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Taxation, 280E, and the Challenges of Accounting for Cannabis Dispensaries

280e 471 cannabis dispensaries Dec 19, 2022

From cash control and management issues to correct reporting, to seed to sale and POS software, providing quality accounting for Cannabis dispensaries is not easy. Furthermore, make the wrong move and you could incur large penalty fees for your client, land them in serious legal trouble, or both. 

Currently, there are hundreds if not thousands of accounting professionals claiming to have Cannabis accounting experience but they’re making big mistakes. Misinterpreting the tax code in an attempt to increase the deductions dispensaries take is not a solution, it’s how to trigger an IRS audit. It’s a sad fact that many Cannabis CEOs and business owners are relying on inexperienced accounting teams and are unknowingly putting their companies at risk of incurring hefty penalties, or being shut down for not following IRC 280E.  

Accounting professionals who are new to serving the Cannabis industry are oftentimes untrained on how to work with large sums of cash. Consequently, they can find themselves in a bind when trying to rely on accounting controls that will not work in the Cannabis industry. This highly-regulated niche requires specific internal controls including immaculate records of all payments, daily cash counts, and the proper segregation of duties (SOD). 

Many CPAs and accountants now serving licensed Cannabis businesses do not realize how far behind they’ve gotten, nor the opportunities they have missed to properly reduce their clients’ tax liability before it’s too late. Those who are conscientious will likely pull a few all nighters to try and catch up. Unfortunately, the truth of the matter is that unless things were set up correctly in the first place and the proper accounting practices have been performed at regular intervals since that setup date, there’s a strong chance that the business will require a lengthy cleanup of all of the financials, bookkeeping, and back taxes.

How can you ensure your clients are in compliance?

280E. It’s likely that this is hardly the first time you’ve heard about it. You probably know it’s the IRS’s internal revenue code that stops Cannabis dispensaries and other businesses from being able to take tax deductions. Keeping your Cannabis clients in compliance has everything to do with understanding 280E, and a bit more than that. Let’s take a look at 280E now.   

According to the Legal Information Institute, IRC 280E says the following:

 “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.”

Despite the green wave that’s sweeping the nation in which more and more states have legalized both the medical and recreational use of Cannabis, it is still classified as a Schedule 1 substance. As such, any business that distributes, owns, or processes Cannabis products is technically “trafficking” it, regardless of the intent. Therefore, the options for reducing tax liability are greatly reduced for Cannabis companies. 

While one tax code makes it impossible for Cannabis businesses to take deductions and credits the way traditional companies do, another IRC code serves as part of the solution. By relying on IRC 471, accountants can determine which costs can be allocated via cost accounting to inventory, and eventually, to Cost of Goods Sold (COGS). Is this process easy? No, it is not. It’s actually very complex, especially for Cannabis dispensaries that are also producing goods and can utilize 471-11. 

It is key for everyone in the licensed Cannabis space to know that there is no getting around 280E. The IRS is more aware now than ever of the games and tactics being used to try to circumnavigate it. Based on information gathered from documents released in response to a FOIA (Freedom of Information Act) request, on April 12, 2021, Cannabis industry publication MJ Biz Daily published a research abstract which showed just how adept the IRS has become at conducting audits of Cannabis business. Their adroitness has enabled them to collect “two to four times as much in unpaid taxes, or revenue – as the agency did from mainstream companies also identified as ripe targets for audits in a given fiscal year.” Auditing more Cannabis businesses makes sound business sense. 

Providing your Cannabis business clients with real value requires implementing specific processes including annual, quarterly, monthly, and daily procedures for dispensary accounting that accord with 280E. In Cannabis accounting, the only way to correctly minimize tax liability is the hard way. There are no shortcuts and no magic formulas.

So, how exactly do you minimize tax liability for Cannabis dispensaries?

IRC 471 and COGS are key. Dispensaries have even more challenges than other verticals in the industry, such as cultivation and processing/manufacturing.  

Before we get into it, let’s go over some of the language in 471, the general code that applies for all Cannabis companies:

“Whenever in the opinion of the Secretary the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer on such basis as the Secretary may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.”

In other words, the method used for inventory has to unquestionably reflect the company’s income, as well as align with the way your client accounts for inventory in the financials.

For dispensaries specifically, we can look to 471-3, which states the following:   

“In the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. To this net invoice price should be added transportation or other necessary charges incurred in acquiring possession of the goods.”

If one is fastidiously adhering to 471-3, dispensary taxable income can essentially be lowered via COGS. The IRS is very strict. It is therefore paramount that any accounting professionals serving Cannabis businesses keep track of their clients’ inventories so that they will be in good standing to pass an IRS audit. This includes doing weekly cycle counts and reconciling to POS and seed to sale systems.

Paltry bookkeeping is no joke. Do a poor job and the IRS fines your client may have to pay can be over $70k, or more. The Altermeds Case is one cautionary accounting tale to remember.

Nevertheless, success and a great career as a Cannabis accountant is more than possible when you know how to properly adhere to IRCs 280E and 471.

Tools needed for proper Cannabis dispensary accounting.

Another challenge facing Cannabis dispensaries and the accountants who work with them is a dearth of tools that make accounting for these businesses easier. There are notorious glitches that need to be worked out in the several state-mandated seed to sale systems. There are POS systems which integrate terribly and are hard to reconcile. 

Another big issue is cash controls. Taking the time and prioritizing setting effective controls and procedures in place is essential for Cannabis dispensaries. Banking options for Cannabis companies are essentially non-existent in many states (although this is slowly changing), and local licensing authorities hold the dispensary owners responsible for creating and maintaining adequate security measures, so theft is not an excuse for missing cash.  

And did you know most accounting software is not Cannabis friendly? There are a few products out now, but chances are you will need tools like a dispensary-specific chart of accounts and workpapers to be able to do proper accounting and legally minimize your clients’ tax liabilities. Seeing and experiencing firsthand just how few tools and how little guidance there is out there is what led to the creation of DOPE CFO—to provide guidance AND tools for accounting professionals who are looking to support today’s growing Cannabis companies and help them thrive. 

Are you ready to better serve your Cannabis clients or get into the industry? Join our ever-growing community of over 500 Cannabis accounting, tax, and legal professionals who are actively involved in the industry. Get workpapers, tools, and guidance to help you successfully keep your clients compliant, audit ready, and informed.

To learn more about accounting and bookkeeping for Cannabis dispensaries, check out our webinar here.

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