Cannabis Business Times: What are some strategies cannabis companies can implement when initially setting up their businesses that can help them with taxes in the long run?
Rachel Gillette: We all understand that the problem with taxation of cannabis businesses is primarily 280E, which is a very punitive tax provision of the Internal Revenue Code, which essentially punishes cannabis businesses with much higher tax rates as a result of them being engaged in “trafficking of a Schedule I controlled substance.” Now, over the years, I’ve seen many different kinds of recommendations by CPAs, attorneys, financial advisers, etc., that seek to minimize the tax effects of 280E.
To this day, I think the best strategy is to have a good understanding of 280E: which of your expenses are either going to be cost of goods sold (COGS) in your cannabis business versus a potentially non-deductible expense under 280E. When you have a good understanding of that, you’re going to have the ability to make better financial decisions. A lot of people don’t understand it quite enough, and sometimes people have gotten what I would call overly creative with both their corporate structuring and their tax strategy, when the fundamentals are what are going to benefit you most as a business owner.
For example, there have been many businesses that have employed the strategy of a commonly owned management company. The understanding was that it would not be subjected to 280E, but we’ve just learned in a recent tax court case that this strategy can certainly backfire. As far as corporate structure, there are certainly things you want to be considerate of. The type of license can be very determinative to how simple or complex you want to be in your tax strategy. Companies that are engaged in the manufacturing side, like cultivators or manufacturers of the edible products or concentrates, for example, by and large, the majority of their expenses are going to fall under the category of cost of goods sold. They’re not going to be as affected by 280E if they’re engaged in manufacturing activity.
CBT: What is one of your favorite tips that you often find yourself giving cannabis businesses to help them navigate 280E?
RG: [Cannabis business owners] should have an understanding of how 280E is affecting their business, meaning what are their disallowed expenses on a monthly basis? They need to know in real time what is going to be a disallowed expense that they are potentially going to have to pay tax on because one of the worst things that can happen to a cannabis business is come Tax Day, April 15, they do not have their correct amount of estimated taxes that have been paid or they do not have enough money set aside to pay their tax bill. That happens very, very often, and oftentimes, it happens as a result of cannabis business owners not knowing what their disallowed expenses are or the dollar amount of their disallowed expenses, and therefore, the taxes due based on disallowed expenses at the end of the tax year. So, it becomes a big surprise, and they haven’t planned accordingly. That is the biggest problem that I see that faces especially smaller businesses in this industry.
CBT: What are some best practices for recordkeeping that will help cannabis businesses with their taxes?
RG: Way back when, when I first started practicing in this area, back in 2009 and 2010, there was this fear of the federal government coming in and arresting people and throwing them in jail for a long time. People didn’t want to keep records of their federally illegal activities. Many years passed, and now the advice that I would give everybody is to have very, very good business records because you’re going to be audited, and when you’re audited, if you don’t have very good business records, that’s going to affect your ability to take even your cost of goods sold, which is something that the government is going to allow. So, if you have expenses that are cost of goods sold but you don’t have documents to back them up, you’re doing to get a disallowance based on substantiation of your expenses rather than 280E, which is a silly result.
The other thing is the IRS and the tax man—state and local even—they’re always going to be wanting to look at two major things. One is that you reported the right amount of income so you can verify income. And they also want to make sure that you are managing your inventories right, and there isn’t either product or cash walking out your back door that’s not being reported to the taxing authorities. So, especially in a cash-intensive environment—which we all know that we still have a banking problem and that the industry is significantly under-banked—you have to keep extra records, and you have to keep records of records.
CBT: What are some ways that a cannabis business can prepare for an audit?
RG: Making sure you have good records and you keep those records because you typically are going back three years from the date of filing, but there are circumstances where they might be able to go back even further. So, you want to make sure you’ve kept good records over the years and that you’ve kept those records around.
You want to make sure that you have somebody who can be the point of communication with the IRS who has some expertise in dealing with cannabis business audits and taxing authorities. Personally, I am always the voice of my client. I never allow my client direct contact with taxing authorities. That’s because taxing authorities and the examiners are trained investigators and they’re usually digging for information, and clients and tax preparers tend to overshare. That’s why us lawyers are important, to be the point of communication and to ensure that our clients don’t end up in a situation where they’ve created more problems for themselves than necessary.
Editor’s Note: This interview has been edited for style, length and clarity.