1. Stay current on what deductions are allowable for different business types
Cannabis businesses should analyze their inventory rules and how costs are allocated across the business and then apply consistent methodology for their COGS calculations. Allowable deductions can vary greatly depending on the type of business license a company holds (for example, retail, manufacturing, distribution, or integrated licenses). As a general matter, tax inventory rules are less punitive to manufacturers and growers than to retailers because more costs of manufacturers are production related and therefore included in COGS. Retail operations, on the other hand, generally are more restrictive in what is included in COGS. For an integrated company, distribution company, or delivery company, the rules fall in between. Thinking through what rules apply, to what kind of operation, and consistently applying inventory methodologies can either create significant value or significant tax risk to companies.
Businesses should periodically review how the most recent federal court decisions and IRS guidance affect their 280E positions.
2. Make careful decisions when setting up the legal entity structure
Companies seeking tax advantages by separating their business into different legal entities should proceed with caution. The IRS will scrutinize these decisions and might argue that all related-party businesses are unitary and subject to 280E. Establishing separate profit motives is a critical step. Companies should also follow the formalities of the entity structure that is created, including having written operating agreements, lease agreements, royalty agreements, and appropriate documentation of intercompany loans. Companies should model the tax implications of various entity structures and choose a structure that best fits their tax risk profile.
3. Maintain thorough documentation and bookkeeping
High-quality recordkeeping arguably is the most fundamental cannabis accounting best practice. Finance leaders should maintain separate accounting books for a company’s different legal entities and check that recordkeeping aligns with the business structure and accounting methodologies set up at the outset. Detailed documentation should back up all decisions and deductions, from employee wage allocations to shared service agreements.
Patience is a virtue in today’s environment
A bright future appears to await the cannabis industry. The U.S. legal cannabis market is projected to reach $35 billion by 2025, and prospects are growing for cannabis-friendly federal legislation. Now is the time for cannabis businesses to mitigate their risks on Section 280E tax compliance, monitor potential changes in tax policy, and establish accounting foundations for long-term growth.
