A Cannabis Accounting Survival Tale
The truth about 280E strategies and “workarounds”
A Cannabis Accounting Survival Tale
This is our inaugural blogpost and guess what: we’re coming out swinging! Did you know that when you start a business you have a fiduciary responsibility to maintain accurate financial records? Did you know that financial information drives the business, and when effectively managed, keeps you compliant and can help grow the top line? Did you know that four out of five businesses fail within the first five years of operations?
The burdens of IRC §280E
Marijuana business operators should be all too familiar with the burden caused by IRC §280E. The code states that “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 consists of trafficking in controlled substances”. Given that Marijuana is still a Schedule 1 controlled substance, no selling, general and administrative deductions are allowed in determining taxable income. Despite this prohibitive code section, the code does not address §61, which defines gross income. By not addressing gross income, cannabis operators are still able to reduce income by costs of goods sold (COGS). COGS by definition is a reduction in gross income rather than a deduction; therefore, COGS is the only “deduction” permitted to cannabis businesses.
Legal marijuana businesses have a substantially higher effective tax rate
Due to the limitations under §280E, legal marijuana businesses have a substantially higher effective tax rate (upwards of 70% according to the National Cannabis Industry Association) when compared with other businesses. This astronomical effective tax rate has led businesses to explore alternatives to circumvent §280E. We at Akene are often asked, “how do I get around §280E?” The answer, sadly, is that you can’t if you want to be compliant. We are stuck with §280E until marijuana is rescheduled. We have seen businesses poorly deploy capital to sidestep §280E in many ways, including the following (this is not a comprehensive list):
- Creating complex structures to shift deductions to non-plant touching related party entity
- Related party transactions not treated as “arms-length”
- Management agreements
- Aggressive allocations of indirect COGS
- Allocating Selling, General and Administrative expenses (SG&A) to COGS
- Accelerated depreciation in excess of book depreciation
- Utilization of §263A instead of §471
Creative maybe, effective not so much
While perhaps extremely creative, none of the above strategies are effective and recent Tax Court cases have ruled that the above strategies are not allowed under the current tax code (see Patients Mutual Assistance Collective Corp v. Commissioner, T.C. 151 No. 11, Sec(s) §280E; §162, and Alternative Health Care Advocates, et al. v. Commissioner, 151 T.C. No. 13, Code Sec §280E; §162). Although in the short-term your business may reap the benefits of reduced taxes, once audited by the IRS, the business will lose those deductions, owe more in taxes, and get hit with interest and penalties. Thus, many businesses will not survive the consequences of these aggressive past decisions.
What can be classified as COGS?
§1.471-3(b) states that retailers (dispensaries/distribution) can include in inventory only the purchase price and the necessary costs incurred to deliver/transport the marijuana to your business premises. This means the store, delivery vehicles, budtenders, utilities, etc. are not tax deductible. This rule accounts for why dispensaries have an effective tax rate of over 70%. For producers (cultivation/manufacturing), COGS is defined under §1.471-3(c) and §1.471-11. Under the regs, producers can include in the cost of inventory both direct and indirect costs incurred to cultivate, or manufacture marijuana as outlined in the relevant regulations.
In 2018, the emancipating IRC §471(c) took effect with The Tax Cuts and Jobs Act (TCJA). Some service providers encouraged cannabis businesses to take advantage of this erstwhile ‘loophole’ created by regulators for the cannabis industry. Why did they preach this? Service providers want to help navigate the burden of §280E while at the same time looking like heroes. Let’s face it, operators want to hear good news and many service providers benefitted from taking this uncertain, albeit hopeful, position. It’s easy for someone to advise you when they don’t have to live the consequences of their advice.
What is §471(c) when it’s at home with its feet up?
In a nutshell, businesses with gross receipts under $25M were provided an exemption from the use of Secretary prescribed inventory valuation methodology and allows small businesses to develop their own methodology for accounting for inventories. Based on the rules, the IRS stated that it would not question any method chosen by an eligible entity (paraphrasing here). To those pushing §471(c), I ask the following:
- What if someone is not selling marijuana…would they call all costs COGS under §471(c)?
- What about cannabis industry best practice?
- What about seed-to-sale compliance forcing inventory tracking?
- What about federal legality and §280E?
Did the TCJA create a §280E loophole?
Let’s start here…the federal government hates marijuana because it is federally illegal. Harsh words, I know, but let me explain. Due to the illegal status of marijuana at the federal level, the government is intentionally punitive to operators allowing the IRS to generate higher tax revenues through their punitive legislation. The government received approximately $4.7B during 2017 (from an estimated $12.9B in revenue per BDS Analytics) in tax revenues from marijuana businesses. Yet, when COVID-19 hit earlier this year and our economy tanked, the SBA excluded both direct and indirect marijuana businesses from SBA relief. I find that a bit hypocritical since, through tax revenues collected, the federal government is effectively the largest indirect marijuana business that exists to date. Do you still think my words harsh? Do you think the government intends to give marijuana businesses a loophole to avoid a rule they created to punish those trafficking a federally illegal substance?
In the words of Admiral Ackbar – “It’s a trap!”
Recently the IRS drafted Reg-132766-18 Notice of Proposed Rulemaking. In the notice of proposed rulemaking, the IRS clearly states its position on §471(c). The notice indicates that for any taxpayer using §471(c) as an alternative method of valuing inventory, the IRS will require book tax adjustments for costs capitalized that are otherwise not deductible. This also means that if you followed §471(c) when filing your 2018 and 2019 tax returns, you might want to consider amending those returns, or at least calculating your potential exposure and be ready to pay these back taxes plus interest and penalties.
It’s too easy to be in non-compliance of tax regulations
If the implications of inventory valuation are not scary enough, then you should read Treasury Inspector General for Tax Administration (TIGTA) dated 3/30/2020 Ref # 2020-30-017 – pdf. This outlines the TIGTA’s estimated uncollected tax revenues due to non-compliance of tax regulations by cannabis operators. The TIGTA sampled a population of 237 marijuana businesses’ 2016 tax returns for companies located in California, Oregon and Washington. Based on their review of the cannabis entities’ tax returns, they determined the estimated deficiency of taxes paid to be $7.3M. TIGTA forecasts the tax impact to all three states due to cannabis operators underreporting of taxable income to be $48.5M. The average tax impact per operator is estimated to be $103K in California, $11.7k in Oregon and $12k in Washington. The report only reviewed data for 2016 and does not account for even further aggressive underreporting due to §471(c) in 2018 and 2019.
We are here to help.
Although you may not like what you hear, don’t shoot the messenger. Our goal (and challenge) is to help businesses navigate the rules that someone else created until such time as those rules are changed. At Akene, we focus on internal controls, process mapping, documentation to support allocations of indirect costs, support to be audit ready, and strategies to grow your top line. If you want to successfully capitalize on this merging industry, you need to build a solid foundation for your business to be successful. Benjamin Franklin said it best, “…in this world nothing can be said to be certain, except death and taxes.” Don’t let taxes be the death of your business.