Cultivation Accounting and Tax for Cannabis Business Owners and Investors

If watching the pioneers in the Cannabis industry has taught us anything, it’s that getting businesses up and running and maintaining compliance has been a rocky road with plenty of tax and regulation pitfalls. It’s a lucrative industry slated for exponential growth. Experts predict the industry will breach $89 billion in the next two years – but those aren’t the only numbers that should concern new Cannabis business owners.

Along with growth in this industry comes great risk. Those in the know have seen Cannabis businesses tied up in legal issues, tax troubles, loss of licensure, and even business failures as a result of faulty, noncompliant practices. 

It’s more apparent than ever that having cultivation accounting and tax professionals who specialize in the field is a necessity. And while it’s fine to delegate the nitty-gritty to the practiced accountants, Cannabis growers, owners, and investors should still have a working knowledge of the industry’s financial side, and what’s at stake if they don’t adhere to regulations. Here’s a quick guide to help you brush up on the financial behind-the-scenes of the industry.

Understanding State Mandated Seed-to-Sale Systems

With the boom of the Cannabis industry comes plenty of new regulations, including the requirement to use state mandated “Seed to Sale” software. Similar to some of the systems that have been previously used to prevent illegal sales of controlled substances in the pharmaceutical industry, the “Seed to Sale” system is an all encompassing tool that is specifically designed to track the lengthy Cannabis production process from the time a seed is planted, to the time that it is sold. It has the ability to record data from the time a seed is planted through growth and all the way up to sale. 

Seed-to-sale software may be able to track the process starting at the farm all the way through chemical processing, labs, product manufacturing, transportation, and retail, but the problems are that they are often buggy, difficult to deal with, and don’t integrate well with other tools. 

States require that you use the mandated software because it monitors and finely details the process from the plant’s growing stages all the way to final retail sale. Recording work in process inventory counts weekly and monthly is required to maintain licensing and compliance. To prevent getting fined, shut down, or even arrested, owners and CEOs need to ensure accounting and compliance reporting is accurate and timely at every possible stage in the process. 

Implementing these systems and having everyone on the same page (as for as procedures are concerned) for inventory management can be incredibly challenging, especially when the tools used for this have glitchy functionality. States have contracted with three major Seed-to-Sale software providers, BioTrack, MJ Freeway, and Metrc, that must be used to tag Cannabis products at all times so businesses can present records when they are inspected. Any other systems that claim to be Seed-to-Sale may serve different purposes, and the data collected is not directly reported to or accepted by the state. You can use these other systems that claim to be seed to sale as an ERP of sorts if they’d like, but no matter what, Cannabis companies are required to use whatever the state has identified as their tool of choice.

Seed-to-Sale inventory management systems still have some growing pains to work out, but making sure your business is using an approved system can give you the peace of mind that you’re keeping accurate records and maintaining compliance.

The Inevitability of Audits and What Triggers Them

The Cannabis industry is exploding, but due to the nature of it being cash based and prone to illegal activity, getting flagged for audit is inevitable. Auditors from banks and state and federal agencies want to make sure you’re paying what you should in taxes (and aren’t taking shortcuts with tax codes or backdooring product to avoid taxes). The issue for businesses is that there are so many regulations and procedures to follow that it’s easy to slip up and fall out of compliance and not even know it. As someone invested in the industry, the best thing you can do for your business is to make sure that you’re ready when those auditors come knocking. 

What exactly will auditors call businesses out on, and how can you make sure you’re not on their list? Bookkeeping, recordkeeping, inventory, and cash discrepancies end up being the major culprits that cause the business to get flagged for audit. The best preparation is to maintain what we call a Permanent Audit Trail, a trail that’s ever changing and can be traced backwards or forwards from source documents to final reports.

How can you be sure that your audit trail is “audit ready?” Keep these two words in mind: documentation and consistency. A Permanent Audit Trail isn’t static; it goes backwards and forwards and must be updated frequently. Your trail should be cloud-based, and not a jumbled mess of papers that are easy to lose track of. Think formal documentation written in meticulous detail that can be easily understood by an auditor. DOPE CFO Cannabis accountants understand the importance of such documentation, and are trained to provide world-class accounting so that their clients are always prepared and audit ready by implementing and maintaining systems like this.

Having professionals in charge of your accounting that know what auditors are looking for, means a clean, stress-free audit that doesn’t require you or your accountant to be given the third degree and go on a hunting expedition to find missing information, or raise concern that something illegal is going on.

What’s the Deal with 280e and 471-11?

The 280e and 471 tax codes certainly get a lot of attention in the Cannabis business, and it’s not without good reason. They’re both the problem and the solution, respectively, of tax regulations that affect Cannabis businesses. 

Federal tax code IRC 280e states that any business or trade that participates in the trafficking of a Schedule I or Schedule II Controlled substance (yes, Cannabis counts as a Schedule I drug still) is prohibited from deducting ordinary business expenses. While that may seem simple to avoid, once you realize that that list includes most things that businesses are used to deducting, such things as rent, vehicle expenses, mortgage interest, salaries, and much more, you’ll realize just what a blow to profit that this code is dealing. 

CBD and hemp were removed from the list of controlled substances back in 2018, but if your business sells any other forms or strains of Cannabis, you’ll be subject to following the 280e regulation, which equates to taxation on a much larger dollar amount since the code prevents businesses from lowering their taxable income with “normal” business deductions. 

Trying to find tax loopholes in any business usually backfires, but trying to get around 280e will really come back to bite you in the form of fines, license revocation, legal trouble, and even potential arrest. The best way forward is through tax code 471 which allows your taxable income to be lowered with strict adherence and tracking of COGS, or the Cost of Goods Sold, and by following GAAP (Generally Accepted Accounting Principles). GAAP is the key here, so if you’re not familiar with accrual GAAP accounting, and if you aren’t doing regular “rock solid” accounting and recordkeeping your deductions that you could have taken may go by the wayside. Which is why getting a DOPE CFO accountant onboarded the minute your business starts spending money (even pre-license) is crucial, so that you can take advantage of the maximum allowable deductions possible. Having to go back in time and trying to claim old deductions like you might be able to for a traditional business isn’t as easy for Cannabis companies since the rules are so strict.

Tax code 471 helps because it has a broader definition of what can be accounted for as inventory (which will eventually turn into COGS), but make no mistake in thinking that this list is wide open. Being able to lower your taxable income per code 471 and remain compliant depends on accurate cost accounting in terms of direct and indirect costs. In other words, you can’t add everything under the sun as COGS, and it’s not worth a shot to try.  

The list of what is allowable as direct and indirect costs varies for dispensaries and retailers vs. growers, cultivators, processors, or manufacturers of products like food, beverages, tinctures, lotions, or Cannabis infused products. Regardless of your business’ place in the market, cultivation or retail, inaccurately deducting indirect costs is what puts Cannabis businesses in hot water. The list of direct costs (material and labor) is short compared to the lengthy list of indirect costs, with that many more ways for your business to get tripped up.

For cultivators, this requires that you have a really organized grow process so that you can take advantage of every single deduction under the sun, and that you work closely with your accountant on work in progress inventory procedures and reporting so that you can deduct every penny possible. Having an accountant that can document and record how every dollar is spent to create your end product that gets sold, you will get the most tax deductions. You have to know how to properly break things down, like your water bill, electricity, square footage, and all of your materials and labor so that you CAN properly add it to inventory and eventually deduct it.

For more information on accounting for Cannabis cultivators and growers, check out our article 5 Keys to Managing Cost Accounting and Taxes in Cultivation Verticals.

Our program has the tools, workpapers, and processes that cultivators and other Cannabis verticals can use to do proper, compliant cost absorption accounting. When following GAAP, you can compliantly reduce your tax liability but you must have your documentation and accounting processes in place that clearly show that you’re allocating costs properly in case you get audited.

Cannabis Companies That Don’t Comply

The goal of looking back at history is to be able to avoid the same mistakes that were made in the past. Analyzing the errors that Cannabis business predecessors have made and the consequences they faced serve as cautionary tales that bring awareness to how vital it is to get compliant. 

Even more major cases have come to light in the last few years that have shown how unyielding tax courts are regarding Cannabis businesses. If you weren’t already convinced of the severity of 280e’s stipulations, consider the case of Altermeds, a business that was mandated to pay a 20% penalty fee for their poor recordkeeping that did not follow the 280e rules. Additionally, the company ended up on the hook for paying taxes on taxable income that exceeded their profits as a direct result of trying to take too many deductions. 

Industry giant Harborside claims to be one of the oldest and most respected brands in the field, and even they were not exempt from the consequences of their failed attempt to circumvent 280E by using multiple entities the wrong way. . 

Tax courts are not your friends. They know the tricks, and they aren’t playing games when it comes to compliance. Do your due diligence up front by making sure you have that permanent audit trail current, updated, and accurate. If the word “audit” has you sweating, biting your nails, and envisioning a disorganized stack of reports or transactions, it’s a sure sign that you’re not audit ready. We advise any Cannabis business, even those just starting out, to have a Cannabis-trained accountant, CFO, or CPA on your team – they’re worth their weight in gold.

The Complexity of Corporate Entity Structures for Cannabis Companies

One of the first questions business owners should be asking is “what kind of corporate structure should I pursue?” Should you be establishing a C-Corporation? An S-Corporation? There’s no one-size-fits all in this regard, and the decision really depends on each individual business’ goals and risk profile. 

Corporate structures have their own appeal for different reasons. The complexity of filing for a C-Corporation and the potential for having to deal with double taxation - business tax plus shareholders paying separate taxes on what they’ve received from the company- are major drawbacks; however, they’ve become a common structure among Cannabis businesses for their mitigated risk factor.  A C-Corporation inherently separates the business as a legal entity from its shareholders with stronger defenses from overall debt, which adds some degree of shareholder protection over and above what LLCs can offer.

On the other hand, S-Corporations solely tax individual shareholders instead of the business entity, but of course this comes with added risk to those shareholders. Any non-deductible expenses (think back to code 471) may be passed onto shareholders. Which entity works best for you? It’s an important question, and not one answered lightly in a quick guide. It’s best to sit down and speak with investors and a business lawyer who can fully detail the pros and cons and how they will impact your business going forward so that they can recommend a structure best suited to your immediate and future needs.

Controls and Corporate Governance

We know that business owners are itching to get to the good part, the fun part: running the business and selling their product. Don’t be too hasty. There’s much more involved in setup before getting to the day to day sales. Though it mainly concerns the accounting aspect of the business, business owners should at the very least be aware of establishing guidelines for corporate governance so that they can help enforce their internal controls and standard operating procedures.

Simply put, corporate governance is the philosophy, the standards for ethical practices that the business will adhere to in order to protect against fraud and illegal activity. They dictate how the financial operations of a business will be run and to what standard. This is more than just policy and a talking point, it’s the foundation you set that prevents errors and omissions from happening and having money walking out the door. 

Along with a Cannabis business’ overarching corporate governance standards, successful businesses also need to implement internal controls. Think of corporate governance as “what” you will achieve and the internal controls as “how” you will meet that goal. In practice, your corporate governance may simply state that your business will close your books on a certain date, and your internal controls, like a detailed checklist, outlines actionable steps you will take to get there. Keeping accurate records could be your company’s goal, but the internal controls, such as having a monthly sales cut-off procedure to ensure transactions are placed in the correct accounting period, will be the practices that help you reach that goal. 

There’s more to it than just being a stickler. Having procedures in place helps make sure you are ready for audits, investors, lenders, and exits at any time. It also helps prevent theft and fraud. Without tightly established controls in place that are consistently followed, the IRS will have a field day auditing you. As a business owner, keep your business safe by being involved and helping to set up and enforce those controls and SOPs that will keep you compliant. 

Cannabis growers and business owners just getting started shouldn’t scoff at the nightmare dispensary case studies, but they shouldn’t live in fear of that fate either. Being aware of what’s required and allowed of Cannabis businesses and preparing accordingly can ensure your business smooth sailing from the beginning. 

Give yourself a head start by partnering with a Cannabis accountant that is not only an expert in the Cannabis industry, but understands what’s needed for cultivation businesses specifically, and who can walk you through the arduous process- the result is worth it.

For more info on accounting for Cannabis cultivators and growers, check out our webinar HERE.

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