All across America, dozens of states and municipalities are decriminalizing and legalizing the medical or recreational use of marijuana. Many people anticipate the federal government may also soon legalize or decriminalize marijuana, but political opinions on this are divisive. Even so, many state-legal cannabis companies are operating across the country and need reliable advice on how to file taxes.
Some financial professionals have chosen not to serve this industry because of risks under federal law. However, there are a few accountants who are ready to pioneer changes and represent clients navigating this very murky area of tax law. Accomplishing this comes down to the application of specific provisions under the Internal Revenue Code.
What Is IRC 280E?
IRC 280E is a restrictive way of accounting in the cannabis industry. It makes it difficult or impossible for people in the marijuana industry to deduct business expenses. This can cause business owners to overpay taxes. When this happens, it affects the profitability of the business and even the long-term feasibility of the industry.
Cornell Law reports that the law prohibits weed businesses and its owners from taking any tax credits or making any deductions during the tax year for any expenses related to carrying on a business that involves the buying and selling of Schedule I and Schedule II controlled substances. The Drug Enforcement Agency still lists marijuana as a Schedule I substance.
In spite of this, some accountants have found “loopholes” in the wording of other tax laws to define income. Some say that the income taxed by the IRS for alleged drug trafficking is not gross receipts, but gross income. As a result, some business owners may choose to treat the deductions as adjustments, instead.
What Is IRC 471?
Cornell Law describes IRC 471 as a general inventory rule for business owners. It provides details for how, when and why businesses may use inventory as a reliable indicator of income. This section of the tax code also provides tests that inventory estimates must conform to. The first is that the system must closely reflect the established best-accounting practices for that business or industry.
The second is that it must clearly show the individual’s or business’s earnings. This cements the fact that there is no uniform method for inventory valuation for tax purposes. Finally, it also limits the circumstances under which the IRS may force business owners to change their accounting methods.
Because this approach offers more flexibility, many business owners have made or considered making the switch. Several entrepreneurs have even gone back to amend former returns filed for their cannabis businesses. Almost any small business that generates revenues under $25 million may become eligible to use this method of accounting. To qualify, the business must not be a public company or tax shelter.
What Is IRC 263A?
Before IRC 471, many cannabis businesses turned to IRC 263A to capitalize administrative and general costs into the inventory calculations. Business owners could then deduct these as cost of goods sold. Thus, it achieved a similar effect to IRC 471. However, this practice soon came under fire by the IRS. This compelled many business owners to go back to the drawing board, re-strategize and even amend tax returns.
What Accounting Changes Can Businesses Make To Remain Compliant?
There is no foolproof advice for cost accounting in the cannabis industry. Consequently, accounting professionals and their clients must continue to tread carefully. Observers of the legal system believe the federal government is on the lookout for a strong case to take to court before delivering any clear and binding rulings on the cost accounting process for marijuana. Even so, there are some recommended practices to consider.
1. Change the Accounting System
Many cannabis business owners find that they may reduce taxable income by changing from cash accounting to an accrual system. It accomplishes this by deferring a portion of the income until the following year. By then, the federal government or the IRS may make substantial changes to tax or drug law, which could improve the accounting dilemma.
2. Keep It Consistent
There is no guarantee that the IRS will rule for or against the use of any specific accounting rule, but consistency can make all the difference. Ensure your records and accounting books reflect the same accounting method to estimate income and file taxes. Inconsistency may put businesses in a position where the IRS may have the power to decide what accounting method they must use.
3. Consider Size and Revenue
If you wish to earn or maintain eligibility to use IRC 471, it is imperative that you keep business revenue in mind. You may supply only so much inventory to generate the prescribed revenue or you may even reconsider your business hours. Some business owners even try splitting up the company between business partners or family members.
4. Prioritize Inventory Management
There are two main reasons to pay keen attention to inventory. The first is that it can help you ensure you generate revenue below the threshold. Secondly, inventory management can help provide proof of regular inventory checking and its accuracy for determining income for tax purposes.
5. Plan Ahead
If this all sounds complicated to you, you may feel tempted to simply focus on keeping your business open. After all, you can worry about the tax implications later, right? CNBC warns that some cannabis businesses are burdened by as much as 70% in taxes. Depending on the cost of doing business, taxes may be even more than the business’s net income. Plan ahead so you know exactly what you are up against and can work on an early solution.
Thankfully, many organizations and media companies are continuing to speak out against the injustice faced by cannabis businesses. At least one California-based business has decided to take the matter to court. The dispensary aims to declare Section 280E restrictions unconstitutional. If the case proves successful, it could have a positive, widespread impact on cannabis business accounting across America.
Until then, you need experienced accountants who are willing to take the legal risks of advising you. MI Tax CPA is committed to changing the tax game. Contact us to see how our team of professionals can best serve your business needs.