Cannabis companies are springing up across the country, and for good reason. There is a huge opportunity for growth in this market and businesses are just scratching the surface. However, it’s your job to be the expert on the numbers and the complicated rules to stay ahead of the game and keep your clients moving forward.
Despite the many opportunities in the industry, Cannabis companies face certain challenges due to its federally illegal status, especially in regards to tax liabilities. CBD/hemp companies can deduct normal business expenses, but must proceed with extreme caution as they are still highly regulated and often audited. Both niches require complex accounting and tax processes to stay compliant.
According to 280E, any business associated with the “trafficking” of Schedule 1 substances may not deduct ordinary business expenses (i.e. rent, vehicle expenses, mortgage interest, and much more). The only way Cannabis companies can lower taxable income is by correctly allocating costs to inventory and Cost of Goods Sold (COGS) in compliance with 471.
CBD/hemp is no longer subject to 280E, as it has been federally legal since the 2018 Farm Bill declassified CBD/hemp as a Schedule 1 controlled substance. However, 471 is still applicable for all CBD/hemp companies, as are 263A and 199A. If CBD/hemp business owners are unaware of the different tax codes under which they qualify for deductions, they will essentially be leaving money on the table.
If you have clients who have inventory (hint: all of them), you need a thorough and accurate understanding of 471 in order to correctly calculate their Inventory and COGS. Improperly reporting your clients’ tax obligations could lead to exorbitant fines, loss of licenses, or worse - legal ramifications.
Many Cannabis and CBD/hemp CEOs do not understand the technicalities of 280E or 471. Let’s take a look at the four main things accountants must know about 471, so your clients can lean on your expertise to guide them toward compliance and potential financial wellbeing.
IRC 471 allows you to correctly reduce tax liabilities through the use of inventory accounting and COGS for both federally illegal Cannabis and legalized CBD/hemp companies. It is complicated, however, by the many verticals in the Cannabis industry with their own sets of regulations, processes, and requirements (i.e. farming, processing, distribution, retail, manufacturing, lab).
Different sections of the tax code apply to different verticals. 471-2 is fairly straightforward; it describes the valuation of inventories for all companies. Inventory must clearly reflect income and be consistent from period to period (usually going to be LCM [lower of cost or market], which is also GAAP).
471-3 applies to Cannabis retailers and dispensaries. These companies can only lower their taxable income through 471-3, which narrowly defines what can go into inventory and not indirect costs. Very little can be added to inventory for retail. For these businesses, inventory is invoice price, plus transportation and necessary costs to acquire goods. If any “production” is done to the product, more costs can be allocated (i.e. if there is substantial change to the product; for example, flower turned into a gummy bear), but this is quite rare.
471-11 is the most complex section of the tax code, and only applies to growers and cultivators (both for Cannabis and hemp), processors who extract THC and CBD, and manufacturers of edibles, foods, beverages, or other Cannabis and hemp-based products. For a Cannabis retailer to utilize 471-11, they would need to be a producer as well. Unfortunately, most aren't cultivators or manufacturers.
The benefit of 471-11 is there are many more allowable costs in this category, but accrual and absorption accounting are required. A firm understanding of the direct and indirect costs outlined in 471-11 is required to properly file the companies’ taxes, yet our founder and students in the DOPE CFO program consistently find that more than 90 percent of Cannabis CEOs with whom they work are documenting and allocating both their direct and indirect costs incorrectly.
For Cannabis companies, direct costs include direct labor and direct materials. Direct labor costs for federally legal CBD/hemp companies can include salaries, compensation packages, overtime, vacation time, and sick pay. For Cannabis cultivators, processors, and manufacturers, some of these direct labor costs can be allocated to COGS and inventory, but must be accurately tracked.
IRC 471-11 is very specific about what can and cannot go into Inventory and COGS.
Indirect costs must be accurately tracked and allocated on a reasonable basis such as square footage or labor hours depending on the cost. Indirect items that can go into inventory and COGS for Cannabis and CBD/hemp businesses include repair expenses, maintenance, rent and utilities, such as electricity and gas, but only to the extent that such costs are necessary for the growing/cultivation, production, or manufacturing of the goods.
Indirect items that MUST NEVER go into inventory and COGS for any Cannabis or CBD/hemp company include marketing and advertising expenses, distribution costs, and the cost of any research and development. General and administrative fees that pay for the betterment of the business as a whole, but not specifically production or manufacturing operations, are not allowed either. Since CBD/hemp is federally legal, they are essentially able to deduct normal business expenses (including both direct and indirect costs), but they must track it and allocate it correctly and these costs will not be included in inventory or COGS.
Some indirect costs for Cannabis and CBD/Hemp growers, processors, and manufacturers can go into Inventory and COGS if they are treated the same way in recurring financials and in accordance with GAAP. These costs include employee benefits, depreciation and cost depletion on assets necessary for manufacturing or growing, costs attributable to strikes, rework labor, scrap, and spoilage, as well as insurance expenses and factory admin.
For a complete list of direct and indirect costs outlined in 471-11, please refer to 26 CFR § 1.471-11 - Inventories of manufacturers.
Keep in mind, the financial report and GAAP clause in 471-11 means Cannabis and CBD/hemp CEOs are required to do this complex cost accounting in their normal recurring financials and not just once a year. If this is not done correctly, the CEOs lose a potentially sizable increase to COGS.
Once you determine which costs can be included in inventory and COGS you must select a method of allocation. You could potentially use the Standard Costing method or the Burden Rate method, but both are very complex.
Another option is to use the Practical Capacity method using reasonable and appropriate allocations. This is what we recommend to the participants in the DOPE CFO program.
In cost accounting, Practical Capacity is the highest theoretical level of output your client’s production facility can handle, taking into account unavoidable delays. Practical Capacity can be measured by any unit of production appropriate to the cost accounting system established by you and your client. Your Practical Capacity calculations should be modified regularly to reflect the most current operations of your client.
Cannabis and CBD/hemp businesses are highly visible and often generate massive amounts of revenue. The IRS is alert and prepared to audit any business who tries to cut corners.
For Cannabis clients in particular, beware of:
The IRS is winning nearly every court case against companies who abuse the regulations outlined in applicable tax codes.
All of these were the result of compliance and accounting issues. Each of these court cases could have been avoided or mitigated with trained accounting professionals managing the Cannabis companies’ books and correctly filing their taxes.
The consequences of improperly filing taxes for CBD/hemp companies are not as severe, but by missing applicable deductions you could cause your client to pay more in taxes than is necessary for their industry and vertical.
The compliance and probable success of Cannabis and CBD/hemp companies is the responsibility of accounting professionals. Niche-trained accountants and bookkeepers can help business owners in both industries avoid the negative repercussions of the businesses mentioned above.
Utilize the following tools and systems to ensure you are complying with 471:
Staying compliant with tax codes is equally as difficult as it is crucial to a Cannabis or CBD/hemp company’s success. With proper training and regularly updated resources, your expertise becomes invaluable to the ever-increasing number of businesses gaining traction in this growing industry.
DOPE CFO has curated and created all the necessary tools, skills, and processes to keep your clients in all verticals of both niches compliant.
Let’s help Cannabis and CBD/hemp businesses thrive together. Learn more about DOPE CFO and IRC 471 in our webinar, here.