By Romeo Chicco, CPA
Leave it to the IRS to have written specific tax code for just about every profession and activity imaginable, both legal and illegal. Unfortunately, in the case of a state legal cannabis-based business, that falls under tax code §280E which was written for trafficking illegal drugs. This 1982 code states that “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 consists of trafficking in controlled substances which is prohibited by Federal law.”
Separating business segments now becomes very important for businesses that generate revenue through cannabis sales. In T.C. Memo. 2018-83, the Tax Court found that Altermeds, LLC, whose primary revenue source came from the sale of cannabis, was not allowed to deduct business expenses relating to the sale of pipes and other paraphernalia because it was seen as only a supplement to their cannabis sales. One way Altermeds, LLC would have had a better chance at winning their case would have been to create a second company and sell their other merchandise in a completely separate business. Another case in 2007, Californians Helping to Alleviate Medical Problems, Inc. (CHAMP) v. Commissioner, a medical marijuana dispensary successfully convinced the court to allow cannabis companies to deduct expenses that could reasonably be separated from the trafficking of the drug from their non-cannabis business activities.
The aforementioned examples highlights the fact that the wages a cannabis company pays their employees cannot be deducted from Gross Income to determine Taxable Income. Good news is that there is an exception to this. Deductions CAN be made for the cost of goods sold (COGS). T.C. Memo 2018-83 states that while ordinary business expenses related to a federally illegal business are disallowed, they are allowed to deduct their costs of goods sold.
Let’s look at an example of a non-cannabis business compared to a cannabis business in regards to income, taxable income, the tax paid, and how COGS play a huge role:
As one can see in this example, the tax due came out to be seven times higher for the cannabis business. Therefore, to minimize tax due and maximize net profit after tax, the goal is to legally allocate as much labor and expenses to COGS. COGS refers to the production costs for products manufactured and sold or purchased and resold by the company.
For a cannabis cultivator, COGS not only includes raw materials and supplies, but also includes direct labor costs such as planting, cultivating, harvesting, processing, packaging, and anyone else who touches the raw product. Indirect labor, which can also be included in COGS, is the cost of any labor that supports the production process but is not directly involved in the active conversion of materials into the final product, such as production supervisor, quality control staff and materials management. For a cannabis reseller, the labor costs will be minimal, but can include wages such as a driver picking up and transporting the product in for resale. The rules as to what is included are extensive and too lengthy for this article, and can be found in IRS tax code §263a Uniform capitalization of costs.
When it comes to payroll, here are the lessons learned:
● Maintain meticulous records in order to substantiate the COGS and support the gross profit reported from the sale of products.
● Utilize a payroll system or service that can track and report labor costs by various departments in addition to indirect/direct costs.
● Utilize a payroll system that can allocate the related expenses along with the wages, such as payroll taxes and employer paid benefits to the departments worked.
● Utilize a time and labor system that can track an employee’s labor by hours worked in various departments.
● Familiarize yourself with §263a as to what costs can be included in COGS.
● Utilize the services of professionals who are familiar with this complex industry.
Whether you have an existing business or looking to enter the industry, it is important to be well-versed in corresponding tax codes, rules and exceptions not only to be IRS-compliant, but to increase the profitability for your business, as I have highlighted in this article.
Romeo Chicco, CPA, is President/CEO of PayMaster. For more information, visit www.paymaster.com.