Where There’s Smoke…
By Kristina Drzal Houghton, CPA, MST
Kristina Drzal Houghton
The production and distribution of cannabis, once known to many only as marijuana, is the newest and most variegated industry in America. Some would even say it is one of the toughest industries in America in which to do business. This article will discuss a few unique challenges from a financial perspective faced by the industry.
The first complexity starts with the difference between cannabis and CBD. When you look at a cannabis plant and a hemp plant side by side, the plants themselves look identical to an untrained eye, making it a bit challenging to identify, as the real difference lies in the chemistry of the plants.
CBD can be extracted from hemp or marijuana. Hemp plants are cannabis plants that contain less than 0.3% THC (the compound that creates the ‘high’ sensation), while marijuana plants are cannabis plants that contain higher concentrations of THC. This article will refer to all products containing more than 0.3% THC as cannabis, while products with less will be referred to as CBD.
So, basically, the only difference from a scientific standpoint is the level of one chemical. However, things are much more complex from a legal and tax perspective. Under the 2018 Farm Bill, CBD and hemp are now legal, and not on the schedule I list of controlled narcotics right up there with heroin and LSD. In 2016, Massachusetts passed a law making all cannabis legal, and all but five other states have passed laws making it either fully legalized, decriminalized, or medically authorized. While cannabis is federally illegal, the Internal Revenue Service is perfectly willing to collect taxes on companies that handle the product.
Federal tax law is very punitive on the cannabis industry. Internal Revenue Code Section 280E is a very short part of the tax code (just one sentence) and 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.”
Under 280E, you’re not allowed any deductions or credits on your return, but you can deduct the cost of goods sold, as that is part of the definition of taxable income. A cannabis farm will only be allowed to allocate various costs, direct and indirect, into cost of goods sold and inventory. Section 280E will affect only cannabis entities. CBD companies, since they are legal, are allowed all normal business deductions and credits available to other non-cannabis companies. This provides many more opportunities to reduce taxable income to a hemp/CBD company.
It is not only the federal tax difference which significantly attributes to the disproportionate cost of cannabis versus CBD. Due to discrepancies between state and federal law, legal cannabis businesses are forced to operate almost entirely in cash, with very little access to financial services, since most banks are federally insured and therefore unable to establish accounts for this federally illegal business. This leaves thousands of dollars stored in backroom safes and transported in shoeboxes and backpacks, creating a prime target for crime. Another banking challenge that cannabis businesses regularly face is exorbitant monthly account fees, or banks that take a percentage of each deposit.
The industry faces many other challenges as well. For example, most states have a mandated ‘seed to sale’ software-tracking system that must be used and accurate (daily), and must be reconciled with POS (point of sale) systems and accounting systems. Additionally, because this is a new industry, many of the tools other industries use are simply not readily available, including a cannabis-tailored chart of accounts, QB POS systems, reliable inventory software, and common merchant service platforms.
There is an opportunity for dispensaries to separate some revenue streams outside of the cannabis division, meaning normal business deductions are allowed for the non-cannabis division. These might include clothing, paraphernalia, coffee, CBD, and other goods. While this is good news for the industry, it only creates even more complexities when allocating selling and administrative expenses.
A recent report from the U.S. Treasury inspector general for Tax Administration recommends increased audits by the IRS of cannabis businesses to identify potential non-filers and returns that are not 280E-compliant. For this as well as the above reasons, cannabis businesses need to find an accounting firm that really knows what it’s doing. The cannabis accountant has to not only understand Section 280E, but also know how to treat a business that deals strictly (and necessarily) in cash. Many cannabis companies have bad books because their bookkeepers do not understand the special accounting and therefore didn’t properly categorize expenses. It can be time-consuming to fix them.
So, while the many layers of regulatory control and reporting may be of utmost importance to those operating in the cannabis industry, overlooking the complexities in the finance area of the business can lead to the proverbial perfect storm — or the business going up in smoke.
Kristina Drzal Houghton, CPA, MST is a partner at the Holyoke-based accounting firm Meyers Brothers Kalicka, P.C.
