If you thought that Congress and Internal Revenue Service (IRS) was making your life hard every year by changing the tax code. Spend a few days trying to figure out your accounting and tax issues if you run a cannabis business. To start with Marijuana and Cannabis are not the same thing. Marijuana is the bud or flower of the Cannabis plant. While Cannabis entails essentially everything the business owner can get from the cannabis plant such as the hemp, CBD oil, leaf, shake, popcorn, edibles, dabs and water-soluble and the list goes on.
The first thing to do is that Cannabis is still listed as a Schedule 1 drug and thus under federal law, it is still illegal to traffic or does business with it.
As of the election of November 6, 2018, ten states have legalized recreational Marijuana with 33 states that allow medical marijuana along with the District of Columbia, Puerto Rico and Guam
On the federal level, the IRS has a long history with cannabis. In 1974 Jeffery Edmundson was released from prison for drug trafficking, and the IRS Al Caponed him. Meaning they decided that he had made money selling drugs and thus had not declared that income. This being so they sent him a Notice of Deficiency detailing that the taxes he owed.
This led Mr.Edmundson to ask the US Tax Court for a court date. In 1981 Edmundson v. Commissioner went to trial. The Trial Judge in his ruling stated that he appreciated how forthcoming Mr. Edmundson had been about his business. In most cases, if you have no documentation of your activities, you essentially have no proof. However, in US TAX Court testimony can be used to justify expenses.
Judge Goffe looked at the testimony of MR. Edmundson, who in detail talked about his expenses in buying the drugs, his travel needs, his home office, and telephone charges. All these things Judge Goffe stated were legitimate business expenses and thus allowed them to be deducted from Mr. Edmonson taxes and in the end lower his tax bill to the IRS. However, that is not the end of the story. Congress and the IRS were so upset by this ruling that they passed Section 280E. It states in part: " No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if such trade or business (or activities which comprise a trade or business)consists of trafficking in controlled substances (within the meaning of Schedule I an II of the Controlled Substance Act) which is prohibited by Federal law or in any state in which such trade or business is deducted.” In effect, it says that in the course of a business all income is taxable which is why in some cannabis businesses you see such high rates of 70% or more going to taxes.
Section 280E was the law till around 2007 when the California company Californians Helping to Alleviate Medical Problems (CHAMPS) sued the IRS. CHAMPS had a sort of different business model then most others they charged a membership fee for their services which include the cannabis and alternative treatments when you came to their location. These included such things as yoga and essential oils.
Because CHAMPS did other things besides selling their cannabis, they took deductions for the cost of those other activities. The IRS disallowed those deductions based on Section 280E, and the fight was on.
CHAMPS initially appeals the ruling of the auditor, and the appeals court agreed with the auditor thus they appealed that ruling and in the US TAX Court Judge Laro decided that CHAMPS was running two different business and therefore could deduct those expenses for that other business. Judge Laro provide the groundwork for much of the accounting measures that are taking place in the Cannabis industry today.
In deciding that a cannabis business owner could run a second business in the same location as the dispensary a thus allocate some of those expenses to the ancillary business allowed the tax burden to become much lower then it had been. Other businesses have tried to use this approach, and some have won, and some have lost. One of the most notable was Martin Olive. He owned several cannabis businesses in Southern California based on the CHAMPS model and lost to the IRS.
The big difference with Olive was that the Judge ruled that Mr. Olive’s ancillary businesses were not trying to make a profit and thus he was not allowed to a deduction for their costs based on Section 183 of the IRC: if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed."
What this means today is that a cannabis business can deduct the Cost of Goods Sold (COGS), In plain English, they can deduct the price of the marijuana they buy, and that is essentially it.
Or so we thought. A COGS is defined as: is the direct costs attributable to the production of the goods sold in a company. This amount includes the value of the materials used in creating the good along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs.
This is what the average business looks at when they start thinking about what they can deduct from their income. With cannabis business, it is a little simpler and little harder at the same time. By the time the cannabis gets to the dispensary what is exactly the cost of it?
It all depends on how much of the supply chain you own?
As we discussed with CHAMPS the tax court decided that a dispensary can sell the cannabis but at the same time sell other things through another business on the same location. If we look at just the retail shop, it is perfectly fine for them to sell the paraphernalia in another part of the retail shop. These are two completely different companies and as such the paraphernalia part of the business can take part of the expense of the building, i.e., rent utilities, insurance and so forth. However, in most business, it is the cost of labor that is the most significant deduction. Under Section 280E the wages cannot be deducted only the cost of the cannabis.
What you see other accountants suggest is that you split the time of your workers. They spend half of their time selling the cannabis and the other part selling the paraphernalia. This way you pay them minimum wage for their time selling the cannabis, and you pay them a higher wage on the hours worked for the paraphernalia company. That way the paraphernalia has more business deductions to help make up for some of the tax loss on the other side of the business.
In many ways and I hate to use this phrasing, but the cannabis industry is one giant pyramid. You want to make as much money as possible just like every other business out there, but at the same time, you don't get the same tax deductions, so all your income is actual income. What this force you to do is to separate everything into a separate business and then merge them into the final product.
Every part of the supply chain must be looked at to see how you can move the cannabis along while at the same time keeping the costs as low as possible so that you can pay everything along the way.
In many ways, it all starts with the grower. Nearly everything they do goes into COGS then as they move the product along the idea should be that by the time it reaches the retail store the vast majority of the going market price is built into COGS so then your retail outlet is not making a ton of money after you sell the product. You make all your money along the food chain leading to the retail store.
Of course, like every good rule, there are exceptions to the rule, for instance, Nevada says that if you own a retail dispensary you can’t own any other business so then you must look at other ways of spreading the costs out. Then, of course, every state is different than the next which also means how the state allows deductions from say California to Colorado is different.
And of course, there is a good notion that once you learn the rules if you turn around, they change they on you. Personally, I had to set up a different email just to handle all the emails I get on the cannabis industry. There is talk that President Trump is allowing the government to look at how it classifies Cannabis and if that happens, it could be a huge game changer. I heard someone say the other day that if the Feds allowed the sale of cannabis that the next day Walmart would have it in stock.
If you have any questions, please call or email me. I am here to service your accounting needs and get you on the correct financial track.
Terry Blevins Advantage Accounting Associates 1000 N 9th Street Suite 23 Grand Junction, CO 81501 970-985-4321
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