Since 2012, 19 states have passed adult-use cannabis laws for adults over 21 and 38 states currently have medical cannabis laws. Regardless of where you stand from a political perspective, the cannabis industry is here to stay. As long as they can pay their tax bills.
In 2021 California cannabis business owners petitioned the state to reduce the substantial tax burden on the industry claiming that hefty income tax bills, topped by hefty sales tax bills left businesses burdened to the point of financial solvency.
Legal operators told the state regulators without a tax break the industry was facing the inability to continue operating and sales were being pushed back into the illicit market.
Cannabis operators in many states face tax bills that look very different compared to traditional businesses. From a federal standpoint, cannabis businesses are still subject to 280(e), the IRS tax code that essentially says no deductions will be allowed against income that’s earned from the sale of Federally controlled substances.
The result is business owners paying nearly 40% to the federal government on their gross income.
While everyone sees the cannabis industry as a gold rush, operators without sound professional advice are bound to struggle. Only cost of sales can be used as an adjustment to revenue to help reduce the tax burden.
That’s before state taxes and sales taxes. A handful of states including Colorado, California and New York have elected to decouple from the federal statute and allow deductions at the state level. The break is minimal though. Sales taxes on top of everything else can exceed 8%-10% in some areas.
In most cases, cannabis business operators have to clear a minimum of a 40% profit margin just to break even when you take into account the tax liabilities across the board. In many cases, new operators are shocked by the unexpected tax bill in their first years of operations and very few have adequate tax planning to help them address such a hefty bill.
Tax practitioners looking to work with the industry need to be well versed in the regulations before anything else. State regulations widely vary. Federal tax planning is highly critical to helping a cannabis business achieve enough cash flow to stay afloat.
While everyone sees the cannabis industry as a gold rush, operators without sound professional advice are bound to struggle. Only cost of sales can be used as an adjustment to revenue to help reduce the tax burden, which means business operators need a lot of support to understand generally accepted accounting principles and how variable cost accounting can be used to support certain expenses being allocated to cost of sales.
Most importantly, tax practitioners need to help these clients plan accordingly for big tax bills. The earlier they understand their burden, the sooner it can be built into cash flow plans so owners are not caught by surprise. Because of the lack of deductions, many operators will be facing immediate tax bills well over $100,000 without any ability to dig themselves out of that hole before another year’s worth of estimates are due.
Tax planning is critical for this industry and as advisors, we have the ability to help.