is “attributable” to a business of trafficking in a controlled substance. (Nitti 2018).

Conclusion

In review, Cannabis Dispensaries are only allowed to deduct Cost of Goods Sold (COGS) from Net Revenue to determine the business Taxable Income attributable to the owners. The lack of proper classification of Cost of Goods Sold purchases (inventory and shipping of inventory to the dispensary) can lead to a massive increase in the already high tax exposure of Cannabis Dispensaries.

Remember, typical business expenses (Operating Expenses) are not allowed for consideration for Cannabis Dispensaries, in regard to taxation. Cannabis businesses pay taxes on the profit left after the purchase of the product. Storage, shelving, rent, insurance, and other normal business expenses are not taken into consideration for federal (and Oklahoma State) taxation.

Works Cited

www.deadiversion.usdoj.gov/schedules/.

Bloomenthal, Andrew. How Operating Expenses and Cost of Goods Sold Differ? 13 Apr. 2020, www.investopedia.com/ask/answers/101314/what-are-differences-between-operating-expenses-and-cost-goods-sold-cogs.asp.

Choosing the Structure of Your Business or Organization. www.sos.ok.gov/corp/organization.aspx. Oklahoma Secretary of State Website

Cost of Goods Sold for Marijuana Companies. 5 Aug. 2016, www.californiacannabiscpa.com/blog/cost-of-goods-sold-adjustments-for-marijuana-related-companies.

FindLaw’s United States Ninth Circuit Case and Opinions. 9 June 2015, caselaw.findlaw.com/us-9th-circuit/1707249.html.

Fishman, Stephen. Can Medical Marijuana Dispensaries Deduct Their Business Expenses? 31 Oct. 2014, www.nolo.com/legal-encyclopedia/can-medical-marijuana-dispensaries-deduct-their-business-expenses.html.

Fortenberry, Jeramie. Double Taxation vs Pass-Through… 24 June 2019, www.fortenberrylaw.com/double-taxation/.

Hecht, Peter. Medical Marijuana Dispensary Takes on IRS over What It Calls ‘Punitive’ Taxes. 23 Feb. 2014, www.washingtonpost.com/politics/medical-marijuana-dispensary-takes-on-irs-over-what-it-calls-punitive-taxes/2014/02/23/25fa6458-9cd3-11e3-ad71-e03637a299c0_story.html.

Marijuana Business Cost of Goods Sold (“COGS”) Overview. 18 July 2016, www.californiacannabiscpa.com/blog/marijuana-business-cost-of-goods-sold-cogs-overview.

United States, Congress, McElroy, W. Thomas. “Taxpayers Trafficking in a Schedule I or Schedule II Controlled Substance — Capitalization of Inventoriable Costs.” Taxpayers Trafficking in a Schedule I or Schedule II Controlled Substance — Capitalization of Inventoriable Costs, 23 Jan. 2015. https://www.irs.gov/pub/irs-wd/201504011.pdf. Accessed 11 Apr. 2020.

Nitti, Tony. Ninth Circuit: Legal Or Not, Marijuana Facility Cannot Deduct Its Expenses. 10 July 2015, www.forbes.com/sites/anthonynitti/2015/07/10/ninth-circuit-legal-or-not-marijuana-facility-cannot-deduct-its-expenses/#3a282f481d9a.

Nitti, Tony. The Top Tax Court Cases Of 2018: It Wasn’t A Good Year For The Marijuana Industry. 17 Dec. 2018, www.forbes.com/sites/anthonynitti/2018/12/17/the-top-tax-court-cases-of-2018-it-wasnt-a-good-year-for-the-marijuana-industry/#2a03267dc55c.

Taxes & Accounting for Oklahoma Cannabis Businesses. 27 Aug. 2019, cbpok.org/taxes-accounting-for-oklahoma-cannabis-businesses/.

Zollars, Ed. Business Consisted Solely of Selling Controlled Substances, No Deductions Other Than Cost of Sales Allowed. 14 June 2018, www.currentfederaltaxdevelopments.com/blog/2018/6/14/business-consisted-solely-of-selling-controlled-substances-no-deductions-other-than-cost-of-sales-allowed.