If you’re a Cannabis accounting professional, or are working towards learning how to serve clients in this space, you may have already experienced the frustrations of trying to reach out to Cannabis clients, only to be told that you’re not needed because they “already have an in-house bookkeeper” and that they’re sure their current accounting system is just fine. Until Cannabis CEOs understand that their practices are often inaccurate and self-damaging (as they likely don’t have access to or an understanding of the cost accounting tools required), they may not understand until they’re slapped with a severe penalty.
Understanding the myths that business owners believe about Cannabis accounting can give you a leg up on understanding their perspective, and may better form how you pitch your value to them when you do reach out. For every myth they believe, you can counter with a well-researched answer, illuminating the consequences of misunderstanding tax codes and regulations in their industry, and leading them towards a path of eventual profitability and compliance.
Myth #1: “You can ‘beat’ 280E and get out of owing so much in taxes.”
One of the biggest mistakes a Cannabis company can make is to assume they can “beat” 280E. Often encouraged by an accountant or lawyer, many Cannabis companies get in serious trouble for attempting to circumvent taxes this way.
This advice is the polar opposite of what companies should be doing.
IRC 280E is a tax code that states:
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.
Unlike businesses in non-Canna industries, Cannabis companies cannot claim deductions or credits when filing taxes because of the federally illegal status of the substance. Cannabis is still a Schedule 1 illegal drug, making it an industry easily red-flagged by the IRS. The only way Cannabis companies can reduce their tax liability is by allocating certain indirect and direct costs to inventory through proper cost accounting via IRC 471, which is later categorized as Cost of Goods Sold (COGS) after the product has sold.
In an attempt to “save” money, Cannabis companies generally try one of three tricks to circumvent 280E:
- Incorrectly setting up multiple-entity structures: Setting up multiple-entity structures is a common practice in Cannabis, such as having a glass accessories retail shop in addition to a grow operation. When done correctly, it can help offset some of the tax burden if each entity is substantial on its own, has a “real” purpose (other than just avoiding tax), and is founded on proper, solid accounting. Problems happen when the multiple entities formed are not profitable or substantial, don’t serve customers outside the Cannabis entity, and are not accounted for separately.
- Loading up Cost of Goods Sold (COGS): Using cost accounting, Cannabis companies are able to allocate some P&L costs out of expenses and into inventory and (eventually) COGS, pursuant to IRC 471. 471 helps accountants determine which indirect and direct costs can be allocated to COGS. Some companies try to load up too many costs for COGS, appearing unrealistic and raising red flags for the IRS. Adherence to 471 (especially 471-11) and GAAP cost accounting is essential for accountants to keep companies compliant. Cannabis accountants must also know how to set up a great vertical-specific Chart of Accounts and cost accounting workpapers to determine at each reporting period which costs and how much of each can be allocated into inventory and COGS. Done correctly in accordance with GAAP and in taxpayer recurring officials, this will lower taxable income and allow even more costs to be added into inventory.
- Insignificant non-Canna divisions with high allocated costs: One of the most talked about court cases surrounding incorrectly trying to minimize tax liability is the Harborside case. This California dispensary hoped they could make substantial deductions based on their non-Cannabis entity that, allegedly, sold various products and services. However, the IRS found the non-Cannabis entity was not a non-trafficking business (which is required for a business to make deductions not pursuant to 280E). The IRS doesn’t mess around.
One important lesson from the Harborside case is practicing caution around the use of an insignificant non-Cannabis division. However, the tax court determined Harborside’s additional business was only set up to try and gain more deductions and bypass 280E. Less than 1% of total revenues were attached to the non-Cannabis business, not meeting the court’s requirements for non-Cannabis divisions being significant, profitable, and accounted for separately. To date, Harborside has incurred approximately $11 million in recordkeeping penalties and back taxes because of inadequate accounting — a huge wakeup call for all Cannabis accountants and companies.
Myth #2: “My accounting is fine, as is.”
Most Cannabis companies think their accounting is “just fine” without having a specialized Cannabis accountant on board, not realizing the potentially disastrous consequences of accounting missteps until the IRS comes knocking. They also might find themselves in a mess of untrackable financials when reaching out to a future lender or investor, or preparing for a time of exit.
The biggest concerns are that most companies are missing complex cost accounting processes, have not built a Permanent Audit Trail, don’t have accurate support, and are missing deductions via 471-11. Returns are often done incorrectly, putting the owner and investors at greater risk of encountering hidden liabilities.
As an accountant, the solution is to be trained sufficiently in Cannabis accounting, including having a “toolbox” of workpapers and templates to efficiently keep track of records. You also have a responsibility to explain to Cannabis company owners that what they are missing in accounting knowledge could be the undoing of their company – or at least could cause a sizable drop in value. Remaining cash-flow positive and not paying through the nose for taxes or penalties are major pain points for Cannabis companies. You can leverage (and soothe) these pain points when approaching a potential client to prove your value to them on a call.
Myth #3: “Accounting isn’t important.”
Some CEOs and owners aren’t even aware that accounting is important at all. The case with smaller mom-and-pop companies is that many just have someone in-house (maybe even a family member or friend doing the books), and the CEO believes this is sufficient.
The truth is that due to the complexities of Cannabis, full-service accounting conducted by a professional trained in this space is imperative. Much more than just recordkeeping, a trained Cannabis accountant or bookkeeper runs the day-to-day operations, processes transactions, files reports, and reconciles the POS, seed-to-sale tracking, and accounting systems (and much more!). Without solid accounting procedures in place, many components required for regulatory compliance will be omitted, leading to a lack of sustainable growth and (quite likely) high penalties.
In Cannabis, each vertical has its own set of complicated state and federal tax requirements and other accounting issues. Without a knowledgeable, specialized accountant at the helm, so many details would be ignored; it would only be a matter of time before the major headaches occur. Furthermore, startups and capital raises, investors, lenders, acquirers, and board members all require strict corporate governance, strong controls, processes, and procedures to be in place to pull off correctly managing accounting, tax, and operations, all while continuously being prepared for a successful exit.
Myth #4: “My net income should be high because my revenues are high.”
Many business owners who enter this space unrealistically assume that just because their revenues are high, their net income will also be high — and may place the blame on their accountants if it is not so.
Yes, revenues tend to be very high in many of these verticals, but so are costs: real estate (purchase or lease), labor, fixed assets, inventory, taxes on all levels, managing services, and more. The reality in Cannabis is that, for most companies, net income is often a “net loss,” and only well-capitalized companies will survive to exit.
If your client brings up this concern during outreach or after onboarding, explain to them that you will be able to help them with their capital raise (if you have the necessary startup tools, models, deck templates and more) and potentially decrease net loss through proper mitigation of tax burden, helping them gradually meet their net income goals. Rock-solid accounting and cost accounting are the prerequisites for lowering net loss, which you can provide, immediately increasing your value to their organization.
Myth #5: “Net Income must be high to succeed.”
On the other hand, net income doesn’t necessarily need to be high (or even exist) for companies to succeed or exits to be priced high, especially in the first few years of business. Many industries, such as technology, depend on revenue- and growth-based valuations, and not net income. Cannabis will likely continue to be the same type of industry, with many exits based on product, brand, growth, and location. Even though avoiding a net loss is a strong goal for any new or struggling company, remind your clients that they can be successful even without high net income.
Just as is the case with improving net loss, if you can provide a strong accounting foundation and advise your clients on growth, budget, tax planning, and investor relations, your value-add Cannabis accounting skills can help your clients stay profitable and compliant amid this constantly changing industry.
Due to the layers of complexities in accounting and tax for Cannabis, it’s easy for business owners and non-specialized accountants to be misled and misunderstand the importance of proper day-to-day books and year-end tax returns (and all processes and systems in between). To learn more about debunking the myths your clients may believe (and how to turn them into believers of rock-solid Cannabis accounting), turn to DOPE CFO for accessing the necessary knowledge and tools.