Until major regulatory changes occur, IRC 280E will remain the biggest obstacle to profitability for cannabis operators. The inability to deduct common operating expenses makes cannabis operators endure a tax rate three times higher than mainstream businesses. The good news is that with proactive tax planning and documentation, there are many ways cannabis cultivators can take deductions to reduce the impact of 280E.
The key to navigating 280E is understanding Cost of Goods Sold (COGS). Costs are deductible if a cannabis operator can prove that a business expense is necessary to the production of goods. The goal is to allocate as many indirect costs as direct costs included in COGS. Thereby minimizing tax exposure for our cannabis clients. As cannabis accountants, we can help operators reduce the adverse taxation of Section 280E; by analyzing cash flow, properly planning, and documenting intentions.
In the following we’ll walk through some key considerations. In addition, we provide a side-by-side sample of a Profit and Loss statement so you can see the impact of correctly allocating costs.
What is the impact of 280E on cannabis cultivators?
The biggest challenge with 280E tax law is understanding how to maximize deductions allowed for each vertical and within their operations while minimizing their tax burden. The company either pays the taxes itself or passes through to the shareholders or members of the business. Then operators report and pay tax on their personal income tax returns depending on the entity structure. Calculating your own business and personal tax returns can be very complex. Rapidly changing legislation and tax law require well-trained accountants specializing in the cannabis space. By staying abreast with current tax law affecting the industry and each vertical.
Operators who have filed their own returns often experience issues after incorrect tax filing sparks an audit by the IRS. Adverse audit findings can cause monetary penalties, additional taxes owed, and additional fees. Especially, the cost of an accounting professional to examine the incorrectly filed tax returns and audit findings before refiling them.
Some states do not include the 280E tax code for calculating state income, like Oregon and Colorado. Cannabis businesses effects can differ depending on which state they are in. It is crucial to obtain the advice of licensed professionals. Especially, if you operate out of multiple states or are unsure about the 280E tax law for your state. GreenGrowth CPAs operates nationwide in all states with legal cannabis adult use and has experience navigating 280E for all verticals.
How to approach 280E deductions for cannabis cultivators
A cannabis grower can maintain accurate inventory by applying the full-absorption accounting method of inventory costing. Through this analysis, we are able to create an inventory valuation for the balance sheet while still staying compliant with 280E. Direct and indirect costs can be categorized as production costs and fall under cost of goods sold if they are necessary and directly relatable for the growing of the plant. They won’t be recognized as expenses during the month the business paid for them, but will remain in inventory listed as an asset until the crop is sold. Once the sale is complete, we move them into the cost of goods sold.
What cannabis cultivators can deduct under 280E
We have incorporated an example below of a profit and loss statement. In this sample, we provided a side-by-side comparison for a new client. A typical cultivation operation’s profit and loss statement would look similar to the provided example. The first column is a cannabis cultivation business not allocating indirect expenses under the cost of goods sold. While the second column demonstrates the same company when indirect allowable expenditures are deductible under the CoGS.
Sample of deductible cannabis cultivation expenses:
- Soils, Nutrients, Clones, etc. – All allowable as they directly associate with the cultivation process.
- Management Fees – We can allocate a portion of management fees to the cost of goods sold as they pertain directly to the cultivation of the product.
- Rent – All rent can be allocated under the COGS if the entire site is used for cultivation, and there are no administrative offices.
- Security – All security costs are deductible as they are directly associated with cultivation.
- Utilities – Utility costs can be extremely high for growing operations. All utilities for the direct cultivation site can be allowable if the site is not used for anything else.
- Insurance – If business insurance covers the cultivation it is allowable.
- Technology – All costs are associated with direct cultivation software.
- Depreciation – Assets are directly attributable to cultivation.
Sample Profit and Loss Statement (P&L):
Note: Second column indicates tax burden without deductions based on COGS, and the third column properly deducts costs in compliance with 280E.
Sample Breakdown:
As you can see in the above example, properly allocating deductions to COGS drastically impacts your bottom line. In this example, we allocated the cost of goods sold and increased the business’s operating profits before tax by $197,500.
Note: The information contained in this example is for discussion purposes only, for a true comparison of your cannabis business reporting methods we recommend seeking out the advice of a tax professional.
How does section 280E apply specifically to cultivators?
If a cannabis company is solely in the business of growing and selling cannabis, most of its expenses can be deductible. When completing returns, it may be necessary to omit certain onsite offices, bathrooms, break rooms, etc., from the allocation based on the percentage of size/use. Determining the exact use of the property is complex. The help of a tax accountant can provide insight and prevent incorrect information on the filing.
Out of the four main cannabis verticals, cultivators have the most opportunity to minimize their tax payment compared to the other three. Because most costs are directly relatable to the end product and are easier to prove. It becomes more cumbersome when the operation expands into other verticals or does not grow the product itself. We will address deductions for the other verticals in future articles.
The future of 280E and the cannabis industry
Until the DEA and federal government remove marijuana from the Controlled Substances Act, cannabis will remain classified as a Schedule One drug. In addition, operators can be considered traffickers under federal law regardless of the state’s applicable laws. While there has been some discussion to declassify cannabis from a Schedule I to a Schedule II drug, there remains a lot of controversy in this area. Substances listed as Schedule II drugs require the authorization of a physician. Once federal legalization goes into effect, the 280E rule will become obsolete in the cannabis industry. However, until then operators must continue to wade the waters of the unfolding market.
For more information on how to navigate the 280E, reach out to our accounting experts at GreenGrowth. We are here to help your cannabis venture through any level of the tax filing process. We employ several financial programs that can assist the company with its fiscal responsibilities including, tax planning and compliance, outsourced CFO support, audit preparation, tax controversy support, and much more.
For recommendations and assistance with tax planning and 280E compliance, schedule a free consultation or contact us at 1-800-674-9050.