Implications of 280E in Daily Operations
All for-profit business that earns profits must pay income taxes in the United States, including business involved in the California cannabis industry. However, the taxable income from cannabis is subject to different rules because cannabis is still illegal at the federal level and the taxing agencies impose additional scrutiny on cannabis companies. Therefore, it is crucial for you to keep meticulous accounting records to support tax-related filings.
IRC Section 280E:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances which is prohibited by Federal law or the law of any state in which such trade or business is conducted.
The 1982 Senate Report explains that while IRC Section 280E disallows “ordinary and necessary business expenses” adjustments to gross receipts for COGS (Cost of Goods Sold) are “not affected by this provision” and therefore are allowed as deductions for federal tax purposes.
An California cannabis grower or processor may include direct material costs (such as seeds) and direct labor costs (such as planting, harvesting, sorting, cultivating) in COGS.
COGS generally include the costs incurred for the purchase, conversion, materials, labor and allocated overhead incurred in bringing the marijuana inventories to their present location and condition, as well as the costs of transportation.
IRC Section 471:
Indirect costs that are “incidental and necessary for production” may be deducted. For an indirect cost to be deductible, it must be explicitly related to the production, processing, and storage of the product, as compared to other non-deductible activities such as administrative, marketing and retail operations.
Since 1958, IRC Section 471 has governed inventory and what type of cost are considered inventory or Cost of Goods Sold.
Under code section 741, indirect costs are treated as Cost of Goods Sold if they are “incident to and necessary” for production or manufacturing.
Under this code section the following cost can be (but not always) be included in COGS:
- Repair Expense
- Utilities such as heat, power, and light
- Indirect labor and production supervisory wages
- Indirect materials and supplies
- Tools and Equipment not capitalized
Indirect Production Costs Not Included in Inventory Costs are:
- Marketing Expenses
- Advertising Selling Expenses
- General and administrative expenses incident to and necessary for the taxpayer’s activities
- Legal and professional expenses
- Overhead Wages such as bookkeeping, office management
- Salaries paid to officers attributable to the performance of services
- Grower & Processing – 75% of their expenses are going to be tax-deductible
An IRS audit can be scary, expensive, and time-consuming. In an audit, the IRS will examine the business’s financial information and compare it to amounts reported on income tax returns to ensure compliance with tax laws. For most individuals, the chances of an IRS audit are somewhat low because the IRS audits only about 1% of taxpayers. When operating a small business, the chances of an IRS audit increase slightly because about 2.5% of small businesses are audited. When operating a cannabis business, the odds of IRS audit increase substantially. There are reports that 10% to 15% of cannabis businesses get audited.
Most of these audits we call “paper audits.” The IRS will send a notice wanting further explanation of a deduction.
Ways to Reduce Chance of Audit
- Be conservative
- Be realistic
- No Estimates
- Create separate entities for the business instead of filing as a sole proprietor
- Do not consistently report a loss for tax purposes
- Do not report excessive deductions for meals, travel, and entertainment
- File all forms including W-2’s and 1099’s appropriately
- File Tax forms electronically
- File tax forms on time
- Pay owners a reasonable salary if the business is incorporated
Banking and California Cannabis Accounting
Report of Cash payments over $10,000 received in a trade or business file with the IRS within 15 days of receiving the cash payment.
Can an California cannabis business head down to a local bank and set up a checking account like any other business?
That is a complex question…
The first step in getting a bank account is to tell the bank you are a cannabis business. Do not break this rule and pretend to be another type of company. The bank will find out and close your account immediately. This could red flag you and cause you more difficult in getting bank accounts in the future. All bank accounts, even those unrelated to the cannabis industry could be closed.
Your best bet is to talk to local banks or credit unions in your area.
Remember, from what we have heard, the cost of these accounts or relationships are high, however; it could be worth it if you are dealing with a lot of transactions.
Without access to banking, most cannabis companies depend on cash accounting. This, unfortunately, means the audit trail is difficult. Without proof, auditors can easily question whether funds came from legitimate sales or if payees exist at all, bringing concerns about money laundering. To solve this, each transaction must be substantiated.
Your goodwill and promises are not good enough. The proof must be in the paperwork.
The Internal Revenue Service requires that all receipts contain the following information:
- Place’s Name and Address
- Items Purchased
- Purchasers Name or Initials
You must be protective of all your transactions. Keep ALL of your receipts
Due Date April 15th – Extend them to October 15th
Filed on the personal Tax return under schedule C
Due Date- March 15th – Extend them to September 15th
File as a separate Tax return but it is not a taxable entity. All income (loss) flows through on a Schedule K-1 and is reported on the owners 1040.
Must have two owners (can not be a partnership if there are no partners)
Can have an unlimited number of partners
Each partner can have different ownership allocations based on the partnership agreement.
- Due Date- March 15 – extend to September 15th
- File as a separate Tax return but is not a taxable entity. All income (loss) flows through on a Schedule K-1 and is reported on the owners 1040
- Can be a single owner or up to 100 owners
- Can only have one class of stock – All owners must be treated equally based on ownership
- Due Date- March 15 – Extend to September 15th
- File as a separate tax return the entity is taxed on the net income
- Income or losses do not flow through to the personal income tax return of the owners
- Can be a single owner or unlimited owners
- Can have multiple classes of stock. i.e. Common stock owners or preferred stock owners
- Very Flexible and can be Taxed
- Sole proprietorship Partnership
Entity Formation Decisions
What is nice about an LLC is that you don’t have to decide on how you are going to file your tax return until you file your return. Which means, in most cases, you don’t have to worry about it until March 15th of the following year. Even then, you can change your mind once you see how your company is operating.
There are many options as to how to tax an LLC and unfortunately, there are no black and white answers. The only way you are going to be able to see how to tax your company is to see how you are spending the profits.
In general, but not always the case:
If your company is dispersing the profits to the owners, then you will want to want to file as a partnership.
If you are paying employees, including owners of the company a wage, then you may want to file as a Scorp or a C-corp.
Right now our favorite entity type for California Cannabis Businesses is the C-Corporation, and the reason for that is that? Because it is taxed at a maximum of 21% federal compared to an individual rate that can be as high as 37%. However, the key to making a C-corporation work is that you must pay all owners through a wage and not a dividend distribution because a dividend is not deductible to the corporation, but it is taxable to the individual. So if you are taking money out of the company as a dividend, then that money could be taxed at 21% corporate level, plus an additional 15% at the individual level and in many cases, you may be paying more in taxes than you would if you were just a pass-through entity such as a partnership or S-Corporation.
Syntegric Advisors is an accounting firm with a special practice in the cannabis industry that continues to pioneer strategies and services for startups in the California cannabis space.