The cannabis industry might be one of the largest industries in the next decade, but right now, it’s risky, expensive and faces uncertain legal and tax hurdles, says an accountant who specializes in the cannabis industry.
Matthew Foster CPA, a partner with Frazier & Deeter, LLC and the firm’s National Practice Leader for the Cannabis Industry, spoke about accounting and the cannabis industry earlier this year at the Georgia Association of Business Brokers.
“This is not an industry for the faint of heart,” warned Foster. “If you have a very low risk tolerance, I would just advise you to stop right now and wait until the feds open it up in about five or six years, possibly longer.”
The biggest risk? The whole industry is illegal in the eyes of the federal government.
“From a federal perspective, every one of these companies that are in cannabis are lawless citizens of the U.S.,” said Foster. “They’re all breaking the law.” Federal officials could “come in at any moment and break them up if they wanted to.”
If the company is in one of the many states that has legalized cannabis, most assume that federal officials won’t intervene, “unless they do something really out of line,” Foster said.
Georgia’s Cannabis industry
Georgia’s cannabis industry is poised for growth because the state recently passed a law legalizing the production and manufacturing of low THC CBD oil, defined as anything with a THC content of 5% or less. That’s just strong enough for medicinal use, and not strong enough for intoxication. The new law allows up to six licenses for growing medical marijuana, plus licenses to the University of Georgia and Fort Valley State University for research.
Of the six private licenses, two will be for large productions, up to 100,000 square feet, and four for up to 50,000 square feet. There’s a $25,000 non-refundable application fee for a large license, along with an initial $200,000 licensing fee and $100,000 annual renewal fee. The smaller licenses carry a $5,000 non-refundable application fee, along with an initial $100,000 licensing fee and $50,000 annual renewal fee.
“So you need a lot of capital just to hold the license in Georgia,” Foster said. “That’s before you even start with the production and the costing and everything else.”
Recently Flourish, an Atlanta-based supply chain management startup that helps cannabis companies monitor logistics, raised $2.1 million in a seed round led by 7thirty Opportunity Fund, the Atlanta Business Chronicle reported.
Georgia has made cannabis companies ineligible for any state tax incentives. “You are going to pay tax on every single dollar that you make here in Georgia,” Foster said.
Which means that companies in the cannabis industry right now must be highly capitalized. “You have to have a lot of money at your disposal to weather the storm until the feds open it up,” said Foster.
Frazier & Deeter works with clients to set up inventory methodologies that will move as many expenses as they can under current tax law from their overhead into the cost of inventory.
Another obstacle for the industry is banking. Under current laws, federally insured banks are not allowed to do business with cannabis companies.
“These companies can bank with state-sponsored banks, with credit unions, if those banks decide they want to work with this industry. But they can’t bank with FDIC-insured banking institutions, your Wells Fargo, your Bank of America, your Chase, because they are federally regulated,” Foster said.
Cannabis industry investors are lobbying legislators to pass a law that would make cannabis similar to hemp, which would open up a more traditional taxation and banking.
Foster predicted that Congress will act on banking before legalization because right now, the federal government is losing lots of potential tax revenue from the industry.
Cannabis VS Industrial Hemp
Cannabis and industrial hemp represent different segments of the market. For example, industrial hemp is becoming a very attractive option for people to invest in thanks to last November’s farm bill. The farm bill, in essence, descheduled industrial hemp, defined as a product with a less than 0.3% THC content per gram. Hemp fiber and oilseed can be used in variety of industrial and consumer products. What the bill did was deschedule hemp, meaning it’s still illegal at the federal level, unless you are producing and working in a state that has legalized industrial hemp.
Cannabis is still illegal from a federal standpoint, despite being legal for medicinal uses in 33 states and the District of Columbia, and in 11 states and D.C. for recreational uses. Because cannabis is included in Schedule I of the Controlled Substances Act, it falls under section 280E of the IRS code. “That means cannabis businesses cannot deduct any necessary or ordinary business expenses for federal income tax purposes, nor can they claim any Federal credits,” Foster said.
“You can deduct your cost of goods sold, but everything else in your return is non-deductible,” Foster said. “You can’t have R&D credits, you can’t have business credits, and you can’t have jobs credits. Take your revenues, deduct your cost of goods sold, get your gross profit, and that’s your taxable income: your gross profit.”
But companies with shrewd accountants can take advantage of certain sections of the IRS code that allow companies to capitalize their overhead, which would allow them to deduct some of the expenses for rents, utilities, property taxes, salaries, depreciation, etc.
Managing Cannabis Finances
Foster recommends that their traditional cannabis clients do full financial statement audits which allows for an opinion on what’s capitalized into the cost of inventory and what’s being deducted as cost of goods sold. If the IRS does come in and audit, “we have a lot of support for the position that we have taken.”
Cannabis companies should NOT use the name of the plant in their company name, Foster recommended, to try to minimize the red flags that the IRS will see on these companies.
“First and foremost, the words cannabis, hemp, and marijuana should not appear on your tax return, anywhere,” said Foster.
Also, these companies should not get creative in taking deductions, Foster said. If you go that way, “start putting money aside because you’re going to get audited.”
He also recommends that anybody in this space should operate as a C Corp, mainly because it’s the lowest tax rate that you can find on federal level right now. Also a C Corp allows a company to “put up a corporate wall around your investors.”
If the IRS starts attacking the company, the investors are only out what they put into the company. It won’t be able to go after their personal assets. He also recommends portioning off different sections of the business into separate entities for real estate, equipment or intellectual property.
Potential Profits Huge
Returns on investment are a mystifying 10 to 30 multiples on revenue streams in the industry. “I haven’t quite figured out what’s going on in this space,” Foster said. “This must be Toad’s Wild Ride for investors.” But last year, a lot of people made a lot of money.
“So, it depends on when you get in, what you get in to, and how long you’re willing to ride this roller coaster,” Foster said.
Big U.S. companies are awaiting new banking regulations that will ease investment into this industry. Foster said “They’re either waiting to go public, or they’re waiting for big pharma, big tobacco, or big alcohol to come in and buy them up.”Read More
New Tax Loophole May Allow Many Small Businesses to Claim Large Tax Write-Offs For Inventory In The Year Purchased! Can it be true? How do Companies Sign Up?
Senior Tax Manager at Frazier & Deeter (Atlanta, GA)
Congress, either intentionally or unintentionally, as part of the Tax Cuts and Jobs Act provided for a potentially huge tax write-off for many small businesses that have inventory –basically any company that has physical products they intend to sell to a customer. Prior to the new tax law (before 1/1/2018), if your company kept an inventory, you generally couldn’t claim a tax deduction for inventory until the inventory was sold. As a result of the Tax Cuts and Jobs Act (TCJA), savvy small businesses may be able to take advantage of a new loophole that could provide a large tax windfall by completely expensing their ending inventory in the year purchased starting with returns that are about to be filed in 2019 (for the 2018 tax year).
For taxpayers and CPAs able to piece together several sections of the Tax Code and Regulations, the new law creates a huge opportunity and marks a significant change from prior tax accounting for inventories that didn’t allow for tax deductions for inventory until sold. There are a number of hoops to jump through and hurdles to overcome before companies can write off ending inventory, but will likely provide immediate tax savings to a large percentage of taxpayers who keep an inventory with a cost of less than $2,500 per inventory item. According to Donna Beatty, CPA, we may even see those companies that are able to take advantage of this loophole manage their tax bill via purchase of inventory before the end of their tax year.
Cash Method Now Allowed For Small Business –Even Those With Inventory
It works like this. The Tax Cuts and Jobs Act generally effective as of January 1, 2018, provides that taxpayers, in general, with less than $25 Million in gross receipts (average of past 3 years gross receipts) can now use the cash method of accounting, even if they keep an inventory. This is a major shift from prior law that required many companies with inventory to use the accrual method of accounting. This rule alone does not provide that businesses under the $25 Million threshold can simply start expensing their inventory as purchased – there are several additional nuances before a cash basis taxpayer can expense inventory when purchased.
First, if you are under the $25 Million average gross receipts threshold and currently using the “accrual method” of accounting, and you think you qualify to expense inventory based on all other parameters below, or you just want to start using the cash method of accounting for some other reason, you will need to file a “change in accounting method” with the IRS to begin filing tax returns on the cash basis. If you are already using the “cash method” of accounting for tax purposes that’s great – you don’t need to file a change with the IRS. If you need to file with the IRS to change your accounting method, don’t worry, the IRS has provided for a simplified filing requirement for small businesses rather than forcing you to complete the normal Form 3115 with all of its required schedules and disclosures. After you change your company accounting method to the cash method with the IRS, you still ARE NOT home free! There are additional steps to take before you can expense inventory as purchased – keep reading.
Required Tax Elections
Once you are on the cash method of accounting one of the two keys that makes this work is what’s called the “de minimis safe harbor election.” If you want to get technical, the election can be found at Treasury Regulation Section 1.263(a)-1(f), and provides that items under $2,500 per unit can be expensed if this election is made and your company accounting records are also in compliance (see next heading). Before the Tax Cuts and Jobs Act, this election did not apply to inventory.
As a result of the Tax Cuts and Jobs Act, either deliberately or inadvertently, Congress provided that when small businesses meeting the $25 Million gross receipts test use the cash method of accounting they can also elect to treat inventory as “non-incidental materials and supplies.” What’s the big deal with this you might ask? When you apply the “de minimis safe harbor election” to “non-incidental materials and supplies,” companies can then expense all items under $2,500 per unit if properly accounted for. That’s right, the “de minimis safe harbor election” that allows all companies to expense items under $2,500 per item also applies to “non-incidental materials and supplies.” There are also a number of rules here that are highly technical in nature dealing with the definition of inventory and definition of items qualifying for the “de minimis safe harbor election” that are beyond the scope of this article. Companies should consult with a knowledgeable CPA about these.
The “de minimis safe harbor election” is a very simple election that companies can have their CPAs make on their annual tax returns. The election to treat inventory as “non-incidental materials and supplies” on the other hand is not so simple. This election requires a change in accounting method with the IRS on a Form 3115. Again, just as with the change from the accrual method to the cash method noted above, the IRS has provided for a simplified Form 3115 filing requirement for small businesses making this change.
Required Financial Reporting
Ok, your company is now on the cash basis for tax purposes, filed the change in accounting method to elect to treat inventory as “non-incidental materials and supplies,” and ready to include the “de minimis safe harbor election” on your annual tax return. You still aren’t home free! There are a few more considerations before you can claim that big tax write off for all the inventory you purchased last year (instead of leaving it out on the balance sheet only to deduct whenever it’s sold to customers).
The magic that makes all of the above work is a little bookkeeping and financial reporting. To expense all your company purchases under $2,500 per unit using the “de minimis safe harbor election,” the Regulations mandate that you also expense these items on your financial statements and not just your tax returns. If your small business has no requirements to issue GAAP basis financial statements (audit, review, compilation) there may be an opportunity to implement this strategy. If you are required to issue GAAP financials, or for some other reason can’t expense inventory as purchased on your financials, you will be prevented from using this strategy. GAAP will not allow a company to expense inventory; instead, ending inventory under GAAP must stay on the company balance sheet and be expensed as it is sold.
If your company is like many small businesses with no external stakeholders to be accountable to, and you don’t mind expensing inventory as purchased, you may have an opportunity to expense all inventory otherwise sitting on your balance sheet at year end. To clarify, the rules dictate that you expense inventory on your financials – they do not prevent you from tracking inventory as you always have for your internal management purposes. The unit cost of each item must be included on the invoice from your vendors as well. Best practice would be to create an internal written accounting policy to expense all inventory purchases. Additional rules apply to labor and materials of manufacturing companies that produce their own inventory for sale to customers.
Putting It All Together
As you can see, the expansion of using the cash method of accounting for small business coupled with allowing small companies to elect to treat inventory as “non-incidental materials and supplies” may provide a large tax benefit when coupled with the “de minimis safe harbor election.” According to Donna Beatty, CPA, the tax professional industry is anxiously waiting on further guidance on this issue. In fact, the American Institute of Certified Public Accountants (AICPA) submitted their recommendation on the above issue to tax policy makers in Washington in a letter dated July 23, 2018. The AICPA recommended that the IRS and Treasury permit a small taxpayer to make a “de minimis safe harbor election” that would allow them to expense inventory. Although still awaiting further guidance, the way the law is currently written, some believe many small business taxpayers will take advantage of this potential loophole and expense all of their inventory. For example, we may see many small local retailers with maybe $100,000 – $200,000 of inventory at December 31, 2018 completely expense those amounts using this strategy –that would provide an average Federal tax savings of $37,000 – $74,000 (even more considering state income tax). Companies with a bit larger inventory of lower priced items under $2,500 per unit would experience even higher tax savings –and may even create taxable losses.
There are a number of rules and items not mentioned in this article, especially how the above might apply to production labor and overhead costs applicable to manufacturing companies. Accounting method changes, tax elections, and tax returns all have deadlines and must be properly and timely filed and reported – that could all impact the strategy discussed above. As with anything tax related, there are probably other unique items related to your business that would affect the tax strategy discussed in this article. This is a highly technical area of tax law which is very fluid, and this article may not be cited as authority, and is no substitute for counsel with your tax attorney or CPA.
How Can Frazier & Deeter help? Involve Frazier & Deeter early in the process of working through this tax strategy to determine if you qualify, and help to quantify the tax savings and potential risks.
If you have questions regarding this strategy or any other tax planning strategies feel free to reach out to one of the Frazier & Deeter Tax professionals: Andrew Moore at 404-573-4336 (Andrew.Moore@FrazierDeeter.com) or Donna Beatty at 404-573-4098 (Donna.Beatty@Frazier.Deeter.com).Read More