Banking & Finance, Law, and Retail

Accounting for the cannabis industry: Prepare yourself for tax scrutiny

September 30, 2019
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Erik Schumacher
Erik Schumacher. Courtesy Rehmann

In light of the recent legalization of recreational cannabis in Michigan, the industry is rapidly growing and changing. Business owners and entrepreneurs are seeing the infinite opportunities, but they should be aware of the many risk areas to avoid fallout.

The cannabis industry is a tightly regulated and high-risk business, and on the financial side, those involved must prepare to have their financial and tax information scrutinized.

While the decriminalization of marijuana in the state of Michigan makes this a legal industry at a state level, it still is considered a federally illegal activity, which brings with it some very specific issues. While there is no guidebook when it comes to finance for the cannabis industry, business owners should familiarize themselves with two distinct tax code sections.

The biggest nuance businesses may come across is the non-deductibility factor from Section 280E of the Internal Revenue Code. This tax code section forbids businesses from deducting any cost that doesn’t go directly into inventory, such as selling, general and administrative costs. Specifically, the code says businesses can’t deduct otherwise ordinary business expenses from gross income associated with the “trafficking” of Schedule I or II substances, as defined by the Controlled Substances Act. Currently marijuana is listed as a Schedule I narcotic.

Another important piece of tax code is Section 471, which provides general rules for determining the cost of goods sold as it relates to inventory regulations. Businesses should have internal policies outlining exactly how to allocate costs to protect them in case of a tax audit. It is essential to have specific documentation policies in place, as it tends to be a cash-heavy industry, and proper receipts are vital. Together, the two code sections call for more structured and well-documented accounting procedures.

The goal for businesses is to maximize after-tax cash flow, so detailed structuring for tax purposes is crucial. Setting this up similar to other industries, such as traditional real estate or operating business structures, will not always produce the best result in the cannabis industry. In this industry, moving toward C corporation rather than flow-through structures can sometimes produce the best results for businesses. In any case, cannabis-related businesses should work with certified public accountants or tax preparers who have experience in this industry and a thorough understanding of the two tax codes in conjunction with inventory costing and expensing costs related to controlled substances. In doing so, businesses will be better prepared when they receive questions from the Internal Revenue Service or undergo a tax audit.

Tax court cases are heavily relied on in the cannabis industry and can be used to help structure the business. Understanding precedent from prior court cases can help businesses determine what may or may not be risky in operations. There are a number of marijuana-related court cases over the past decade that businesses can reference, including Canna Care Inc. v. Commissioner, Alpenglow Botanicals LLC v. U.S. and Harborside Health Center v. Commissioner.

Although there may appear to be short-term gains from taking shortcuts, being compliant and handling cannabis business financials the right way is best practice and will give companies a solid reputation in an industry subject to increased scrutiny. In looking for a tax preparer, companies should be aware that capabilities in the industry vary drastically. The key is to look for service providers who understand positioning, have experience in the cannabis industry and recognize the associated risk. Firms with a holistic industry view are able to assist with day-to-day accounting, tax, assurance, background checks, technology services and human resources outsourcing.

Though the industry is one of the most tightly regulated, business owners and entrepreneurs shouldn’t lose sleep at night over operations. Determining what practice works best, acknowledging risk and preparing accordingly all are aspects of proper due diligence. As with any industry, working with a team of competent advisers will help these businesses be successful in the future.