Companies that grow, produce, sell, and distribute marijuana are just like many other manufacturing organizations, from an operational and financial perspective. Dispensaries and growing facilities have revenues, cost of goods sold (direct and indirect costs), and selling general and administrative expenses (SG&A). However, there are drastic differences that govern the taxation of a traditional manufacturing and distribution company versus one that is involved with the cultivation and sales of marijuana. Marijuana is a Schedule I controlled substance under the Controlled Substances Act, which means that only those costs identified under the Internal Revenue Code Section 280E, IRS Chief Counsel Advice 201504011, and IRS regulations under IRC Code Sec. 471 as written in 1982 when IRC Sec. 280E was ratified, are permissible deductions under the federal tax code.
Simply stated, companies that grow and sell marijuana may only deduct those costs directly related to the production of inventory that is being sold, i.e. cost of goods sold. All other costs incurred or paid in running the business are impermissible and nondeductible. However, there are a few things from an accounting perspective that may alleviate some of the tax burden. It is important to work with accountants that fully understand the legal framework guiding the taxation of a marijuana business. For example, there are many indirect costs associated with maintaining and storing inventory that may be allocated to cost of goods sold in addition to the direct costs of growing and cultivating marijuana. Some of the indirect costs that may be allocable to cost of goods sold include a portion of repairs and maintenance, utilities, rent, depreciation, and supervisory wages, provided those costs are necessary and incidental to the manufacturing operations of the business. In order to allocate indirect costs, it is important to perform an analysis of various indirect expenses with an accountant who understands the laws and regulations so that the expenses are adequately substantiated in the event of an IRS audit.
“For example, there are many indirect costs associated with maintaining and storing inventory that may be allocated to cost of goods sold in addition to the direct costs of growing and cultivating marijuana.”
Lastly, depending on the magnitude and materiality of expenses a business in the marijuana industry incurs, it may be beneficial to have financial statements prepared under generally accepted accounting principles (GAAP) in order to absorb even more costs into the cost of goods sold calculation. Financial statements prepared on the GAAP basis method are the standard for businesses who must report their financial statement results to the Securities and Exchange Commission (SEC). While it is not common for a marijuana grower or retailer to have financials prepared on the GAAP basis, it may prove to be economical provided that additional costs such as taxes (other than income based taxes), employee benefits, administrative expenses associated with production, and insurance costs may be deductible on top of what would be permissible under the IRS code sections and regulations mentioned above.
It is crucial for a business undertaking in the marijuana industry to operate within the legal parameters and have accurate financial statements. In addition, the substantiation of expenses is vital in order to have a defense in the event of an IRS audit, which is exceedingly difficult for many businesses that are unable to obtain a bank account. The lesson here is to tread carefully, and choose an accountant carefully who knows the rules.