Running a marijuana-based business is equal parts financially rewarding and endlessly confusing. Between the various local, state, and national laws, finding that sweet spot for effective business operations is tough, even for experienced accounting firms.
At Green Valley Tax Services, we stay up to date on the latest changes and regulations to ensure your cannabis business avoids any adverse tax implications and can maintain a bright future. That includes reporting on the recent decision to include Cost of Goods Sold (COGS) as part of your end-of-year or quarterly reporting on your taxes.
Accounting Why Does this Matter?
As it stands from a federal perspective, there is no relief for cannabis farms, dispensaries, or other related businesses within that niche to take significant deductions for business expenses. The problem is that marijuana is still considered a Schedule1controlled substance under federal law.
This is a problem for businesses trying to take advantage of the current tax code by lowering operational expenses and, equally, their tax obligations. For the rest of the business world, being able to lower gross profits by deducting rent, utilities, meals, and other such expenses is valuable because it translates into more disposable profit for the owner's shares or reinvestment into the business.
For cannabis-related businesses, the story is much different. As of this writing, recreational marijuana is legal in 19states, as well as Washington, D.C., and Guam. If you look at medical marijuana, that grows to 39 states and another 5 for legalized use of CBD oil only.
This creates a challenging give and take between states and the IRS. As of March 2022, there was a reported $11.2 billion in tax revenue from 100% legal, adult-use cannabis sales. That generated more than $3.7 billion in applicable taxes at the state level. To say this industry is growing is to define an understatement.
Tax Court Feinberg v. Commissioner of Internal Revenue
Then in 2019, a legal decision titled Feinberg v. Commissioner of Internal Revenue was passed down. This made the distinction between business expenses as deductions and COGS for cannabis-related companies. Citing Section 280E of the Internal Revenue Code, deductions for businesses engaged in unlawful trafficking of controlled substances are not allowed to make deductions.
That isn’t to say there will not be movement on this issue, as 280E has created a massive financial drain on government revenue. Every time you hear about Colorado or California issuing statements on the vast wealth being generated and thousands of jobs surrounding the industry, you can read the “tea leaves” to see change is on the horizon.
Especially when you consider the banking industry. Most cannabis-related businesses are not allowed to use FDIC banks to store their funds. The number of business owners relying on cash accounting and stuffed mattresses full of hundred-dollar bills would surprise you.
COGS how does it work?
Cost of Goods Sold is a standard accounting term that refers to all the costs and expenses used in the production or manufacturing of any product sold by a business. If you are an ice cream company, everything from the delivery truck to distribute your treats to the rainbow sprinkles used at the counter can be wrapped into COGS.
This does not apply to the costs that are not directly related to production or manufacturing. For example, the sugar used to make the ice cream is included, but the flyers you print to market your new chocolate flavor are considered a different business expense.
Why does this matter to cannabis businesses? COGS is the only method to lower tax obligations. These hardworking companies cannot write off the cost of repairing their dispensary after a storm or the gas going into any vehicles used to transport products around a city. The everyday expenses used by most companies are entirely unavailable to the accounting of a cannabis business, and that has massive tax implications.
Farming & Cultivation How does it work?
This is where tax law gets even more confusing. Most farms cultivate multiple types of products. You are likely to see a farm growing corn in an open field and marijuana in a closed and secure greenhouse. The reason is it makes more financial sense to diversify your growing portfolio.
These unique situations create complex accounting issues that trained tax accountants should document to ensure complete compliance with the IRS. Basically, anything used to produce that marijuana crop is off-limits for deductions except COGS. However, all the equipment, water, marketing, transportation, and employee costs are allowed for the corn or anything else federally recognized as legal.
Cannabis COGS what can you include?
This is where the fighting tends to be the most. Some IRS agents may want to argue what qualifies as COGS, and there are multiple court cases related to this subject spread out around the country.
In general, for those with the primary business of marijuana cultivation and sale, the COGS would typically cover anything involved in growing the actual plant. This would include:
- Seeds
- Soil
- Water
- Electricity
- Testing
- Labor – as it relates to cultivation, care, and harvesting
- Physical Infrastructure for the crop
- Inventory equipment or software
This does not include marketing and advertising, accounting, rent, office management, administrative costs, and similar non-production-related expenses.
What Does This Mean for the Future?
In practical application, it means accounting for your cannabis-related business is going to take some strategic decisions – all of which are reliant on your current state tax laws first.
Many states allow vertical licenses that allow the person designated to grow, transport, and create a dispensary for the purpose of retail sales. There are ways to designate parts of the business as separate from one another, allowing some things like rent to be expensed legally.
The point is that there is no clear guidance, and it takes an experienced team to ensure you are getting the most advantage for your particular situation.
This has created a rough situation for resellers and dispensaries. Whereas a producer can use a lot of expenses in COGS, a reseller only uses the invoice price of purchased cannabis, less any trade or other discounts. That may include the initial transportation and other expenses necessary to gain possession of the inventory. However, that is it.
This is where the argument will likely continue to be had. As more dispensaries come online and the call for free commerce between states grows, we are likely to see changes to the tax code at the federal level. Hopefully, the pressure of all these states will be the tipping point for cannabis-related sales to be fully legal at the federal level.
Until that point, you are going to need expert help to navigate these situations, so your tax obligations and risk are minimized. That is why it is critical to work with professionals like our team at Green Valley Tax Services. We are a complete business services firm with the experience and qualifications to ensure your tax preparation and bookkeeping are always kept in full compliance, so you get a clear picture of your financial health.
Schedule a consultation today if you would like to learn more about how we can help support your cannabis business operations. We look forward to helping you through this transitional period.