Do’s and Don’ts of Cannabis Cost of Goods Sold and IRC 471-11 Accounting and Tax
Oct 05, 2021
Due to the fact that Cannabis is classified as a Schedule I drug (in spite of the fact that the majority of states in this country have voted to legalize Cannabis in some form or fashion), ALL Cannabis companies must comply with 280E. There’s little grey area here, but if you’re in the business of harvesting, producing, manufacturing, or selling Cannabis in any way, shape, or form, your business is not able to legally take deductions.
IRC 280E clearly states:
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 (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted. Source: Cornell Law
Naturally, Cannabis investors, CEOs, and accounting professionals are going to try their hand at getting around 280E, but if you’ve been paying any attention at all, one would know that this is a terrible idea for the simple fact that the tax courts are winning cases against Cannabis companies left and right. But can you blame them? 280E is crippling. Having to pay state and federal taxes on 100% of income without any legal deductions cuts massively into profits, and in some cases it can make it hard to be competitive within the grey market if the product is too expensive.
So how can Cannabis companies legally reduce their tax liability?
The answer lies in IRC 471. What makes reducing tax liability even more complex is that the rules vary from vertical to vertical, and can make things even more complicated for companies that have several verticals integrated within their business. (ie. A company with a dispensary, a grow/farm, and a manufacturing side of the business).
IRC 471 gives an overview and applies to all Cannabis companies. It states that the method used for inventory must "clearly reflect the income". Also, it must conform to how the client accounts for inventory in the financials, which is usually going to be GAAP and Lower of Cost or Market (LCM).
IRC 471-2 applies to all cannabis companies as well, and states how you must value inventory. It again says that the inventory must clearly reflect income and be consistent (usually going to be LCM, which is also GAAP).
IRC 471-3 can be applied to retailers/dispensaries.
IRC 471-11 is for cultivators, edible producers, and extract/processors. It requires GAAP if you want to maximize what is included in COGS. Also, 471-11 lists applicable ways to allocate costs via Burden Rate, Standard Cost, or Practical Capacity. We use a Practical Capacity approach in our program.
Cost of Goods Sold and Cannabis Vertical Specific Cost Accounting Tools
If you’re an accounting professional that isn’t familiar with the operations for each of the different types of Cannabis verticals, you may be at a bit of a disadvantage when it comes to helping these businesses maximize on their legally allowable tax deductions.
In order to do the cost accounting correctly and effectively you’re going to need to help your cultivation clients (for example) best understand how much it costs to grow a pound of weed, for example. You’ll need to know how to allocate the different costs to the various phases in the grow cycles, among other things.
To be able to do effective cost accounting for your clients you will need some very important tools, if you plan to help your clients take advantage of the maximum tax benefit. For starters, a very good cannabis Chart of Accounts that is QBB/Xero/ready (specific for grow, processing, edibles, and retail operations). You will also need a client inventory template to accumulate monthly/quarterly counts, weights, estimated yields and estimated percent complete, and finally cost accounting templates to perform the calculations.
The DOPE CFO Cannabis Accounting 4.0 program offers over 100 workpapers, templates, and tools that will help you do proper cost accounting for all of the Cannabis verticals, and provide world-class service to your customers. Visit here to learn more
Diving in to Cost Accounting and Tax for 280E
- To effectively do cost accounting you will need to allocate some of the P&L costs out of expenses and into Inventory/COGS. Use the Trial Balance at any ending reporting period to determine which costs to allocate, and how much of each, using allocation percentages determined once or twice a year. Always allocate total YTD amounts. Allocations for items related to labor (ie direct labor, indirect labor, payroll taxes, etc.) use hours, and for allocations related to facility (ie rent, utilities, etc.), use square footage percentages.
- Next, determine the quantity of Inventory, and quantity of Sales at the reporting date, to determine how much costs (per groupings listed in 471-11) to allocate to inventory, and how much to COGS.
- We then take the total allocated cost and make an AJE considering opening inventory balances.
- Finally, you must consider Inventory Valuation which for GAAP (and usually for tax) is lower in cost or market.
- Have a great Chart of Accounts tailored for cannabis cultivation, extract, and manufacturing (ie. edibles).
- Have cost accounting templates in Excel that are tailored to do 471-11 and GAAP cost accounting correctly and easily each month.
- Have operational templates that capture client data easily each month, such as stage of completion of each strain, estimated yields per strain, direct and indirect labor allocations, and facility allocations.
- Read 471-11 top to bottom MANY times so you completely understand and apply it correctly. Read the entire IRC 471 as well.
- Keep your records straight so that you are audit ready anytime/all the time. The IRS is ramping up its efforts to catch Cannabis companies trying to beat 280E.
- Adhere to GAAP and make sure that you’re doing monthly accounting and proper record keeping. Doing accounting once a year or even once a quarter doesn’t work all that well when trying to do proper cost accounting, nor is it GAAP compliant.
- Stay current on all Cannabis accounting and tax court cases.
- Provide world-class accounting so that your clients are audit ready anytime, all the time.
- Don’t try to write off expenses like you would normally do for a traditional business, even if they are considered COGS. A Cannabis trained accountant knows how to do proper cost allocation for the various verticals.
- Don’t use 263a, as it’s not allowed (see Harborside case).
- Don’t put too many expenses into low revenue, non-cannabis divisions.
- Don’t play games with complex legal entity structures. Non-Cannabis divisions must be substantial and must be able to stand on their own as a business. Don’t just make up a Cannabis division out of a few pieces of apparel and think that you’ll get away with that.
- Don’t put so much in COGS that it’s not believable. This is how you’ll easily get your client’s company flagged for an audit.
- Attempt to work with a Cannabis company without proper training, tools, and guidance. You may ultimately be doing more harm than good.
- Don’t wait until the end of the year to try to do cost accounting in order to try to reduce tax liability. Ongoing accounting is a must!
- Don’t treat each vertical the same; they all have to follow different rules as they pertain to cost accounting. Some verticals can do different things with COGS without triggering an audit, while others can’t. Understand each vertical clearly before proceeding. If the company that you are working with is vertically integrated with multiple verticals, you will need to understand what you can and can’t do in those specific situations. Consolidations can be tricky, so you will want to be sure that your records are pristine and that any intercompany transactions are properly documented and accounted for so that if you are audited transactions can easily be tracked to the appropriate entity.
Looking to serve the Cannabis industry? Join our community of over 800 Cannabis accounting, tax, and legal professionals that are actively committed to serving the fastest growing segment in the US. The Cannabis industry is in dire need of trained Cannabis accounting professionals that can help guide them through the tricky rules and regulations of this industry in order to remain compliant and maintain their licensing.
If you’re interested in learning more about this thriving industry, and are looking to get in quickly, click here to for more info and to apply.