With the steep decline of wholesale flower prices in several mature cannabis markets, already slim profit margins for cannabis cultivators are now razor thin. Compounding the problem is the ever-present issue of IRC 280E, which limits the business deductions cannabis businesses can take on their tax returns. That’s why it is more important than ever that cannabis cultivators take a proactive stance on tax planning and compliance. By implementing appropriate inventory costing accounting methods, cultivators can limit the impact of 280E, reduce their tax burden, and turn more of their hard work into profits they can reinvest in their business.
The key to this advanced tax planning approach is IRC 471, which has updated the rules to allow most of a cannabis business’ operating expenses to be registered as Cost Of Goods Sold (COGS). In the following we’ll lay out the reasoning and processes behind implementing this new accounting method. Determining what is deductible, and applying those changes to your tax returns, is complicated and we highly recommend working with dedicated cannabis accountants to make sure you get the details right. To schedule a consultation with our expert cannabis tax team, schedule a consultation here.
How does IRC 471 impact cannabis businesses?
Under 280E, cannabis businesses may only deduct the COGS from gross receipts and attempts to use the allocation method of IRC 263A have been struck down by Federal Tax Court decisions. In 2018, the hope for relief from 280E came via a little-known provision in the Tax Cuts and Jobs Act. A section titled Small Business Accounting Method Reform and Simplification enacted provisions that allow businesses with less than $25MM to utilize alternatives to the accrual method of accounting — as long as that method of treating inventory is supported by its financial records of the business.
As a result, by correctly implementing inventory cost accounting methods, business owners can absorb many direct expenses into their COGS. This is especially true for cannabis cultivators, who are categorized as “processors” under federal tax rules and gain even more exceptions than other parts of the cannabis supply chain.
What is inventory costing, and how does it affect cannabis cultivators?
Inventory costing is assigning value to inventory, and thus to the cost of goods sold. Proper inventory costing is essential for any business as it directly affects the gross profits and taxable income of the cannabis cultivator. Having a comprehensive inventory costing approach is essential for the preparation of all the essential financial statements of an entity, including income statements and balance sheets. For example, on your balance sheet, an inventory valuation lists direct and indirect costs as production costs.
According to the IRS definition of COGS, cannabis cultivators qualify as “processors” and fall under IRC 471-11. This subjects them to value inventory at the beginning and end of each tax year to determine the cost of goods sold. Tax liability reduces when the cost of goods sold is incorporated into allowable expenses. The following are some types of expenses cultivators often include:
- Seeds or clones
- Growing medium
- Repairs and maintenance expenses
- Some tools, equipment, and supplies
- Packing and processing materials
- Special Purpose Agricultural Structures (i.e.,greenhouse)
- Manufacturing overhead
- Leaseholder improvements to a building’s interior
- HVAC, fire protection, alarm, and security systems
- Some administrative costs
- Employee’s salaries
Essentially, our accountants assign all expenses and costs associated with the cultivation and the finished cannabis product to inventory. Although, they are not recognized as expenses during the month the business paid for them. They remain in inventory as an asset until the flower sells, and then we move them to COGS. By assigning inventory in this way, we can lower the business’s taxable income, and the business owner pays less in taxes.
Steps to Perform Inventory Costing for Cultivators
In the following we’ll show the steps we follow in figuring out the cost per pound and allocating expenses into the COGS category.
Step 1: List and categorize all expenditures of the business. Most of this step should be performed by your internal bookkeeper.
Step 2: Record COGS and appropriate inventory. When setting inventory, our accountants use the methodology the IRS defines as practical capacity.
How to assign inventory:
A. Define inventory: crop inventory, in-process inventory, and finished inventory (flower & trim)
B. Establish equivalent unit: pounds or grams of flower
C. Convert each type of inventory into equivalent units
i. Finished flower – easiest to convert (already in pounds)
ii. Trim – 10% since the trim is generally 10% of flower yields
iii. Crop inventory – based on percentage completion and expected yield
Step 3. Crop Inventory Schedule
A. Reconcile plant counts, yields, and ending quantities to the system in place
B. Calculate equivalent units and trial balance
C. Calculate allocation percentages, inventoriable costs, estimate taxes
D. Record all applicable entries
Step 4. Frequency of recording – the IRS guidance states this should be completed regularly but does not further clarify. We recommend reconciling monthly or quarterly.
Keys to Proper Inventory Costing
- Develop financial reports/statements in accordance with GAAP.
- Capture key operational data each month, including stages of completion, estimated yields, direct/indirect and facility allocations.
- Chart of Accounts (COA) must be cultivation-specific.
- Advanced record keeping and storing in the event of an IRS audit.
- Close your books each month and maintain those records.
- Do not overdo writing off expenses, this is a red flag for the IRS.
- Do not attempt cost accounting at the end of the year. On-going accounting and record-keeping is required.
- Do not attempt to avoid taxes through complex legal structures. Tax court cases have created precedent that these will not work, and may indicate “intent” to avoid taxation.
- Do not try to apply the same cost accounting principles to different verticals. Each vertical has its own requirements and must be addressed individually.
Inventory Management is at the Root of Inventory Costing
Inventory management is often challenging for cultivators, especially in a predominant cash industry and with products sold by weight (rather than more defined units). The current seed-to-sale software systems on the market track inventory quantities and support operations to meet state compliance regulatory standards. Yet most do not support advanced data needed to verify the cost of the growing plants, track the yield or price of the crop, estimated harvest, or expected date of sale. Therefore, most cannabis business owners track their products using various reporting techniques such as bill pay, online banking, Quickbooks, bookkeeper, etc.
Cannabis cultivation owners must understand annual department costs, sales by product type, and current inventory levels. The obligation to verify inventory reporting from expenses lies with the business owner. If you’re having difficulty with basic reporting, we can help. Our Outsourced CFO service may be the perfect solution for your business.
Final Thoughts and Next Steps for Cannabis Cultivators
After working with cannabis businesses for nearly a decade, we understand every operator’s top priority is profitability. Although, daily operational pressures for cultivation businesses can make it challenging to focus on optimizing business performance. Our experts can help by meeting the IRS requirements and using GAAP accounting methods to save on tax payments. Also, we have been through several audits, which provides us with insight into the Federal and State’s interpretation of both 280E and 471.
Our experts have fostered excellent partnerships across the U.S. and help cannabis business owners streamline efforts to ensure you stay compliant and abide by industry regulations in your state. For recommendations and assistance getting started, schedule a consultation or contact us at 1-800-674-9050.