As the cannabis industry continues to expand and laws change, more practitioners are looking to start serving the industry. While 2020 was wrought with challenges, cannabis saw some big political wins in terms of law changes, and the industry is expected to surpass the $30 billion mark in 2021, according to Business News Daily and Global News Wire. However, accountants are apprehensive about jumping in with two feet, struggling in the gray area of laws, regulations, and risk.
Here we start defining some key terminology that is critical to understand before offering services to the cannabis industry.
Hemp vs. Marijuana
Knowing the difference actually plays a hugely important role in accounting and taxation for cannabis businesses. It is important as an accounting and/or tax service provider you have a clear understanding of the difference and that you know which one your clients are working with. Hemp is defined as the plant of the genus Cannabis or any part of the plant, whether growing or not, with a delta-9-tetrahydrocannabinol (commonly known as THC) concentration that does not exceed 0.3% on a dry weight basis of any part of the plant of the genus Cannabis. Hemp products, including the increasingly popular CBD products, that fall below the 0.3% THC concentration are NOT subject to the same rules and restrictions as marijuana. Marijuana is a slang term for the dried flowers, leaves, stems, and seeds of the cannabis plant that typically exceed 0.3% concentration of THC. THC is the most common cannabinoid found within the cannabis plant. THC accounts for most of the psychoactive effects of the plant.
Why does it matter which plant your client is working with? Marijuana (not hemp) is still listed on the Federal Drug Enforcement Administration Schedule List of Controlled Substances.
Schedule 1 – “Drugs, substances, and certain chemicals used to make drugs are classified into five (5) distinct categories or schedules depending upon the drug’s acceptable medical use and the drug’s abuse or dependency potential. The abuse rate is a determinate factor in the scheduling of the drug; for example, Schedule I drugs have a high potential for abuse and the potential to create severe psychological and/or physical dependence.” Dea.gov
What it means to have marijuana on Schedule 1 is that anyone participating in the sale of marijuana and/or related products containing marijuana (again above the 0.3% THC threshold) are considered to be participating in the illegal trafficking of a Federally controlled substance for Federal purposes even if their individual state may have passed laws to make their business legal – this where accounting starts to be impacted.
IRC Section 280(e) - Section 280E reads as follows: “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.” Irs.gov
In accounting terms? Your cannabis clients cannot legally deduct operating expenses incurred in their cannabis business’s normal operations under this tax provision. However, under Senate Report No. 97-494, “the adjustment to gross receipts with respect to effective cost of goods sold is not affected by this provision of the bill.” Meaning that cannabis businesses can still adjust their gross receipts for cost of goods sold. This leads us to look at IRC Section 471 and how we need to account for the cost of goods sold for cannabis businesses.
IRC Section 471 – This code section provides specific guidance on accounting for inventory (and thus cost of goods sold). It is critical for cannabis businesses to maximize their adjustments to gross receipts. The code section itself is lengthy and cross-references several other sections. Key takeaways for accountants serving cannabis:
- In general, this section refers to absorption costing methods for accounting for inventory and thus cost of sales
- Generally accepted accounting principles typically must be followed, and cash basis taxpayers cannot account for inventory and cost of goods sold under this section
- Physical inventory counts are required
- Lower cost or market inventory costing is typically required
This can be a heavy burden for many of your smaller business owners, but the alternative option is $0 in adjustments to gross receipts and paying tax on 100% of their sales.
A couple more industry-specific terms to note:
- Metrc – a regulatory cannabis system. This system is required in some states for cannabis businesses to track and report inventory to the government.
- Biotrack – Similar to Metrc, Biotrack is a seed-to-sale tracking software gaining popularity across the country.
- Xero – If you are not already familiar with Xero, we highly recommend looking into it before you start serving cannabis. They are not the only provider for cannabis accounting software; however, it is critical for you to note that QuickBooks is not cannabis-friendly and should not be utilized by your cannabis business clients, otherwise beware of data confiscation.
- CBD - The second most commonly used cannabinoid found in the cannabis plant. CBD is an antagonist to THC and is nonpsychoactive. CBD has become popular for its therapeutic effects, and hemp-derived CBD is not subject to 280(e) restrictions as it is not listed on Schedule 1.
Retailer vs. Dispensary
A dispensary is a store that can legally sell cannabis products, either medical, recreational, or both. A retailer is defined as an entity licensed to purchase and deliver cannabis and cannabis products from cannabis establishments and deliver, sell, or otherwise transfer cannabis and cannabis products to cannabis establishments and consumers. While a dispensary requires a physical location, an individual can be a retailer without a physical store space. Make sure to note the difference in your clients as it will impact fixed overhead in your absorption costing.