Most people in the cannabis industry can share at least one story of someone getting hit with an IRS audit and a crushing tax bill. If you have visions of tax forms and auditors dancing in your head, don’t fret. Cannabis Business Times reached out to six cannabis-industry tax experts for cultivator-focused tips to help you enter tax season with confidence.
Sanjay Agarwal, JD, LLM, Tax Partner at MGO, LLP
As tax partner with California-based CPA and accounting firm MGO and office managing partner of the firm’s Silicon Valley office, Agarwal sees many similarities between the cannabis and technology industries. “Things are growing really quickly, and the founders and the investors are moving fast on the business side. Tax is always something that gets overlooked,” he says.
1. Understand your entity choice. Agarwal stresses that entity choice, such as a C corporation or S corporation, is one of the most important decisions you’ll make. “It impacts not only your bottom line, but also your tax-efficient exit in the future,” he explains.
Consult with a tax advisor to ensure your current structure is tax-efficient and understand that changes are possible. Your short- and long-term plans, including any exit plans, determine what entity is best for you.
2. Keep clear, concise records and let technology help.With cannabis still federally illegal, IRS audits can end with drastic results. “If you don’t have receipts [to support a deduction] and you get audited, it’s going to get disallowed,” Agarwal says. He recommends scanning receipts and other documentation to avoid piles of paperwork. Perform this work internally or outsource it, but do it nevertheless—for your tax preparer and a potential audit.
3. Engage a tax professional for a 280E analysis. Section 280E of the Internal Revenue Code (IRC) limits cannabis producers to business deductions attributable to production activities, but many producers engage in non-production business, too. A 280E analysis can help you maximize legal deductions for all your business activities.
Agarwal prefers breaking different business lines into separate entities. “It needs to stand on its own as a record-keeping and bookkeeping unit to successfully demonstrate to the IRS that expenses for that separate trade or business are deductible and not subject to 280E,” he explains.
4. Consult professionals early in any merger or acquisition (M&A) transaction. Agarwal compares cannabis today with technology in the mid-1990s: “Everybody is looking to grow through acquisition or [to] buy out competitors.” If you’re inclined to sell, solid advice on structuring the transaction is crucial.
M&A transactions may include stock, cash and your retention as a key employee. Fully taxed deals can leave you cash poor, when terms could have deferred taxes on stock. “Get a lawyer and CPA involved and start talking deal structure and numbers early,” Agarwal says.
5. Keep compensation between related entities at “arm’s length.” To satisfy the IRS, any compensation between your related entities must be at “arm’s length,” meaning the same as you would if you hired a third party to provide similar services. “Even though you have separate entities, if the remuneration is not at arm’s length, then the IRS has the ability to shift profits,” Agarwal says. Commission transfer-pricing studies and put inter-company agreements in place to ensure the IRS is satisfied.
Derek Davis, CPA, Founder, GreenGrowth CPAs
As founder of California-based GreenGrowth CPAs, Davis cuts to the point when it comes to cultivation-related tax tips. “Generally, cultivators don’t want to learn about taxes, so [a tax advisor has to recognize] what’s realistic and what’s practical,” he says.
6. Understand whether your accounting method is cash- or accrual-based. Under cash-based accounting, revenue and expenses are recorded when cash is received and bills are paid. Under the accrual basis, they’re recorded when earned, regardless of when payment changes hands. “[Your accounting method] will tie heavily into what and when you record your income,” Davis says. What’s best for you depends on the business and your sales volume. “It’s really a case-by-case basis,” he explains.
7. Don’t leave tax planning until year end. With planning, you can redirect profits into deductions. “If you have a lot of profits at the end of the day, you want to consider reinvesting and growing your company. Otherwise, you’ll just owe a lot of tax,” Davis says. He advises to start planning in October and November. “You may be able to build out that new greenhouse or get that new indoor cultivation site set up to reduce your taxes,” he says.
8. Understand which assets need to be depreciated over time. IRS regulations may require that certain assets be depreciated over their useful lives, but Davis says cultivators often unknowingly write off “heavy” assets in a single year. Avoid that mistake. “Review the tax code or talk with someone that has that experience,” he advises.
Dean Guske, CPA, President, Guske & Company
As president of Washington-based Guske & Company, Guske works with cannabis businesses across the industry. “280E doesn’t hit producers and processors as hard as it does retailers,” he explains. Instead of being too tax-focused, he advises cultivators to see beyond 280E.
9. Focus on business efficiencies and cost structures. With an oversupply in most mature recreational markets, Guske predicts prices in newer markets such as California and Nevada are only going to decrease. “Focus on your business efficiencies and cost structures,” he advises. “Focus on getting your production costs down to a point where you’d be able to survive on the prices we have in Oregon and Washington.”
10. Understand your limitations in running a business. “Growing pot is one thing, managing a sizable business is another,” Guske says. He advises bringing in skilled professionals, including tax experts, so you can do what you do best. “Make sure you have a good management team that has the diverse skills you need to run any business. One person can’t do it all,” he says.
11. With new tax laws taking effect, re-evaluate previous decisions. Tax changes may call for changes in your business and its structure. “Cultivators are probably doing business as a pass-through entity, either an LLC or an S corporation,” Guske says. “It’s worth taking a look to see if a C corporation might make sense because the new corporate tax rate is only 21 percent.”
12. Never fall behind on taxes. “Whether it’s excise taxes, income taxes, payroll taxes— you have to make sure you keep current,” Guske says. “Once you get behind, it’s almost impossible to get caught back up, and your chances of failure go up exponentially.”
13. Make sure you file Form 8300 when required. IRS Form 8300 (Report of Cash Payments Over $10,000 Received in a Trade or Business) applies to single transactions or a series of transactions over a 12-month period. “There is no downside to filling the form out. There’s only a downside to not filling it out. The fines are exorbitant,” Guske says.
Chris Madison, CPA, MT, Partner, Cohen & Company
A partner at Ohio-based accounting firm Cohen & Company, Madison believes more tax professionals will move into the cannabis space. “Many in this profession want to help the people who are trying to comply with existing law. It’s an interesting time,” he shares.
14. Hold real property in a separate legal entity from the operating entity. Madison recommends holding real property, such as land and buildings associated with your business, in a separate entity and entering into a leasing-type arrangement with your operating entity. “Care should be taken to substantiate the amount of rent charged between the related parties,” he says. “We would recommend having a professional pricing study done to substantiate the inter-company rental and lease payments.”
15. Understand state and local tax implications in your jurisdiction. Don’t overlook state and local taxes, including sales tax, franchise taxes and business licenses. Certain taxes, such as sales taxes, are considered “fiduciary,” meaning you collect those taxes on behalf of the state.
“Even if you are organized as a corporation or LLC, you can be personally liable for those taxes, including penalty and interest, if you are considered a key employee and these taxes are not paid,” Madison says. In some situations, because that money belongs to the jurisdiction and not you, non-payment may be considered theft.
16. Plan on how to remit tax payments. Some states prefer or require taxes be paid via electronic funds transfers (EFTs), which can be difficult given cannabis-related banking challenges. “Planning ahead on how these taxes will be paid is crucial,” Madison says. He recommends checking with your state and local jurisdictions regarding special programs for the transfer of these funds.
17. Investigate opportunities for tax breaks on equipment. “In some states, there are income and sales tax breaks for the purchase of equipment and supplies used in agricultural activities,” Madison says. Sales tax exemptions may apply to cannabis, but sellers must collect tax unless you present an exemption certificate.
Mike Moran, EA, CEO, Cannabis Tax Solutions
Founder and CEO of Colorado-based Cannabis Tax Solutions, Moran is a federally licensed Enrolled Agent, the highest credential awarded by the IRS. “When it comes to cannabis, unfortunately, it’s still the Wild West. It’s alarming what people still don’t know [about taxes], even the basics,” he says.
18. Take time to review your own books and tax returns. Don’t be satisfied with knowing your bottom line. Moran has seen accountants take aggressive stances on 280E without the client’s full understanding. “Don’t put your full trust and faith in a preparer,” he advises. “If you know nothing else, make sure those 280E adjustments are reflected on your tax return.”
19. Create a banking atmosphere in your business. “[Great bookkeeping] is really the difference between having allowable deductions and having everything thrown out,” Moran says. He advises creating a bank-like atmosphere by creating your own cash logs and attaching or uploading receipts and documentation to every transaction.
20. Stay in a state of perpetual tax planning. Moran urges operators not to cruise along until your first million-dollar tax bill arrives. “Know ahead of time what’s going on. Do tax projections and rolling forecasts in your business so you have the correct information at all times, as best as you can based on current data. It will go a long way to help keep your doors open,” he says.
21. Maximize COGS deductions with tighter employee tracking. Legal deductions are lost by failing to track and document activities of employees whose work involves production-related activities that qualify as cost of good sold (COGS) deductions, as well as non-production activities disallowed under 280E. Moran recommends using technology such as Würk’s cannabis time-tracking and attendance software system to track employee activities and produce records that can satisfy the IRS.
Brandon Van Asten, CPA, Manager and Senior Associate, Bridge West CPAs, LLC
Based in Bridge West’s Minnesota office, Van Asten works with clients throughout the industry. “Dispensaries have the largest 280E liability since less of their activity relates to producing inventory. Cultivators and processors have more opportunity to reduce tax liability,” he says.
22. Maximize deductible costs under 280E. “Keep your [selling, general and administrative] expenses low—advertising, meals and entertainment, and travel,” Van Asten says. “None of those expenses are going to reduce the tax liability of a cultivator.”
23. Perform routine inventory counts. “Knowing your inventory at various points in the year and keeping high-quality inventory records is directly correlated to your tax,” Van Asten explains. He recommends monthly inventory counts, as well as annual counts, to keep records in line—and make sure your count agrees with state-mandated inventory tracking software.
24. Minimize year-end inventory to match demand. “When product is sitting in inventory and not flowing through COGS, you’re putting yourself at risk of a much higher tax liability,” Van Asten says. He recommends minimizing year-end inventory as much as possible to reduce your tax liability, yet still have enough to meet market demand.
25. Document employee activities in job descriptions. “Employees’ activities determine whether their labor is deductible (allocable to COGS) or non-deductible,” Van Asten explains. He recommends documenting labor for all the tasks in your operation and documenting activities in employee job descriptions to support the allocation of labor to deductible COGS.
26. Review your strategic floor plan. “Review the floor plan to identify opportunities to deduct rent and other related items under 280E,” Van Asten advises. Cushy offices and lounge areas are nice, but won’t help your tax. “Minimize any space not directly related to growing cannabis,” he says.