As we all know, Cannabis businesses are allowed to deduct only COGS on their tax returns. That brings your taxable income up and your profit down. This rule especially hurts dispensaries and distributors.
However, there are a couple of legal strategies that distributors and dispensaries can use to reduce their IRS Cannabis taxes. Below I will explain this 280E mitigation strategy.
Let's look into the IRS regulations and see if there are any legal loopholes:
Treasury Regulation 1.471-3 is what governs accounting rules for retailers and distributors, and according to it only "direct purchases, transportation, and other necessary charges incurred in acquiring possession of the goods” can be deducted.
Direct purchases and transportation costs are self-explanatory. Those are so-called COGS and they are fully deductible. But what do “other necessary charges” mean? Is there a possible tax deduction? And this is when we find this 280E mitigation strategy.
"Other necessary charges" would be costs of purchasing, safety, handling, storage, and preparing goods for sale. Basically, anything related to the procurement of inventory.
Sometimes these "other necessary charges" are easy to identify as they are separate from other charges. But sometimes, these charges are only a fraction of a total expense. For example, your rent expense includes rent for inventory storage, sales floor, and a break room for your personnel. But only a portion of the rent pertaining to inventory storage is deductible.
So, how do you separate deductible costs from non-deductible? This can be done based on hours worked and square footage used.
- You can deduct a portion of payroll costs related to inventory procurement. This means that you can deduct time your employees spent on negotiating pricing, testing/counting/weighing inventory, packaging, and preparing inventory for delivery.
- For example, if John worked 40 hour weeks and spent 8 hours each week on inventory, then the percentage of tax-deductible time is 20%.
- You can keep track of this time manually or via specialized software. And yes, you should keep exact records. As experience shows, the IRS is unwilling to accept estimates for the Cannabis industry.
- You can deduct a portion of wages, health insurance, 401k, payroll software expense, and employer payroll taxes.
- As I have mentioned before, you can deduct the cost of facilities used to store inventory.
- The best way to ensure you get that deduction is to secure a special place for inventory in your store.
- You will need to know the exact footage of your inventory storage. After you know this number, the percentage allocation remains consistent for each occupancy cost.
- You can deduct a portion of the rent, utilities, depreciation, property taxes, and mortgage interest.
Please Note: GAAP accounting is required if we want to take advantage of deduction under Section 471c. This means that cost allocation should start at the moment the payment is made. For example, your rent payment should be allocated when it was paid and not after the fact at the end of the year. This makes cannabis accounting more challenging
If all of the above flew over your head, please contact us.
Daria Nagal, Cannabis CPA