By Andrew Hunzicker, CPA
As Pennsylvania inches toward loosening restrictions and barriers for patients seeking legal medical marijuana, there will be an increasing need for accounting professionals who understand how to keep cannabis businesses compliant. Pennsylvania currently has a conservative approach to issuing licenses; however, due to the potential tax revenues and the success of cannabis programs across the country, more licenses may be issued sooner rather than later. In fact, several bills have been brought forward to provide more affordable access to cannabis for patients within the state. Cannabis operators in states such as Pennsylvania have to be prepared when it comes to compliance issues or there can be devastating impacts on their licensing.
Federal Tax Codes
Cannabis is still considered a Schedule 1 drug by federal law enforcement, even though several states have legalized the plant for medicinal or recreational use. Legal state license holders have special rules to follow. One of the most basic rules that most CEOs and some unaware accounting professionals don’t seem to understand is that, due to the fact that cannabis is still federally illegal, businesses in this sector are not able to take any deductions.
Internal Revenue Code (IRC) Section 280e is very clear:
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.1
The rules are clear, but some businesses have tried to use loopholes and find ways around it. They end up losing every time. There are plenty of tricks that the IRS is looking out for, and it is auditing cannabis companies who attempt to take illegal deductions. Lack of compliance can lead to major fines, having licenses revoked, or even prison time for those found negligent. Several court cases have clearly outlined what is allowed and what isn’t, yet there is still confusion.
How to Legally Reduce Federal Tax Liability
IRC Section 471 can be a useful tax tool as it pertains to inventory and cost accounting. There are opportunities to legally reduce tax liability, but you have to have a keen understanding of cannabis operations, especially for the various verticals since Section 471 applies differently in each case.
Without the right tools and an understanding of the rules, accounting professionals attempting to provide services to cannabis companies may be breaking regulations or, conversely, clients may be missing out on ways to legally reduce their tax liability.
Here is a brief overview of some of the dos and don’ts as they pertain to providing accounting and compliance services to cannabis companies:
- Do follow GAAP. Under Section 471, you must follow GAAP absorption accounting to correctly minimize tax under Section 280e. This means that if your client or prospect hasn’t filed tax returns on time, has messy books and records, or doesn’t reconcile accounting records on a regular basis, they may be missing out on lowering taxable income. Inventory is a return of capital and not a “deduction,” so the cost of goods sold will be allowed on the return.
- Do use accrual basis of accounting for cannabis companies.
- Do keep perpetual data rooms and meticulous records. Your clients must be audit-ready anytime, and all the time. It’s not a matter of if a cannabis company will get audited, but when. In the Altermeds case, the owner was charged $78,000 in accuracy penalties for poor recordkeeping. There are many more like this, so be frank about needing a paper trail for everything.
- Do not try to deduct other items or you will likely trigger an audit.
- Do understand entity structures and how they affect investors and owners. This is important and complex for a number of reasons, but there are a lot of unknown liabilities that cannabis owners and investors don’t realize until they get a huge personal tax bill at the end of the year. If you know the goals of the investors and operators, you can help them avoid many pitfalls that come with double taxation and things of that nature.
- Do not try to game the system and create noncannabis divisions to avoid taxes. If you want to use a noncannabis entity to reduce your tax liability, it must be substantial and it must be able to stand on its own. It also must have separate accounting. Rarely is this the case in practice, so it’s best to avoid that plan. The Harborside case outlines how they tried to use this tactic, and it was easily struck down by the tax court.
- Do have the right tools to do proper cost accounting for the various verticals. Proper vertical-specific charts of accounts, cost accounting workpapers, and various other tools can greatly reduce errors and ensure that your clients are always audit-ready.
- Do understand how Section 280e affects cannabis businesses. Be an advocate for much-needed reform, especially in states such as Pennsylvania where there are limited licenses.
- Do not try to use tax codes like Section 263a to reduce tax liability. Those have been denied in the courts.
Accounting Guidance and Support
Currently, there is a lack of guidance for cannabis accounting. This is frustrating given that there are so many rules. It is slowly changing, and experts such as the members of DOPE CFO are leading the charge with comprehensive cannabis accounting guidance, support, training, workpapers, and more. If you’ve been approached to help a cannabis company or would like to, we highly recommend training and building your understanding of the nuances of the industry before diving in. This is especially true because it requires several hundreds of thousands to millions of dollars to open and operate a legal facility, and we don’t want people who fought tooth and nail to get a license to end up back at square one.
There is opportunity in this space for CPAs, as these businesses are grossly underserved. There are simply not enough trained cannabis accounting experts for the number of licenses being issued nationwide. The tax courts and enforcement agencies (both federal and state) are chomping at the bit to catch businesses who slip up. It literally requires a great CPA to lead these businesses down the right path so that they can maintain their licenses and, ultimately, thrive.
1 Legal Information Institute, Cornell Law School.
Andrew Hunzicker, CPA, is founder of the cannabis accounting/bookkeeping and tax training program Dope CFO in Bend, Ore. He can be reached at firstname.lastname@example.org.
Sign up for weekly professional and technical updates from PICPA's blogs, podcasts, and discussion board topics by completing this form.