Tax planning is a critical consideration for any individual or business, but this is especially true if you currently operate or plan to start a cannabis business. Tax planning should be conducted throughout the year, and at a minimum, a meeting with your tax advisor should occur in the 4th quarter, prior to the individual's or businesses' year-end. Taking this initial step can help you avoid significant penalties and better prepare you to budget for the consequently significant tax obligation. For first-year businesses, before section 280E of the IRS tax code – of which every cannabis business is likely (or should be) aware – is even considered, tax planning usually starts with determining which entity type (LLC/Partnerships, 'C' Corp, 'S' Corp) to select and operate.
Determining What Entity Structure Is Best Suited for You
Tax planning considerations must be considered separately for those in the first year of business versus those with operating history. For first-year businesses, entity formation is one of the two most important things you can do in preparation for tax planning. Determining which entity type (LLC, 'C' Corp, 'S' Corp) to select and operate involves a deep understanding of the prospective business, including a review of pro forma or projected income statements. (For more information on 280E and determining how to establish your company/entity, see the “Money Talks” column, “Navigating 280E,” in the July/August issue of Cannabis Business Times.)
Keep a chart of accounts so that you can code direct and indirect costs in real time.
The other most important step is to understand Internal Revenue Code Section 280E tax implications and how it applies to cannabis businesses.
IRC 280E
IRC 280E applies to all individuals and businesses who cultivate, transport, distribute and sell cannabis. IRC 280E permits the deduction of Cost of Goods Sold (COGS) and disallows selling and/or trafficking expenses – therefore resulting in a much higher taxable income than net book income and, in the end, significantly increasing the taxes due. If section 280E is not managed properly, the company’s profits can be eroded by the increased tax liabilities and, in some cases, wiped out completely.
Making yourself more familiar with 280E tax implications is important to understanding what operating expenses are included in or allocable to COGS. While consulting a lawyer and accountant familiar with 280E is advisable, the following tips will help you get started, and work toward maximizing your deductions and keeping more money in your pocket.
Labor and Inventory
First, the activities of each employee should be documented in a job description and be monitored throughout their employment. Employees’ activities determine whether their labor is deductible/allocable to COGS or non-deductible.
For cultivation employees, all labor associated with cultivating, trimming, harvesting and processing of cannabis are direct costs of production, or COGS, and are deductible.
Any time spent on marketing and sales activities are considered “trafficking,” per 280E, and will be a disallowed labor expense.
It is important to know your employees and gauge whether any overlap exists in job duties so that the allocation of deductible versus nondeductible labor can be completed.
Know what else can be deducted. In addition to labor, other expenses that fall in direct and indirect production costs include, but are not limited to:
- water,
- nutrients,
- soil,
- electricity,
- rents,
- consumables,
- garden supplies,
- fertilizer
- packing and processing materials.
Since COGS is the only allowable deduction, it is imperative to understand what costs are included in it, so you can determine gross margins and taxable income throughout the year.
To accurately calculate COGS, you will need to conduct a physical inventory count at year end, preferably on Dec. 31 at close of business, and to track the units produced throughout the year.
Cost of Goods Sold is calculated as follows:
Beginning Inventory + (Purchases/Direct Expenses) – Ending Inventory = COGS
To simplify this equation, an inventory count conducted at year-end provides values for beginning inventory for the subsequent year.
The purchases and direct expenses are the key components to the equation because, for growers, cost-absorption methods will be applied, requiring specific identification of costs traceable to inventory. Once all production costs have been properly identified, the cost per unit can then be determined, as well as the ending inventory value, and ultimately the COGS for the year.
Maintaining a chart of accounts (vendors) through your accounting software is also very important and should be completed during start-up. This will help the bookkeeper code the direct and indirect costs to the appropriate accounts in real time. Also, repeating vendors for similar purchases can be set up to automatically classify as direct COGS or indirect costs. This makes tracking and classifying expenses much easier.
Ultimately, by considering these tax-planning items and following through with them, your tax preparation process will be much smoother and you, as the business owner, will have a better understanding of your tax liability — and maybe a little more in your pocket come next year’s tax season.
