For preparers planning to work on cannabis business returns this filing season, pay close attention to the rules related to this industry. There are some black and white regulations, and then there is a lot of gray area that preparers need to be aware of.
Internal revenue code 280E governs the deductibility of expenses when the business is involved in what is considered a Federally illegal activity. In the case of cannabis, marijuana specifically remains on the Federal Schedule 1 list of controlled substances. Regulations around hemp have been significantly lessened since being removed from the schedule but make sure you clearly understand who and what you’re working with. Essentially what 280E does for your cannabis customers is limit the deductibility of their operating expenses. A business subject to 280E is limited to only being able to deduct the actual cost of goods sold. Which then begs the question, what can be considered cost of goods sold?
The following are the basic boxes to check when dealing with a cannabis business tax return subject to 280E:
- Accounting must follow Generally Accepted Accounting Principles regardless of size or tax accounting choice. Sorry, no exceptions, your client can’t elect to be treated on the cash basis here.
- Brush up on your cost accounting skills. You’ll need to carefully work with your client to understand and manage inventory. You’ll need to understand what their work in process was at the end of the year, what went into finished products and what was actually sold. If your client doesn’t have detailed inventory tracking throughout the year, it’s going to diminish the strength of your documentation under IRS audit.
- Cash counts are not optional. Until the banking regulations change, all your cannabis clients are going to continue to operate using a lot of cash on hand. Daily cash counts are an absolute necessity and you’ll need to see those.
- Prepare the return under the assumption that it WILL be audited. There haven’t been a significant number of 280E cases yet. Rest assured, there is a waive coming. The IRS knows this is low hanging fruit. Your due diligence to review documentation and understand what you’re putting in the return is not optional in this industry.
- Beware credits and extra deductions. There is no clear guidance on whether or not Section 179, 199A, R&D credits or any other business credits should be or are available to cannabis businesses. Barring further guidance, proceed with caution. These are all likely to be challenged by the IRS as not falling under the direct cost of sales provision that 280E establishes.
- Don’t forget that GAAP requires inventory to be measured at the lower of cost or market value. If you’re not used to working with inventory heavy clients, or you’re used to working with smaller businesses not following GAAP for tax purposes, this can be an easy step to miss. Inventory valuation is critical to your cost accounting analysis which is critical to you assisting your clients in taking important deductions.
Other items to consider are expenses like rent, storage expenses and payroll. Typically, all of these are operating expenses not considered deductible under 280E. Proper GAAP cost accounting will play a critical role in whether or not you’re able to substantiate any portion of these expenses being moved in COGS for your client’s return. For example, your clients will need to have employee timecards broken down into significant detail depending on job responsibilities. Smaller organizations may have staff that split their time between growing plants and managing a retail space within the same organization. Salary paid towards the grow process fits in to cost of sales while retail time does not. Employees serving in both positions need to carefully document their hours by activity. Whenever possible, advise your clients to keep those responsibilities split. Salaries and wages paid to owners can be the most cumbersome here, as owners will need to keep their own timecards at this level of detail.
Regular tax planning won’t apply. The bonuses at the end of the year, the last-minute drop-ins to the defined benefit plans and SEP IRAs, they aren’t going to afford your cannabis clients the tax savings that you would usually get by advising a traditional business. Focus your tax planning efforts on assisting your clients with following the right accounting principles and getting a handle on adequate cost accounting records. Until rules change, this is where you as the professional service provider will offer the most value.
All of this leads me to my most important point as a fellow preparer. Don’t underestimate the time and value of this work. At a minimum, these returns will take you twice, if not three times longer to prepare than your traditional business returns. You will have significantly more due diligence to do and if your client can’t produce adequate bookkeeping records, you’ll most likely be re-doing most of the transactional work before you can even begin the preparation process. Choose your fees wisely.
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