7 Tax Tips Cannabis Cultivators Should Know

Tax season is a stressful period for any business, but often more so for cannabis operations. Reconciling annual income, expenses (both those related to the cost of goods sold (COGS) and indirect costs), and excise taxes to determine what you owe to state and federal collectors can be time-consuming and often involves many team members.

Not only that, cannabis businesses are taxed on gross profit, not net revenue, increasing their tax burdens in an already onerous market landscape. (This is thanks to Internal Revenue Code Section 280E, which prohibits cannabis businesses from taking itemized business deductions. 280E limits deductions for cannabis cultivators to COGS, therefore they are taxed on gross profit.)

To help lighten the mental burden, Cannabis Business Times spoke with tax experts with years of experience working with cannabis operators to collect their insights and advice on how cannabis cultivators can reduce their tax burdens and avoid failing an income tax audit.

1. Consider the Employee Retention Credit (ERC).

The Employee Retention Credit (ERC) is not an income tax credit, therefore it falls outside the 280E limitations on income tax. Instead, the ERC is a payroll tax credit that applies to qualifying businesses that “continued to pay employees while shut down due to the COVID-19 pandemic or had significant declines in gross receipts from March 13, 2020, to Dec. 31, 2021,” per the Internal Revenue Service. Businesses with 500 or fewer employees that were impacted by a government shutdown order or whose revenue declined by 20% or more for any quarter in the qualifying period can apply.

While the credit won’t have a direct impact on income tax filings, applying for and receiving this credit can reduce a business’s overall tax burden. (You can apply for these retroactively for tax years 2020 and 2021.)

“One of the things that many people are going back and doing now is … applying for, receiving the ERC, and not having problems keeping it,” says Katye Maxson-Landis of Moxy Accounting. Because cannabis businesses were deemed essential businesses during the pandemic-related shutdowns, tax experts agree that cannabis businesses can make a good argument for why they are eligible to receive this credit, and not be among penalized businesses that took the credits but did not abide by the terms.

ERCs that involve higher dollar amounts could attract additional scrutiny from federal authorities, however, either before or after they are issued, according to Maxson-Landis.

2. Maximize deductions …

Many cultivators understand what COGS can be deducted from their gross profit (revenue minus COGS) under 280E: lighting and fertigation equipment (and the energy costs associated with those systems), cultivation team salaries, the portion of rent dedicated to areas for cultivation activities, as well as certain post-harvest costs like trimming equipment, preroll manufacturing, and salaries of those related employees. Since they bear the bulk of the production costs, cultivators are the best-positioned group to make those COGS deductions out of any plant-touching business in the cannabis supply chain.

“Lights in your office space … that’s going to be a general administrative [expense] as opposed to lights in the grow rooms,” says Bruce Andersen, founder of the Andersen CPA Firm and member of the National Association of Cannabis Accounting and Tax Professionals.

In addition to COGS deductions, he advises his clients to use straight-line depreciation, which spreads out the cost of an asset evenly over its life, as opposed to any kind of accelerated depreciation method, where depreciation expenses are higher initially but then lower as time goes on. He also recommends adjusting the life terms depending on the asset type to maximize potential depreciation deductions. “On the … productive assets [those with the ability to generate money/produce income, e.g., farms, real estate rental income], those you can go ahead and take as short a term life as you reasonably can put against those,” Andersen said, saying five years is a typical term.

When it comes to administrative expenses like computers or office furniture, he advises stretching out the depreciation term to seven years or more, if reasonable, “because, hopefully, you’re depreciating at a value that, No. 1, you’re not wasting because it’s subject to 280E. And, No. 2, if there’s a time in which [there is federal legalization], then you have assets that have some life to them to fully depreciate.”

3. … But don’t try to report zero taxable income.

There are very few scenarios where plant-touching businesses can be expected to have no gross profit (revenues minus COGS). One exception: a cultivation business just launched and hasn’t sold any of its crops or products during the tax year.

“Knowing that you’re going to be taxed on your gross profit, I have not come across a client where their cost of goods sold has exceeded their revenue,” says Angela Mays, founder of cannabis accounting services firm The Blunt Accountant. “Not to say that it’s impossible, but I would definitely think that would be a red flag.”

Cultivators who are not selling entire harvests may still generate a taxable income because the only deductions cultivators can take are based on the cost of the goods sold, according to the tax experts CBT spoke to. In other words, if a grower harvested 2,000 lbs. in 2022, but only sold through 400 lbs. in the calendar year, the COGS that can be deducted on the tax bill are based on the inputs for the 400 lbs. sold, not the entire harvest.

4. Consider your local jurisdiction.

Some states have legislated that 280E limitations do not apply to state tax filings, meaning standard business expenses can be deducted from state income tax returns. Andersen notes that California Gov. Gavin Newsom, for example, signed such a bill in October 2019, waving 280E limitations starting in 2020 and for subsequent years. “You have to watch that year by year to find out when that [is enacted in] the state that you’re working in,” he tells CBT.

That said, 280E restrictions still apply to those businesses’ federal returns, so it’s important to segment expenses differently in each filing.

5. Try to avoid consignment sales. Making sales on consignment—where a distributor or retailer pays a cultivator after they sell the product—might seem like an understandable proposition in tight market conditions, and is a standard practice in many places, but it could leave cultivators hanging. With accrual accounting (which records sales as complete before funds are received) being the industry standard, “if you’re creating accounts receivable, you’ve created the income to pay taxes,” Maxson-Landis says.

That means, for example, that a sale to a distributor on terms made in December can create a taxable income event in 2022, even though payment likely won’t be made until 2023. Beyond the taxable event, cultivators incur unnecessary risk when selling products on terms. “Many, many, many, many, many wholesalers in the 10 years that I have been working are happy to take your product, sell it, go out of business, and never pay you,” Maxson-Landis adds. “Please don’t give your product away without being paid.”

Some may wonder, if they are not paid, the potential to deduct lost income. The challenge with deducting product that vendors didn’t pay you for is determining how much you would have received and how much it is worth now. Because there’s no standard way of calculating the value of lost/degraded cannabis, it can get complicated for cultivators to calculate the actual value of the loss product for tax purposes. (Same applies for old cannabis/degraded inventory—there’s an argument that inventory loss for cannabis is not a COGS like it is for grocery stores, but an inventory cost, so it is subject to 280E.)

The other issue is that once the product is transferred, it’s recorded as a sale, and it likely wouldn’t be possible to take that sales loss as a COGS deduction. At that point, any product returned becomes a sales expense, so again, subject to 280E.

6. Use proper SIC codes.

Standard Industrial Classification (SIC) codes are four-digit codes that categorize businesses based on their industry and type of operation. Before state-regulated cannabis markets became the norm, Andersen says, cannabis co-ops would sometimes use a SIC code describing the business as a “retail flower shop” or “cut-flower greenhouse” when filing taxes.

However, cannabis industry-specific SIC codes now exist. Getting caught using misleading SIC codes on federal tax filings to skirt 280E regulations will raise a red flag and can cause an audit. “As the IRS gets better at their auditing capabilities, and knows that now [it is] looking for SIC codes, then it will be more apparent that the preparers of these tax returns have to be more accurate about what the makeup is of the” business, Andersen says.

Relatedly, Mays cautions against separating business assets into different holding companies to avoid 280E.

“That’s been one of the things that we’ve always discussed ... people try to come up with ways to kind of beat or get around 280E in order to improve their tax position,” Mays says. “I have attended some webinars and trainings from attorneys that represent plant-touching businesses before the IRS and that particular model has not won. So they try to steer companies away from trying to set up the holding company or management company-type scenario.”

7. Track daily activities to maximize COGS salary deductions.

At many small cultivation operations, different team members can wear many hats. For example, owners can both lead cultivation activities and oversee business development. “You would have your regular employees where all they do all day long, every day, is work on the cultivation side. So all of their salaries, benefits, and so forth would be 100% allocated to the cost of goods sold,” Mays explains. “However, you may have somebody else who works in the company who may need to provide assistance to the cultivation department, but they only spend maybe 10% of their time helping. So 10% of those costs are considered indirect, and we can allocate that cost to the cost of goods sold.”

Tracking employee activities carefully, at a minimum with clear job descriptions, and better yet with daily activity tracking systems, will help businesses and their tax experts properly allocate those expenses and maximize COGS deductions.

Editor’s note: Recommendations in this article should be verified with your tax professional.

Brian MacIver is a freelance writer and editor, and a partner and the director of strategic communications at Guerrera: The Agency.