Cannabis businesses are subject to the restrictive tax rules under 280(e) which essentially say NO deductions are allowed for normal business operating expenses. Cannabis businesses can however take an adjustment to revenue for costs of sales. Since costs of goods sold are the only offset to taxable revenue, it’s important to understand what can go in that line item. Typically, things like rent expenses, utilities, and non-direct labor cannot unless you’re using proper cost accounting.
A little-known code section, 471, also impacts the cannabis business. This tax code was originally written mostly to describe how manufacturers can properly allocate a portion of their operating costs, like fixed overhead, to the cost of sales. Some leg work is required though. To start, you must be keeping your books and records properly under Generally Accepted Accounting Principles (GAAP) and using accrual accounting. We recommend you contact your accountant for assistance with that part. Once your business is set up to follow those accounting methodologies, you can properly allocate fixed overhead costs. Items previously not deductible as operating expenses, like rent for example, now may be able to be partially allocated to the cost of sales.
Cost allocation does, however, require proper documentation. One method we recommend is cost studies. For example, tracking your employees’ time for 90+ days to gain a good average of where their time is being spent. This is especially important for dispensaries where you may be paying out labor for retail workers whose costs are otherwise not deductible. But if your retail workers spend a third of their time pre-rolling, packaging, labeling, and getting products ready for sale, a well-documented cost study could allow you to allocate a portion of their wages, payroll taxes, and other employee benefits expenses to costs of sales, thus lowering your tax liability.
It's incredibly important that these strategies are employed with the accounting regulations that are required and we highly recommend you not try this at home. I.e. we think you should talk to an accountant that has experience with cost allocation, GAAP accounting, accrual basis financial statements, and hopefully cannabis too!
Not sure where to start? We can help. Cultivate is the only CPA firm in New England that combines cannabis tax and accounting knowledge with an inventory and cost management specialist. Contact us today for more information.