Accounting for Cannabis (#393)

This episode covers the unique issues related to the accounting for cannabis. Many boards of accountancy have issued statements about how CPAs should deal with clients in this business. I’m going to quote from a statement issued by the Arkansas Board of Accountancy, which is pretty representative: “The provision of professional services within states where medical marijuana has been legalized to clients that are properly licensed… does not constitute a violation of Board rules regarding good moral character or acts discreditable to the accounting profession. However, federal law still prohibits the sale, possession, growth, and distribution of marijuana. The Board could possibly take action if a licensee was convicted of a crime related to medical marijuana.” In other words, you can provide services to this industry, but do not get caught using it.

The Classification of Cannabis

At first glance, this might seem like a fairly ordinary industry accounting topic. A cannabis business has sales, and payroll, and rent, and pays taxes, just like any other business. But the real challenge is that the federal government still classifies marijuana as a Level 1 controlled substance. A cannabis business may be completely legal under state law and still face federal tax treatment that’s much harsher than what applies to most other industries.

Tax Treatment of Cannabis Businesses

That federal tax treatment revolves around Internal Revenue Code Section 280E. That section prohibits businesses engaged in the "trafficking" of Schedule I or II controlled substances from deducting "ordinary and necessary" business expenses from their federal taxable income. This means that cannabis businesses are generally denied the normal federal income tax deductions that most companies take for ordinary operating expenses. This creates a very large difference between book accounting and tax accounting.

From a financial statement perspective, a business still records its transactions in the usual way. It recognizes revenue when earned, records wages when incurred, depreciates fixed assets, and so on. So if you looked only at the books, the situation might appear fairly conventional.

But then we have the tax rules.

Under Section 280E, a cannabis business cannot deduct expenses like rent, payroll, marketing, office expenses, and overhead to reduce book income for federal tax purposes. The one major exception is the cost of goods sold. The IRS takes the position that Section 280E does not prohibit a business from reducing gross receipts by a properly computed cost of goods sold. That point is critical.

If you operate a normal retail business, you usually focus on gross margin, operating margin, and net income. In a cannabis business, those measures still matter, but the real pain point is that taxable income can be far higher than book income. A company may report only a modest accounting profit, or even an accounting loss, after considering all of its operating expenses, and yet still owe a large amount of federal income tax because so many of those expenses are nondeductible under 280E.

This is why the accounting department in a cannabis business has to pay close attention to cost classification.

Cost Classifications

Management needs a chart of accounts that clearly separates direct production expenses, inventory-related overhead, retail expenses, administrative expenses, and selling expenses. The more precise that classification is, the easier it is to determine which expenditures can flow into inventory and then into the cost of goods sold, and which ones will remain ordinary operating expenses that will be disallowed for federal tax purposes.

For cultivators, this means that inventory accounting is massively important. They may have direct materials, direct labor, production supervision, utilities for growing facilities, and other expenditures that can be capitalized into inventory. For dispensaries, the ability to capitalize costs is way more limited, which is why the federal tax burden can be especially severe for them.

In short, inventory accounting becomes a tax survival issue.

This also means the monthly close has to do more than produce financial statements. The accounting staff should prepare supporting schedules that reconcile book income to taxable income, identify the Section 280E adjustments, and document exactly how the cost of goods sold was calculated.

If those schedules are incomplete or inconsistent, the business is exposed not only to higher taxes, but also to an audit.

The Need for Three Sets of Books

Another issue is budgeting. In most industries, management can take pretax book income, adjust for a few tax differences, and arrive at a reasonable tax estimate. That approach does not work well here. In a cannabis company, the difference between book income and taxable income can be massive. So the accounting department has to forecast taxes very carefully. Otherwise, you may think the company has enough cash to fund its operations, and then discover that a large tax payment is coming due because federal deductions were denied.

This can create a strange financial profile. A cannabis business may appear operationally sound, with decent revenue and gross margins, while still struggling with cash flow because its effective tax rate is wildly high.

Now let’s turn to the state side of the issue, because state-level deduction rules are completely different. Many states use federal taxable income as the starting point for the state tax return. If a state conforms to federal law and does not provide any special relief, then the federal 280E problem effectively carries over into the state return. That means the business can lose deductions at both the federal and state levels.

However, some states have chosen to decouple from Section 280E for licensed cannabis businesses. When a state decouples, it allows some or all of the deductions that federal law disallows. This creates a very different state tax result from the federal one, even though both returns are based on the same underlying accounting records.

Colorado is a good example. It allows a subtraction for normal business expenditures, which provides relief on the Colorado return for licensed cannabis businesses. Oregon and California do the same thing.

By contrast, in states that conform more closely to federal taxable income, the 280E burden is mostly intact at the state level. And in states without a traditional income tax, such as Washington, the issue shifts elsewhere, because the business may instead be dealing with larger amounts of excise taxes, sales taxes, and business activity taxes rather than a state income tax.

So from an accounting standpoint, the business needs a multi-layered tax model. First, it needs clean financial statements that are prepared under normal accounting principles. Second, it needs a federal tax framework that’s built around Section 280E, with strong documentation for the cost of goods sold.

And third, it needs a state-by-state tax analysis showing where deductions are allowed, where they are disallowed, and how state conformity rules differ across jurisdictions. So, that’s three sets of books.

The result is that cannabis accounting is really two jobs at once. One job is to produce accurate financial records. The other is to translate those records into a tax structure that reflects both federal 280E restrictions and state-level deduction rules. In short, a bookkeeper in this industry is set for life.