Cannabis Knowledge & Insights

Cannabis CoGS: Offset Sales & Marketing Expenses to Reduce 280E Impact on Cannabis Business Taxes

In this video and synopsis, we discuss the cost of goods sold (COGs), and how to offset your sales and marketing expenses to reduce the impact of 280E on your cannabis business taxes.

Now as a cannabis business operator you understand that cannabis business taxes can be quite complicated you have 280e tying your hands together only allowing you to deduct the cost of goods sold from your revenue to create that taxable base and that exposes you to a lot of taxes now one thing that you need to think about is how can you back your sales and marketing expenses into the cost of goods sold and in this video we’re going to teach you how to use intellectual property and royalty agreements to do just that now if you have any questions about this particular tax strategy or cannabis business accounting that please reach out to us via our website at green growth or give us a call at eight hundred 676

business taxes with IP and royalty payments and this presentation is brought to you by green growth CPAs now as a cannabis cultivator or manufacturer your task of managing not only products and their quality but also all the costs associated with your business you look for your P&L and you see your sales your direct cost of goods sold overhead like utilities rent depreciation and equipment and you see some level of predictability around those numbers from there you typically left with sales and marketing expenses and you ask yourself hey how can I have those expenses actually work for me because sometimes those make up five to ten percent of your sales so for a 10 million dollar cannabis company that could be close to a million dollars in expenses that you can’t roll into cogs which means there is a big opportunity to unlock those deductions so in this video we’re going to explore how to unlock your sales and marketing expenses from 280e a little bit about green growth CPAs before we dive into the content here now first we are a cannabis only tax preparation and finance firm we have hundreds of active clients throughout twelve states in the USA as well as international clients in Canada Europe Australia in many other countries now yes we do tax preparation we also do tax strategy planning we do audits in business valuations financial compliance outsourced CFO work to help you get a grasp on the numbers for your business as well as IPO readiness so if you’re ready to go to the public markets we can help you prepare for that we service all verticals in the cannabis industry from cultivation testing manufacturing distribution retail delivery everything cannabis in finance that’s what we can help out with now before we get started I need to let you know that the information contained in this presentation is meant for guidance purposes only and not as professional legal or tax advice infer that does not provide any personalized legal tax investment or any business advice in general so with that out of the way let’s review what we’re gonna cover in this presentation so first we’re gonna talk about the big tax problem that cannabis businesses face then we’ll talk about an outline a potential solution for those tax problems then we’ll show you an example fund flow then discuss how the taxes work we’ll discuss those royalty payment structures I’ll give you an example tax savings and then help you understand the exposure of taking on and using this potential strategy so first the tax problem that cannabis businesses face so as you know 280e restricts the deductions to only cost of goods sold and there’s a strict interpretation for what those direct costs can be pretty much just the packaging and the raw materials so you’re left kind of tied with your hands together on what you can deduct which exposes you to a lot of tax burden now you need to market and sell your products to get awareness and make your business profitable and often again you cannot deduct these costs so this destroys your profitability so the big question that we all face as cannabis business operators is how do you back as many costs specifically those sales and marketing costs in the cost of goods sold so that you can deduct them and lower your tax burden so let’s explore one solution to this cannabis business tax problem and the strategy that we’re going to describe here can work for manufacturers and cultivation operations and even those vertically integrated businesses so first what you’re going to want to do is create a separate entity that owns your intellectual property now when you think of intellectual property you probably think of trademarks images slogans logos things like that but intellectual property also includes things like trade secrets recipes techniques formulations patents okay those very valuable things that are not the sexy things like a brand or a logo but those are considered intellectual property then the operating entity pays a reasonable royalty to the intellectual property entity okay now you roll this in to cost of goods sold and we’ll show you how this works later in the presentation so then the intellectual property entity books that royalty as revenue and now they have cash to run their own fully separate business in this intellectual property entity will perform all the sales and marketing functions for the operating entity in the products that it produces now it also has expenses to offset this revenue and hopefully netting down as low as possible you’d love to hit zero you don’t want to go negative but you wanted to actually hit some type of lower number to offset and unlock that royalty payment from 280e as full as possible now again this strategy works for manufacturers cultivators and vertically integrated businesses and it’s less helpful for those standalone dispensaries or deliveries so let’s look first at an example fund flow so you see at a high level how the money moves around and how this impacts your tax burden so on the left hand side you see the old model or your current model right now you have revenue flowing in to your licensed operating entity which is a manufacturer or a cultivator and then you have below that some expenses now it breaks out into two different ways you have cost of goods deductions things that can be considered cost of goods and then you have non-deductible cost your sgna costs against sales marketing office supplies basic things like that and then it all breaks down and funnels into a particular tax burden for the year now the new model on the right-hand side of your screen has two separate entities now you still have that license operating entity which is a cultivator or a manufacturer and you have revenue coming into that entity from them selling their products now what you see between these two entities which that one on the right is the intellectual property or brand entity that does all the sales and marketing for the licensed operating entity and their products now again between those two entities you see that the operating entity is gonna transfer all their intellectual property rights over to the brand and intellectual property entity and that licensed operating entity is also going to pay a royalty fee to that intellectual property entity for rights to use that intellectual property and that royalty fee is considered revenue for the intellectual property entity now they have operating capital to do the sales and marketing for that other business let’s go deeper into the licensed operating entity they’re gonna have expenses still have expenses right but they’re cogs deduction will go up and they’re non-deductible costs will go down because we’re going to show you in this video how that royalty fee can then be pushed from non-deductible over to a cogs deduction and essentially this will reduce the tax burden for that license cannabis business now on the right hand side the intellectual property entity that does all the sales and marketing they’re gonna have expenses and they’re gonna be all deductible expenses because this is an ordinary business this is not a cannabis business it is not plant touching and then they’ll have their own separate tax burden under that so that’s how the old model and the new model compared to each other so now that you understand how the money in the operations flow let’s go deeper into how do taxes work with this particular arrangement so again the canvas manufacturing or cultivation business they will pay a royalty once per month to the intellectual property entity and it will become fully taxable income for the intellectual property entity but the entity will have its own sales and marketing expenses in operating expenses to offset that income now essentially this new intellectual property entity does all the sales and marketing functions that you used to do in-house for your manufacture or cultivation business but going forward the manufacturer just licensed the intellectual property things like the trade secrets the recipes the techniques the formulations to just make the products and that’s all that they do and then the intellectual property company does all the sales and marketing for those products so that’s how the operations and the money works now on to the taxes now for the manufacturing or the cultivation company the big question that they have and what they need to understand is how do they allocate that royalty payment into cogs so that it can be deductible now there’s a lot at stake here in tax savings if you get this wrong you could be paying again 30 percent tax rate or whatever your tax rate is on a 1.2 million dollar tax payment now 30% of that is three hundred and sixty thousand dollars now if you get this right that’s three hundred sixty thousand dollars in tax savings you get this wrong and now you’re still paying that three hundred sixty thousand dollars in taxes every year now the main pillar is to focus this royalty payment on the manufacturing or cultivation procedures in methodologies and as stated earlier the intellectual property that your licensing includes trade secrets recipes techniques in formulations now it should be understood that if you didn’t have these pieces of intellectual property then you couldn’t make your product to specification or to the level or standard that it needs to be a so it’s incredibly important that you have well-documented SOPs to become your trade secrets and your techniques because without this SOP or any of these big documents you will have a hard time with this strategy so let’s dig deeper into taxes now the IP company should make this a sales based royalty fee to the manufacturing or cultivation company and this is where tax code 1 4 7 1 is most applicable and where we would get our guidance from and yes 1 4 7 1 is pretty broad but it does bring up that indirect production costs are inventoriable costs and we will get more clarity on what those costs are by looking at another tax code section 263 which is also called unit cap now in section 263 there’s a list nonexclusive indirect costs that must be capitalized in those include manufacturing procedures and special recipes so your royalty can be added to cogs as long as it is a manufacturing procedure or special recipe that is necessary or directly benefits the production or the resale of this product but it doesn’t stop there understand that you must use a GAAP accrual accounting adjustment to move those costs from inventory into cogs as you sell those products for every period in which you sell those products and we made another video on this accrual adjustment and how to move costs from inventory into cogs and I’ll link to that in the description below this video so now that you understand how taxes work and how you can actually roll that royalty payment into cost of goods sold let’s talk about the payment structure in royalty payment amount now there are two benchmarks that we’ll use to triangulate a number and those are your financial projections for the manufacturing business or cultivation business as well as what does the market say that we can take and make as a royalty payment or fee remember this has to be what we call a reasonable royalty not just some funky number that you arbitrarily choose out of thin air there needs to be some basis of why this number is a true and reasonable royalty so let’s break it down so first you need to look at what your total projected sales and marketing costs are from that original operating entity so let’s say for this example this is a manufacturing company and its projected to generate 20 million dollars in annual revenue and their sales and marketing expenses is 1.2 million dollars per year as we said earlier the intellectual property company will be taking over all these sales and marketing functions so those are now going to be the IP company’s expenses so understand that this royalty revenue is going to the intellectual property company so to fully unlock that 1.2 million dollars from 280e and from any taxes you have to make sure that the intellectual property company has that amount of expenses the 1.2 million dollars or at least close enough to it to off set that revenue so the 1.2 million dollars is your threshold that we are trying to hit in the royalty payment as well as expenses to offset that now the more you spend on expenses with the intellectual property entity the less taxes that it will have to pay since it’s an ordinary business and can deduct all those costs from revenue to get a taxable base so understand you’ve got these projections we want to hit a 1.2 million dollar royalty payment to offset all those sales and marketing costs that we projected now the next step is to take a look at the broader market of royalty payments and of intellectual property licensing agreements and see what is considered a reasonable royalty now when you look at enough of these royalty agreements you see that there’s typically two parts all right there is a minimum payment and then some percentage of sales so in this example with that 20 million dollar company you may want to set a minimum annual royalty payment of $500,000 or $750,000 maybe even all the way up to 1 million dollars so that you know that at least this amount is going to be deductible every year now this minimum is going to be different for every business because of the different sales levels or revenue levels of that manufacturing or cultivation business as well as the value of that intellectual property and many other factors so it’s important that you have these projections done from that previous step because this is an exhibit of your methodology of how you got to that minimum payment again you cannot just arbitrarily grab this payment amount out of the air because you want that number there has to be some basis to it now the reason for a minimum payment is because until you scale up to say that 20 million dollars in annual revenue you can’t charge a percentage of like 30 percent royalty on those lower end sales numbers that percentage just does not fit into the contract norms right so if you were to charge a million dollars on 6 million dollars in revenue that’s not going to look right okay so the next step once you have that minimum payment laid out the next step is to actually discuss a percentage of sales so once you actually do scale up to that 20 million dollars what percent of revenue does the intellectual property company charge the manufacturing or cultivation business now for cannabis there are not many public markets in numbers around this or contracts that are available for you to look at and create some kind of comparables but typically in other lines of business you see royalty rates from one to five percent of sales but maybe in cannabis because it’s a newer industry you may be able to get away with something higher like an eight to ten percent but again this is something that you have to do some due diligence on and have some reasonable methodology and basis to why you chose this particular royalty rate so to tie this example up if you had a 1 million dollar royalty payment up until the manufacturing company generates 20 million dollars in sales then you would switch over to a percentage of revenue and you could do five percent of revenue is then the royalty payment going forward on anything above that twenty million dollars in sales again you have to have basis for these numbers and we’re just giving you some color in context that you need to look at first what is the amount that we want to hit and then what is the actual reasonable minimum payment and then from there if we exceed that minimum payment what is the reasonable royalty rate above and beyond some sales level amount for that operating manufacturing business or a cultivation business so now that you understand what we’re talking about here I just want to give you a basic potential tax savings amount so we’re gonna talk about a big operator and a medium operator so for the big operator you have the operating company revenue which is twenty million dollars the last example we went through and their annual royalty payment total is 1 million dollars we’ll say and that tax rate for their business is 30 percent so their potential tax savings is $300,000 per year every year going forward now for a medium operator say they make three million dollars in revenue annually and their annual royalty payment is a hundred and fifty thousand dollars which is five percent of their revenue and then tax rate for that business is thirty percent is well that’s 45,000 dollars per year in tax savings from just this one strategy so as you begin to look at this a none packet there is a lot of money saved for your business in taxes and the more that you make as a cannabis business the more that you can save on taxes now that you understand the strategy it’s important that you understand your exposure when implementing this strategy and first and foremost I want to make it very very clear there has not been a tax court case that has been brought up about the strategy specifically for cannabis businesses there have been other royalty cases and intellectual property cases but nothing specific to cannabis and know that this is not some type of cannabis management company style setup that you saw in the alternative health care advocates case rather again this is a pure royalty position cannabis management companies usually fail or those strategies usually fail to stand to the test of the courts for many many reasons that we detailed in another video which is linked down in the description below so we’re gonna detail three ways to reduce your exposure while implementing this strategy so first you need to set the royalty rate at a reasonable amount again you cannot set this reasonable royalty at thirty to thirty five percent of sales because that is not reasonable in no one in any industry does that so have the minimum fee and then set a reasonable percentage and make sure that you have a very tight well-thought-out royalty agreement written by an experienced intellectual property lawyer and also look at the total royalty rate at an annual rate or an annual period if you set a minimum payment of $500,000 and the manufacturing or cultivation business only brings in 2.5 million dollars in revenue for that year that is a 20 percent royalty rate and that is just too big so you got to make sure you have a methodology to work in and get to that reasonable rate that we talked about the one to five percent for typical ordinary businesses and again maybe cannabis gets away with something in that seven eight 10% range next is very important that you keep your manufacturing and intellectual property entities and businesses as fully separate legal entities and fully separate businesses in as many ways as possible they need to have separate books they need to have separate accounting procedures they need to have separate business plans there has to be no commingling of funds at all which means having separate bank accounts and also no consolidated tax returns as well as you know you could see some same ownership percentages but you should consider changing the officers or the managing members and for sure have no share death at all you may even want to have them be in a totally separate location a whole different separate office now to make this point very clear your manufacturing company production manager cannot be the head of sales at the intellectual property company again don’t have any workers be employed by both the manufacturing or cultivation company as well as the intellectual property company who does the sales and marketing fully separate businesses in every manner possible and lastly you want to have well written standard operating procedures that will qualify as your intellectual property these things cannot just be up in someone’s brain in the manager or the operating managers brain they have to be documented and written out and have a certain amount of specificity to them to become trade secrets because again these SOPs will become your trade secrets your formulations and techniques that are then going to be licensed out to your manufacturing business and potentially other people and where applicable you could consider filing for patents and trademarks to establish more substantial evidence that these are in fact protected pieces of property now to build on this point if you want to expand your operation to other states and become a multi-state operator or an MSO then licensing out your IP is how you scale up quickly and these joint venture agreements with another business strengthen the validity of this tax strategy in this position so in your home state where you currently operate you may own both the manufacturing business and the intellectual property licensing company but in other states where you want to expand if you have a relationship with a different manufacturer someone you have no initial ties to other than this business manufacturing agreement licensing agreement then again you can set up this licensing and royalty agreement with them to produce using your intellectual property your trade secrets your formulations your techniques now when the IRS comes in and questions your position you can point out that you have this same type of intellectual property royalty arrangement with a 2nd or 3rd cannabis manufacturing company in different states so if you’re based in California then you say well we have the same arrangement with someone out in Nevada in someone in Michigan and then someone in Oregon this is a side again from that original arrangement you have in your home state having more fence posts to hold up your fence creates this stronger fence and builds a more substantial and stronger argument as to why this position is valid and the strategy is valid for your business now we’ve covered a lot of ground here explaining this strategy so I want to tie it up with a few key takeaways so first understand that intellectual property can include trade secrets recipes techniques and formulations not just images trademarks slogans logos things of that nature secondly royalty payments for certain intellectual property can be rolled in to cost of goods sold but you have to have a reasonable methodology for taking that deduction or rolling those costs in third royalty rates must be reasonable and in line with other industry standards and lastly well-thought-out and documented SOPs and other documentation is the first step to developing your intellectual property and can help you become a multi-state operator and grow your cannabis businesses to very new heights so hopefully you found some value in this video and help you explain and understand and how to reduce your cannabis business taxes with royalty and intellectual property agreements so if you need help with creating your intellectual property strategy in tact saving strategy for your cannabis business then please reach out to green growth CPAs via our website at green growth CPAs com or give us a call at eight hundred 676 and pieces and help you understand where there are trade secrets what SOPs need to be made help you understand and create this tax strategy connect you with the right parties to help you lay out these agreements so that you can save that massive amount of money on taxes every year going forward again if you need help with creating this intellectual property tax saving strategy then please reach out to green growth CPAs via our website at green growth CPAs com or give us a call at eight hundred 676