Thanks to additional regulatory, legal and financial scrutiny, tax season is far more challenging for cannabis businesses than most any other enterprise or industry.
Much of that extra scrutiny stems from Internal Revenue Code 280E, the federal statute that severely limits what expenses plant-touching cannabis businesses can deduct on their taxes.
While these limitations are certainly frustrating, they are not insurmountable. They simply require cannabis businesses to perform a little extra diligence and preparation to successfully navigate tax season and stay on track for sustainable growth in the years to come.
While most other businesses can deduct any number of expenses when preparing their tax returns—salaries, rent, equipment, etc.—thanks to the nuanced limitations of 280E, those in cannabis can only deduct expenses directly related to earning a profit, or the cost of goods sold (COGS).
That doesn’t mean cannabis companies can’t deduct rent and salaries—just those that play a direct role in selling cannabis.
Square Footage: For example, dispensary owners will want to become intimately familiar with their building’s floorplan and not dedicate much space to a lobby or breakroom. That’s because those spaces don’t play a direct role in sales. If a dispensary’s square footage is split between 75% sales floor and 25% lobby, only 75% of rent is eligible for tax deduction because cannabis transactions did not take place in the lobby. The same applies to growers and their spaces. Only square footage designated for actual growing and cultivating of the plant is eligible as a tax deduction.
Employee Duties: Employee classification can be subject to even more subtlety since the IRS takes a keen eye at salary deductions for cannabis businesses. For instance, a dispensary or cultivator might split certain employees’ time between grower and budtender duties. Since, technically, budtenders aren’t required to sell cannabis, only the employees’ time worked as a grower or cultivator can be deducted.
Why Detailed Records are Important
Strong record-keeping is a cornerstone of all good businesses, but for cannabis companies it takes on a whole different level of importance—especially come tax time.
Like all things to do with cannabis and taxes, the reason comes back to 280E and the extra scrutiny the IRS disproportionately gives to cannabis businesses.
That means proper documentation and classification records for employees, square footage and other aspects of the business to justify the claims, deductions and numbers on the tax return. Without good records and documentation to back up the numbers, cannabis businesses likely will face ample penalties and fees when the IRS reviews their filings.
The cannabis industry’s heavy reliance on cash also requires diligent record-keeping. Since cash doesn’t create a natural paper trail, cannabis companies must keep detailed records of those transactions including sales, deposits, wages, bills and any others. Plus, large amounts of cash and cash transactions will draw the attention of the IRS. Unfortunately, the agency will put zero effort into investigating the accuracy of businesses’ numbers. Instead, it will likely assume the worst when reviewing unless proper records and documentation have been provided.
The bottom line is: Because cannabis companies receive far more scrutiny from the IRS, they must prove their numbers with detailed records.
Other Ways to Save
While detailed records are the foundational piece to a successful tax season for all plant-touching businesses, they aren’t the only element in good tax prep. Here are a few more tips to seriously consider when readying to file taxes.
- Take Advantage of Automation: Technology can play a big role in helping dispensaries, cultivators and other plant-touching cannabis firms with successfully navigating tax season. Making use of the right tools for inventory management and seed-to-sale movement will allow operators to properly track and segment product and sales. More efficient automation tools and tracking technology ensures expenses are tracked and classified properly to make it easier to back up the numbers on a tax return when the IRS comes calling.
- Apply Same Tax Methods: Consistency in tax methodology is the friend to cannabis businesses. Using the same methods allows for better comparability year to year. If a cultivator tries to change the way they classify a certain employee or a dispensary suddenly claims a few extra square feet, they will likely raise red flags at the IRS. Now, if there are legitimate reasons for certain reclassifications or a shift in methodology in determining deductions, be sure to have proper documentation to justify those changes.
- Recruit a Pro: The most surefire way for dispensaries and cultivators to maximize their tax savings and limit liabilities is to recruit a tax professional familiar with the cannabis industry. 280E is a unique part of the tax code that not all accountants have worked with. A cannabis-savvy accountant will know the ins and outs of 280E and will be able to evaluate and identify relevant business expenses for a specific business. In addition to addressing 280E issues, an experienced tax professional will be able to highlight other tax code changes that may impact a cannabis business. Every operation is different—even across the cannabis industry—and because the tax code is long, complex and susceptible to new rules and interpretations by the government, it’s vital to have a strong accountant at the helm to navigate a business through tax season.
Diligence is Key
As difficult as 280E compliance (and tax prep in general) can seem for dispensaries and cultivators—just be diligent. While it may be tempting to cut corners or fudge a number here or there, these potential time- and cost-saving decisions can come back to bite hard. Putting in the proper work will go a long way to positioning the business for success today and into the future.
Melissa Diaz is a co-founder and CFO of Arizona-based Rebel Rock, which provides cannabis businesses across North America with specialty accounting solutions, income tax services (U.S. only), CFO and controller services, and business system implementation. She guides companies of all sizes through GAAP compliance, financial modeling, financial reporting and general financial accounting inquiries and functions.