Cannabis-based businesses are growing like weeds (excuse the pun), but pay attention to this prime new niche where your firm may be able to win new clients. If you are already serving them, then you may have already known that they can be challenging due to the complexity of their operations and compliance requirements.
These types of businesses also represent an important challenge when it comes to reasonable compensation because the calculation can drastically change due to the varied nature of these clients’ work.
In addition cannabis based business owners are likely wearing multiple hats which means that as their tax professional or accountant, you need to help them consider the reasonable compensation for each of the activities they perform.
Beyond Gross Revenue: The Key to Reasonable Compensation Accuracy
Here’s a critical point to understand about reasonable compensation: your client may think their reasonable compensation has to be the sum of their profit, but this is not true. It is based on an accurate calculation of the market value of the services they actually perform in their business.
Consider this example:
Your client, Bill Jones who is a cannabis grower in Blissfield, Michigan, made $200,000 in net profit. This is simply the profit his business made, not necessarily Bill’s reasonable compensation for doing the activities that contributed to production of his cannabis crops.
In order to accurately determine Bill’s reasonable compensation, you need to think about the type of activities he has performed to create the output for the services or products invoiced, along with his proficiency in those tasks. For example, in the case of Bill, cannabis business owner, the first consideration is the type of business that he runs.
While Bill is a grower, you may have other clients who are manufacturers, or retailers of cannabis. Another important point is that each state’s regulations on cannabis growing operations are different.
Calculating Bill Jones’ Reasonable Compensation
First, you’ll need to select which IRS-approved approach is most applicable to Bill. Bill not only oversees the farm operations in his company, but he also does various administrative, marketing, and sales tasks. Since he wears many hats, we will use the Cost Approach.
Next, you will want to understand exactly what tasks he performs, at what proficiency, and for what amount of time each week. Then you can look up wage data for each of those tasks in Bill’s location to come up with his reasonable compensation figure.
Keep in mind that you will need to calculate the total compensation by adding up the various wage rates of each activity that Bill performs, proportional to the amount of time he spends on each one.
To do this, you will need to:
- Have your client write down all of the tasks they complete for their business. If they spend time doing it, they should write it down.
- Next, have your client fill in how much time they spend on each task per week on average. Remember, the IRS caps the work-week at 40-hours, so make sure the total time allotted towards tasks adds up to 40.
- Finally, have your client rate their proficiency in each task. Tip: Have your client imagine themselves in a room with 100 people. How much better are they at the task than those 100 people? If they are better than 50 of them, they have average proficiency. Better than 75 of them, they are above average, and so on.
- Now it’s time for you to get to work. Research wages in their location for each task performed based on the proficiency they provided. You’ll break down each wage into an hourly figure, then multiply that by how many hours they spend on the task in a year.
- Once you’ve done this for every task, add up all of the amounts and you have your reasonable compensation figure. Don’t forget to include all of your research and calculations for backup in case your client is ever audited.
If your first instinct is to use spreadsheets and Excel formulas to calculate the total reasonable compensation for Bill, be aware that this can be very time consuming. Instead, try using software specifically for calculating reasonable compensation.
This streamlines this process by providing you with a simple way to look up unbiased wage data that takes into account location and proficiency, saving you days’ worth of work while providing you with a report that holds up against IRS audit and litigation.
In this example, Bill made $200,000 in net revenue, but based on the calculations provided by his accountant, he only needs to take reasonable compensation of $69,938, potentially saving him a lot in payroll taxes depending on what he was paying himself before.
Proactively looking at reasonable compensation values means that your client can effectively stop an audit in relation to payroll taxes and reasonable compensation for your client’s business.
It also can allow you to determine which entity type is most beneficial for them. By having an accurate analysis of reasonable compensation you will be able to determine at what salary your client may be better off drawing from their business.