June 01, 2021

short intro to cost accounting for cannabis businesses

26 U.S. Code § 471 a rule is a general tax rule that states that accounting for inventory should be according ”to the best accounting practice in the trade or business and as most clearly reflecting the income” For cannabis businesses, this means accrual cost accounting that is done in the day-to-day Accounting. It also means strict rules that disallow many operating expenses to be included in COGS. Everything besides COGS deduction gets disallowed on the cannabis tax; this brings down taxable income and increases tax liability. As a result, many CPAs wonder if they can get away by applying the 471c rule.

Section 471c allows companies to create their own method of cost accounting, as long as the taxpayer has less than 25 million in sales and is not required to maintain applicable financial statements. This means that cannabis CPAs are allowed to make adjustments to COGS. This also means that CPAs can classify some of the operating expenditures as inventoriable costs. These expenditures will be capitalized into inventory and then would reduce taxable income as the inventory was sold. Section 471C does not eliminate Section 280E completely. However, it is a good way to significantly reduce tax liability.

Cannabis CPAs disagree on whether they are allowed to apply Section 471C to the cannabis industry. The IRS has not issued proper guidance on the issue and it all comes down to the level of risk tolerance of accounting professionals and their clients.

So, what are the major points of the least favorable but the safest 471a rule? Here they are:

1.       Cultivators refer to the IRS rule 471-11 that requires GAAP if you want to maximize what's included in COGS. Taxpayers can account for their cost accounting by either Burden Rate, Standard Cost, or Practical Capacity methods.

2.       Dispensaries and distributors refer to the IRS rule 471-3. For them, COGS is the cost of product plus costs of transportation plus costs (labor and overhead) to get the inventory ready for sale.

3.       Operating expenses cannot be added to COGS unless they relate to inventory. Such direct costs as purchasing and handling wages, depreciation of inventory equipment, packaging, and printing can be allocated to COGS. However, such expenses as bank service charges, licenses and permits, and continuing education do not touch inventory and cannot be included in COGS. Some expenses can be partially allocated to COGS based on square footage and hours spent on inventory procurement.

4.       Cost accounting for cultivators is especially labor intense and complicated because their inventory cycle includes several stages: growth, harvest, drying, trimming, curing testing, and finally selling. However, since most of the cultivator expenses touch inventory, they can deduct most of their operating expenses.

5.       Cost accounting for dispensaries and distributors’ is less stringent. However, they miss out on many tax deductions. Such expenses as marketing, bartender wages, legal fees do not deal with inventory and cannot be deducted.

For further information please Daria Nagal, California Cannabis CPA