In our previous article on what cannabis CPAs look for in an operator, we discussed the risks of a cannabis company failing to adhere to IRC 280E, which prohibits businesses from deducting otherwise established business expenses from gross income associated with the “trafficking” of Schedule I or II substances. In short, the risks include the possibility of being audited and facing substantial fines. 

In this article, we’ll discuss other facets of this tax code that your CPA should be making you aware of, namely: what you can deduct (also known as the Cost of Goods Sold, or COGS); how to properly calculate and maximize your COGS; how to plan for substantially higher tax liabilities; and state vs. federal taxes. We’ll also cover how to stay abreast of relevant legal changes. Read on to discover what your CPA should already be telling you about 280E.

What You Can Deduct

As we outlined in the last article, it’s almost impossible for an operator not to make some mistakes on their filing. However, that is not to say you should take a lax attitude toward your deductions. The good news is that there are plenty of things a cannabis business can deduct under COGS.

Based on our experience, and substantiated by The Marijuana Policy Project (MPP), most of these deductions will favor cultivators over retailers. With this in mind, here is what your CPA should inform you is generally deductible under COGS:

  • Raw materials and inventory: Direct costs of cannabis seeds, plants, and other materials consumed or that will become part of the final product
  • Labor costs (inventory-related only): Wages and benefits for employees directly involved in inventory management activities (e.g., trimming, processing, harvesting, and preparing cannabis for sale)
  • Utilities and rent (inventory areas): Utilities and rent for spaces used specifically for inventory can be included in COGS, but not for retail or administrative spaces
  • Equipment used in production: Exclusively for growing, harvesting, or manufacturing cannabis products
  • Packaging and labeling: Costs directly connected to inventory and required to bring the product to a sellable state
  • Transportation (for inventory): Costs for transporting cannabis inventory to the location of sale/between production facilities (but not generally for distribution costs)
  • Lab testing and security (tied to inventory quality assurance): Costs for lab testing or security that are required to bring the product to a sellable state; these can only be included when they are directly related to the production process and can be capitalized as part of inventory costs

Your CPA should tell you which deductions apply to your business, depending on your location. If your business operates in multiple vertical segments of the industry and you have a savvy tax strategist, they will know how to utilize Section 471(c) for the appropriate entities.

Calculating and Maximizing Your COGS

An experienced CPA can help an operator calculate and maximize COGS through several strategies, including:

  • Allocating a proportion of all eligible direct costs from General & Administrative expenses to Cost of Goods Sold, with proper documentation
  • Understanding and applying IRC Section 471(c)
  • Keeping meticulous records
  • Excluding non-deductible expenses
  • Keeping the operator updated on IRS guidance, and leveraging state laws where applicable.

An experienced CPA can help an operator calculate and maximize COGS through several strategies, including allocating a proportion of all eligible direct costs from General & Administrative expenses to Cost of Goods Sold (with proper documentation); understanding and applying IRC Section 471(c); keeping meticulous records; excluding non-deductible expenses; keeping the operator updated on IRS guidance; and leveraging state laws where applicable.

An experienced CPA would help an operator calculate and maximize their COGS via several strategies, namely using IRC 471(c): allocating a proportion of all eligible direct costs from General & Administrative expenses to Cost of Goods Sold, with the proper documentation of course; understanding and applying IRC 471(c); keeping meticulous records; excluding non-deductible expenses; keeping the operator updated on IRS guidance; and leveraging state laws where applicable.

Planning for Substantially Higher Tax Liabilities

Your cannabis CPA should tell you that Section 280E results in cannabis businesses being taxed on gross profit rather than net income. This is because the code prohibits businesses involved in the “trafficking” of Schedule I or II substances — notably legal cannabis businesses — from deducting most ordinary business expenses from their gross income. In other words, your CPA should advise you to plan for significantly higher tax liabilities.

State vs. Federal Tax Differences

For operators, the fun doesn’t stop at higher tax rates. Fortunately, there is good news again. Many states have opted out of following Section 280E (yes, it’s possible). States that have “decoupled” from this code include Massachusetts, California, Colorado, Maryland, Vermont, and others. However, it should be noted that this decoupling only pertains to state income tax filings. 

Federal tax returns must still adhere to 280E and are limited to the aforementioned COGS deductions. Your CPA should also inform you that the list of states choosing to decouple from 280E is growing as more states legalize cannabis and look to support their regulated industries.

Keeping You Informed of Legal Changes

Finally, your CPA should keep you aware of regulatory developments as they pertain to cannabis under 280E. For example, chatter has been growing over changing cannabis from a Schedule I to a Schedule III drug. This development would lead to (among many other things) the dissolution of 280E restrictions. 

However, as of this writing, rescheduling has faced new opposition, with some experts claiming the rescheduling move is more politically than scientifically driven.

Conclusion

When it comes to 280E, there are myriad issues your CPA should already be telling you about, from what you can (and can’t) deduct, to how to plan for higher taxes, and even the potential abolition of 280E altogether. While this may seem like an exhausting amount of information for your CPA to keep you aware of, it is wholly necessary. This code is nuanced and can mean the difference between your cannabis business being profitable and your business being saddled with fines—or worse, closure.