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For the past century, America has been in a fierce debate regarding the legal status of marijuana. And while individuals on both sides of the issue are passionate about their positions regarding the morality and safety of cannabis, those against legalization have largely had their way— until very recently.

Fast forward to the present day and you’ll see a significant change in the legal landscape. At the time of writing, 33 states allow medicinal marijuana use and 11 states allow legal recreational use. Furthermore, 9 additional states may organize a vote for legalization on their 2020 ballots.

So what changed? Among other things, the promise of marijuana tax revenue was a huge motivator. Reframing the marijuana debate around its merits as a tool for government funding has been extremely helpful for the pro-legalization cause, and it’s led many states to experiment with legalization.

But what are the results of this experiment?

Has legalization of recreational cannabis actually led to economic growth for these states? And what does this mean for the future of marijuana legalization in the country?

Go to the CPA Accounting Institute for Success to find out more!

This infographic republished with permission.

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 ltaub@bpbcpa.com.