By Lewis Taub, CPA, Director of Tax, Berkowitz Pollack Brant
Despite the legalization of cannabis on a state-by-state basis, federal tax laws continue to limit the availability of certain tax benefits for businesses engaged in cannabis production and sales. Yet, with advance planning and analysis, cannabis companies and their investors have an opportunity to maximize their tax savings while maintaining compliance with federal laws.
Federal Tax Law
Under federal tax laws, most U.S. businesses may deduct from their taxable income the ordinary and necessary expenses they incur to operate their companies, including costs for rent, repairs, interest, depreciation, and employee compensation, and benefits. However, the federal government does not extend this tax-saving benefit to businesses that sell cannabis, which the Controlled Substances Act (CSA) classifies as a schedule I drug that is not approved for medical use in the U.S. This restriction prohibiting cannabis companies from deducting business expenses even extends to those entities located in states that have legalized the sale of cannabis for medical purposes.
There is, however, one significant exception to the disallowance of expense deductions for cannabis businesses.
An Exception for Producers and Resellers
The Internal Revenue Service (IRS) permits “businesses trafficking in controlled substances” to deduct the direct costs of the goods they sell against their income. Cost of goods sold refers to inventory a business purchases to resell to customers and is considered to be an adjustment to income and not an actual deduction.
Cost of goods sold is calculated as 1) the cost of product (inventory) on hand at the beginning of the year, plus 2) the cost of product that was produced or purchased since the beginning of the year, plus 3) direct and indirect production costs, minus 4) the cost of inventory on hand at the end of the year.
This IRS provision allowing a deduction for costs of goods sold represents a significant tax-savings opportunity for businesses in the cannabis industry, specifically “resellers” that merely buy products to sell to customers and “producers” that control the production of the product to be resold. Yet, the opportunities to deduct expenses as part of costs of goods sold are much more expansive for producers than for resellers.
For example, resellers can include in costs of goods sold the amount they pay for the purchase of the cannabis plus any transportation expenses or other necessary expenditures incurred in acquiring possession of the product. In contrast, the tax laws allow producers to include in costs of goods sold their direct material costs for growing the product, including outlays for plants and seeds; direct labor costs for planting, harvesting and sorting product; and indirect production costs, including rent, repair expenses, employee wages, utilities, and maintenance. Therefore, many of the operating costs that cannabis businesses may not deduct because the federal government considers to be trafficking in controlled substances can now become deductible as costs of goods sold for producers. The deductible amount depends upon the company’s inventory costing system. Typically, indirect costs are allocated based on methodologies that include a standard amount based on a fixed formula. For example, a certain dollar value of indirect costs could be allocated based on a fixed percentage of direct costs.
It is important to recognize that over the past few years, the tax court has sided with the IRS in taking the position that a cannabis business was a reseller and not a producer, thereby reducing the cost of goods sold available for the business to offset its gross sales. This issue may continue to influence the cannabis industry as vertical integration among companies will produce true tax advantages. That is, entities combining through acquisitions will be better able to control the entire process, from production through distribution, and qualify as producers that can deduct the additional cost of goods sold,
Cannabis businesses face a complicated tax-compliance landscape. Yet, opportunities are available for maximizing business expense deductions and improving tax efficiency when cannabis companies plan early under the guidance of experienced tax professionals.
About the Author: Lewis Taub, CPA, is a director in the New York office of Berkowitz Pollack Brant Advisors and Accountants, where he works with entrepreneurial business, multinational and multi-state corporations on tax planning and compliance strategies. He can be reached at firstname.lastname@example.org.