Accounting

Taxes & Accounting for Oklahoma Cannabis Businesses

Here is a brief introduction to accounting for Oklahoma Cannabis Businesses

Implications of 280E in Daily Operations

All for-profit business that earns profits must pay income taxes in the United States, including business involved in the Oklahoma cannabis industry. However, the taxable income from cannabis is subject to different rules because cannabis is still illegal at the federal level and the taxing agencies impose additional scrutiny on cannabis companies. Therefore, it is crucial for you to keep meticulous accounting records to support tax-related filings.

Type of Business…………………………………………………………………………………………Standard Business                                                       Cannabis Business

Sales…………………………………………………………………………………………………………………..$500,000                                                                              $500,000

Cost of Goods Sold

  • Materials ……………………………………………………………………………………………….$100,000                                                                         $100,000
  • Direct Labor……………………………………………………………………………………………$50,000                                                                            $50,000
  • Sub Contract Labor ……………………………………………………………………………. $20,000                                                                            $20,000
  • Freight in/out ……………………………………………………………………………………….. $5,000                                                                              $5,000
  • Equipment to produce product  …………………………………………………………$25,000                                                                         $25,000

————————————————————————————————————————————————————————————————————————————-

Total Cost of Goods Sold……………………………………………………………………………………..$200,000                                                                      $200,000

————————————————————————————————————————————————————————————————————————————-

Gross Profit ……………………………………………………………………………………………………………. $300,000                                                                        $300,000

————————————————————————————————————————————————————————————————————————————-

General & Selling Expenses

  • Advertising………………………………………………………………………………………………$15,000                                                                                      $0
  • Contract Labor ………………………………………………………………………………………..$20,000                                                                                     $0
  • Legal & Accounting……………………………………………………………………………….. $6,000                                                                                       $0
  • Meals ………………………………………………………………………………………………………….$3000                                                                                         $0
  • Office Expense……………………………………………………………………………………….. $7500                                                                                         $0
  • Rent…………………………………………………………………………………………………………… $24,000                                                                                       $0
  • Salaries and Wages…………………………………………………………………………………$50,000                                                                                      $0
  • Travel …………………………………………………………………………………………………………$7500                                                                                           $0

————————————————————————————————————————————————————————————————————————————-

Total General & Selling Expenses ……………………………………………………………………..$133,000                                                                                         $0

Taxable Income ……………………………………………………………………………………………………..$167,000                                                                                  $300,000

Tax Rate ……………………………………………………………………………………………………………………….35%                                                                                            35%

Tax on Business……………………………………………………………………………………………………….. $58,450                                                                                    $105,000

Non-deductible Expenses……………………………………………………………………………………….$0                                                                                              $133,000

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Net Income After Taxes…………………………………………………………………………………….$108,550                                                                                  $62,000

 

Effective Tax Rate…………………………………………………………………………….. 35%                                                                                     79.3%

Growers and Processors of Oklahoma Cannabis

IRC Section 280E:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances which is prohibited by Federal law or the law of any state in which such trade or business is conducted.

The 1982 Senate Report explains that while IRC Section 280E disallows “ordinary and necessary business expenses” adjustments to gross receipts for COGS (Cost of Goods Sold) are “not affected by this provision” and therefore are allowed as deductions for federal tax purposes.

An Oklahoma cannabis grower or processor may include direct material costs (such as seeds) and direct labor costs (such as planting, harvesting, sorting, cultivating) in COGS.

COGS generally include the costs incurred for the purchase, conversion, materials, labor and allocated overhead incurred in bringing the marijuana inventories to their present location and condition, as well as the costs of transportation.

IRC Section 471:

Indirect costs that are “incidental and necessary for production” may be deducted. For an indirect cost to be deductible, it must be explicitly related to the production, processing, and storage of the product, as compared to other non-deductible activities such as administrative, marketing and retail operations.

Since 1958, IRC Section 471 has governed inventory and what type of cost are considered inventory or Cost of Goods Sold.

Under code section 741, indirect costs are treated as Cost of Goods Sold if they are “incident to and necessary” for production or manufacturing.

Under this code section the following cost can be (but not always) be included in COGS:

  • Repair Expense
  • Maintenance
  • Utilities such as heat, power, and light
  • Rent
  • Indirect labor and production supervisory wages
  • Indirect materials and supplies
  • Tools and Equipment not capitalized

Indirect Production Costs Not Included in Inventory Costs are:

  • Marketing Expenses
  • Advertising Selling Expenses
  • Insurance
  • Interest
  • General and administrative expenses incident to and necessary for the taxpayer’s activities
  • Legal and professional expenses
  • Overhead Wages such as bookkeeping, office management
  • Salaries paid to officers attributable to the performance of services
  • Grower & Processing – 75% of their expenses are going to be tax-deductible

Oklahoma Dispensaries:

Dispensary – 50% of their expenses are going to be tax-deductible.

Since dispensaries are not in the business of growing and processing cannabis, they are not allowed to deduct the indirect cost mentioned above. Basically, their only deduction is the purchase of cannabis.

Tax Strategies:

Two landmark cases related to IRC Section 280E:

CHAMP v. Commissioner of Internal Revenue Service

In 2007, in the case of Californians Helping to Alleviate Medical Problems (CHAMP), the United States Tax Court allowed business deductions for the “Patient Care” portion of a medical marijuana dispensary in addition to the firm’s COGS. CHAMP with a mission to provide caregiving services, including providing limited amounts of medical marijuana. The caregiving services also included support groups, lunches for low-income members, hygiene supplies, counseling, massages, social events, and field trips. The tax court agreed with the taxpayer’s assertion that the organizations primary business was the provision of caregiving services. As such, business deductions for the caregiving portion of the business were permitted.

The CHAMP case is a precedent for marijuana businesses to argue that, by engaging in a line of legal business that does not involve the sale of marijuana; the taxpayer may deduct business expenses that are properly allocable to the legal business.

Olive v. Commissioner of Internal Revenue Service

The Vapor Room Herbal Center was a legal medical marijuana dispensary in San Francisco set up like a community center with couches, chairs, games, books, and refreshments. The Vapor Room provided patients with vaporizers at no cost with cannabis purchased in its stores or from elsewhere. Staff members discussed health with patrons and offered counseling on various personal, legal and political matters related to medical marijuana.

For years 2004 and 2005, owner Martin Olive claimed deductions on his tax returns for business expenses related to the Vapor Room. However, the IRS determined that the business expenses were not deductible.

The tax court ruled in favor of the IRS and Olive appealed to the Ninth Circuit, which affirmed the Tax Court’s decision. The Ninth Circuit stated that a “trade or business” activity is done “with the dominant hope and intent of realizing a profit.” Since the sale of cannabis was the Vapor Room’s only source of revenue, all other services were provided free of charge, the court concluded that its only trade or business is the sale of marijuana.

Olive cited to the Tax Court’s holding in CHAMP that a taxpayer can have two trades or businesses with only one of those two trades or businesses subject to IRC Section 280E if the non-trafficking portion of the business is a substantial source of revenue. The Ninth Circuit did not disagree with the CHAMP ruling but concluded that the Olive’s only “business” was selling medical marijuana because its other services were free of charge and therefore disallowed Olive’s deductions.

Other examples:

  • Gas Station that also sells medical marijuana
  • Having other products in your store that are legal
  • Vape store selling Medical Marijuana

Audit Risk

An IRS audit can be scary, expensive, and time-consuming. In an audit, the IRS will examine the business’s financial information and compare it to amounts reported on income tax returns to ensure compliance with tax laws. For most individuals, the chances of an IRS audit are somewhat low because the IRS audits only about 1% of taxpayers. When operating a small business, the chances of an IRS audit increase slightly because about 2.5% of small businesses are audited. When operating a cannabis business, the odds of IRS audit increase substantially. There are reports that 10% to 15% of cannabis businesses get audited.

Most of these audits we call “paper audits.” The IRS will send a notice wanting further explanation of a deduction.

Ways to Reduce Chance of  Audit

  • No CFA (Chartered Financial Analyst) Cost
  • Be conservative
  • Be realistic
  • No Estimates
  • Create separate entities for the business instead of filing as a sole proprietor
  • Do not consistently report a loss for tax purposes
  • Do not report excessive deductions for meals, travel, and entertainment
  • File all forms including W-2’s and 1099’s appropriately
  • File Tax forms electronically
  • File tax forms on time
  • Pay owners a reasonable salary if the business is incorporated

Banking and Oklahoma Cannabis Accounting

Form 8300

Report of Cash payments over $10,000 received in a trade or business file with the IRS within 15 days of receiving the cash payment.

Can an Oklahoma cannabis business head down to a local bank and set up a checking account like any other business?

That is a complex question…

The first step in getting a bank account is to tell the bank you are a cannabis business. Do not break this rule and pretend to be another type of company. The bank will find out and close your account immediately. This could red flag you and cause you more difficult in getting bank accounts in the future. All bank accounts, even those unrelated to the cannabis industry could be closed.

Your best bet is to talk to local banks or credit unions in your area.

Remember, from what we have heard, the cost of these accounts or relationships are high, however; it could be worth it if you are dealing with a lot of transactions.

Without access to banking, most cannabis companies depend on cash accounting. This, unfortunately, means the audit trail is difficult. Without proof, auditors can easily question whether funds came from legitimate sales or if payees exist at all, bringing concerns about money laundering.  To solve this, each transaction must be substantiated.

Your goodwill and promises are not good enough. The proof must be in the paperwork.

The Internal Revenue Service requires that all receipts contain the following information:

  • Date
  • Place’s Name and Address
  • Items Purchased
  • Purchasers Name or Initials

You must be protective of all your transactions. Keep ALL of your receipts

Taxable Entities

Sole Proprietorship

Due Date April 15th – Extend them to October 15th

Filed on the personal Tax return under schedule C

 

Partnership

Due Date- March 15th – Extend them to September 15th

File as a separate Tax return but it is not a taxable entity. All income (loss) flows through on a Schedule K-1 and is reported on the owners 1040.

Must have two owners (can not be a partnership if there are no partners)

Can have an unlimited number of partners

Each partner can have different ownership allocations based on the partnership agreement.

 

S-Corporation

  • Due Date- March 15 – extend to September 15th
  • File as a separate Tax return but is not a taxable entity. All income (loss) flows through on a Schedule K-1 and is reported on the owners 1040
  • Can be a single owner or up to 100 owners
  • Can only have one class of stock – All owners must be treated equally based on ownership

 

C-Corporation

  • Due Date- March 15 – Extend to September 15th
  • File as a separate tax return the entity is taxed on the net income
  • Income or losses do not flow through to the personal income tax return of the owners
  • Can be a single owner or unlimited owners
  • Can have multiple classes of stock. i.e. Common stock owners or preferred stock owners

LLC’s

  • Very Flexible and can be Taxed
  • Sole proprietorship Partnership
  • S-Corporation
  • C-Corporation

Entity Formation Decisions

What is nice about an LLC is that you don’t have to decide on how you are going to file your tax return until you file your return. Which means, in most cases, you don’t have to worry about it until March 15th of the following year. Even then, you can change your mind once you see how your company is operating.

There are many options as to how to tax an LLC and unfortunately, there are no black and white answers. The only way you are going to be able to see how to tax your company is to see how you are spending the profits.

In general, but not always the case:

If your company is dispersing the profits to the owners, then you will want to want to file as a partnership.

If you are paying employees, including owners of the company a wage, then you may want to file as a Scorp or a C-corp.

Right now our favorite entity type for Oklahoma Cannabis Businesses is the C-Corporation, and the reason for that is that? Because it is taxed at a maximum of 21% federal compared to an individual rate that can be as high as 37%. However, the key to making a C-corporation work is that you must pay all owners through a wage and not a dividend distribution because a dividend is not deductible to the corporation, but it is taxable to the individual. So if you are taking money out of the company as a dividend, then that money could be taxed at 21% corporate level, plus an additional 15% at the individual level and in many cases, you may be paying more in taxes than you would if you were just a pass-through entity such as a partnership or S-Corporation.

CBPOK

Cannabis Business Professionals of Oklahoma

Cannabis Business Professionals of Oklahoma is a full-service cannabis industry business association that continues to pioneer strategies and services for the Oklahoma Medical Cannabis industry. Cbpok.org’s association of Oklahoma medical cannabis businesses and professionals represent stores and dispensaries, grows, infused-product manufacturers, testing laboratories, and ancillary businesses, including lenders, landlords, CBD and hemp producers, trim companies, security providers, consultants, vendors, inventors, and packaging companies.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

27 Aug, 2019
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