Keys to Operating a Successful Cannabis Business
State legislation that permits the sale and distribution of marijuana is on the rise. Thirty-three states allow it for recreational and/or medical purposes including the District of Columbia. Cannabis sales were estimated to be $15 billion in 2018 and projected to be about $73.6 billion by 2027. Given the unique legal and tax regulations imposed on cannabis businesses, it is important for those businesses operating, or intending to do so, to understand the regulatory, accounting, tax, and regulatory issues.
The most important issue is whether the state permits the sale and distribution of marijuana. If it does not, the owner of the cannabis business is violating the law. Moreover, if the owner operates a business in a state that allows it and crosses state lines to do business in one that does not, it violates the Federal Controlled Substances Act by trafficking in marijuana. One risk of running a cannabis business is the potential for legal liability in such instances.
Some banks are reluctant to allow a cannabis business to open a bank account because of these legal issues. This means a large portion of the business is on a cash basis. As a result, fraud is more likely and the business may not declare the correct amount of taxable income. This can lead to additional income taxes, an understatement of tax penalty, and additional state sales taxes.
Accountants should develop an engagement letter as part of client acceptance and continuance to include:
- Clearly define the scope of services to be rendered.
- Require client management to acknowledge its responsibility to maintain all accounting and tax records needed to comply with the law.
- Obtain a client representation letter from the business principals expressly stating that they fully understand and intend to comply with state laws applicable to their business.
- Obtain professional liability insurance coverage to apply to any claims that may arise from servicing a marijuana business client.
The computation of inventory is quite complex. IRS Regulations establish 2 tests by which ending inventory must be valued:
- The valuation method must conform to the best accounting practice in the trade or business
- The valuation method must clearly reflect income.
The ending inventory should be valued at cost, or the lower of cost or market.
Using lower of cost or market enables a business to recognize a loss for inventory that is obsolete, damaged or otherwise unsalable at normal prices based on the realizable values net of any direct cost of disposition.
Realizable value should be based on the actual price at which those goods are offered for sale during the period ending not later than 30 days after the inventory date.
Additional issues exist including when to capitalize direct costs and indirect costs.
Auditors provide assurance that the financial statements are accurate and reliable and tax accountants are charged with ensuring tax compliance. Since cannabis businesses are state controlled, the entity may be subject to regular audits and noncompliant businesses face years of litigation, back taxes, and legal fees. Quality control procedures should exist to ensure that internal controls are operating to mitigate regulatory risks.
The main issue is whether the correct amount of taxes have been paid. Businesses that traffic in marijuana in violation of the Controlled Substances Act are prohibited under Internal Revenue Code (IRC) Section 280E from deducting business expenses or credits in determining taxable income including rent, salaries, utilities and so on.
The IRS allows for the deduction of cost of goods sold from sales revenue although the amount may be limited depending on how it is calculated. Any overstatements identified or calculated by the IRS could lead to an additional tax penalty, or so-called accuracy penalty.
In an income tax case settled on October 23, 2019, Northern California Small Business Assistants Case Inc. v. Commissioner of the Internal Revenue (https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=12102), the United States Tax Court found that the petitioner had a deficiency in its 2012 income tax of $1,264,212 and an accuracy-related penalty under section 6662(a) of the IRC of $252,842.40. Small Business Assistants argued that section 280E as applied in this case is invalid. The IRS did not agree.
Accountants who are CPAs are regulated by the state board of accountancy. In those states where marijuana is legal for recreational and/or medical purposes, most boards have said they will not discipline accountants who provide professional services simply because it is in the cannabis business. However, it reserves the right to discipline professionals should they be found guilty of a federal criminal act, which could be servicing businesses trafficking in marijuana.
A word to the wise. Accounting and tax professionals should be certain to conduct appropriate due diligence of their clients’ activities and comply with all accounting, tax, and financial reporting requirements. Those in the cannabis business want to earn a reputation of trust, which will help them compete as more and more marijuana dispensaries open.
Steven Mintz is a professor emeritus from the California State University at San Luis Obispo. He is the founder and CEO of Ethics Sage LLC and can be reached at [email protected].
Posted by Steven Mintz, aka Ethics Sage, on June 25, 2020. You can sign up for our newsletter and learn more about Dr. Mintz’s activities at: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics.