The cannabis industry is quickly increasing in popularity and is predicted to become one of the largest industries in the United States economy. In states where cannabis is currently legal, medical and adult use sales are forecast to grow from $12.9 billion in 2019 to $26.3 billion by 2025. As these businesses are enjoying the money making advantages of the cannabis industry, they are undoubtedly thinking about the one unfortunate consequence of making a lot of money, which is paying a lot of taxes.
How does a business minimize their tax liability when operating in the cannabis industry?
Cannabis is not legal for federal purposes, which means businesses operating in this industry are subject to Section 280E of the tax code. Section 280E entails that a business engaging in the trafficking of a Schedule I or II controlled substance (cannabis) is barred from taking tax deductions or credits. This means that cannabis businesses are not able to reap the benefits of the traditional tax deductions that are available to many other businesses.
An important aspect to note is that cost of goods sold is not considered a tax deduction for purposes of Section 280E, and is instead considered an adjustment to gross income. Therefore, businesses operating in the cannabis industry are still able to reduce their gross revenue by the cost of goods sold that they incur. As such, cost of goods sold is clearly an invaluable deduction for these businesses and they should be seeking ways to maximize it in any way possible.
How can a cannabis business maximize their cost of goods sold?
Businesses operating in this industry must ensure that they have internal strategies in place to properly maintain and track their inventory, which will allow for accurate accounting for cost of goods sold. Documentation is extremely important as it will provide support for all of your cost of goods sold calculations.
Which types of costs can be included in costs of goods sold?
In addition to the more well-known inventory costs, such as direct labor and direct materials, the IRS allows cannabis businesses to use absorption costing under the Generally Accepted Accounting Principles (GAAP). Absorption costing allows these businesses to determine any “indirect costs” that can be included in cost of goods sold. For cannabis production businesses, there are various opportunities to include certain “indirect” expenses in cost of goods sold, so long as they are reasonably allocable to the production process. Some of these expenses include:
- Repairs and maintenance
- Utilities
- Rent
- Supervisory wages and other types of indirect labor
- Depreciation
- Insurance
Tracking and allocating these costs can pose a challenge if detailed records are not kept. For example, an employee in a supervisory role should be tracking their time spent on the production process versus their time spent performing other business functions. If their time is not tracked properly, then the business may not be computing the maximum amount of cost of goods sold, thus paying more taxes than they should be.
Implementing various absorption costing strategies and determining how to allocate indirect expenses is a key step in the inventory costing process, especially for cannabis businesses. Taking the time to do so could prove to be very beneficial come tax time.
If your business practices in the cannabis industry, then it’s very important that you are working with a tax professional who understands the various complexities of the tax inventory costing rules; this will ensure that you are maximizing your cost of goods sold deduction, and minimizing your tax liability.
