The legality of cannabis has been heavily debated in the United States as federal and state laws attempt to legislate its use. Recently, state laws have begun to open doors to legalizing cannabis for recreational and medical purposes at the state level; however Federal government still considers it a Schedule 1 controlled substance under the Controlled Substances Act (CSA).

The discrepancy between the federal and state laws regarding cannabis status places businesses in this industry in a fix with significant challenges, pitfalls, and compliance issues. Cannabis businesses must be very cautious in filing taxes, be prepared for potential IRS audits, and abide by Section 280E compliance.

Understanding Section 280E & The State Policy 

Section 280E of the Internal Revenue Code, enacted in 1982 during the War on Drugs in the US, prohibits taxpayers trafficking certain controlled substances (such as marijuana) from deducting typical business expenses associated with those activities.

Marijuana is classified as a Schedule 1 controlled substance under the Comprehensive Drug Abuse Prevention and Control Act of 1970, 21 USC §801–971 (1970) (Controlled Substances Act or CSA).

By preventing the deduction of ordinary and necessary business expenses, such as below-the-line deductions, after reducing gross receipts by the cost of goods sold, or COGS, Section 280E punishes traffickers of Schedule I or II drugs by making federal income tax obligations based on gross income rather than net income. The result is that most cannabis businesses pay heavy taxes, ranging from 40% to sometimes  80% of gross income. 

However, despite heavy taxation, the cannabis industry continues to expand.  Market statistics predict both the legal and illegal cannabis business industry will continue to grow.  The legal portion of the industry is estimated to be larger than $14 billion. 

To support the cannabis industry, states like New York, Colorado, Oregon, California, and Massachusetts are adding new sections to the taxable net income and gross income exception list.

Recently New York passed its 2023 budget on April 9th. The budget appears as the savior for the New York cannabis businesses, allowing them to take deductions for business expenses and claim credits at the state level. The NY law will boost the state cannabis business and help them save taxes.

In a tiff between federal and state laws, cannabis businesses must be very decisive in the choice of entity, accounting methods, and ownership structure. These decisions are vital as they have a significant impact on risk management.

If a cannabis business is not structured wisely and in compliance with the state laws and 280E, the tax rates might exceed the profits pushing the company into a loss.

Let’s dig deeper to learn how cannabis businesses must manage their financial structure, tax compliance, accounting, and strategy.

Cannabis Auditing

An audit is an in-depth review of the business’s financial records, management, inventory, taxation, and federal and state laws compliance. Audits ensure cannabis businesses stay up to date with the tax and legal necessities of the company. 

Internal audits of cannabis businesses allow companies to ensure Environmental, Health, and Safety (EHS) compliance, including risk assessments, industrial hygiene, spill prevention, chemical reporting, air emissions, emergency planning, and more.

Outside audits include audits of cannabis businesses by EHS-related federal or state government agencies with jurisdiction over the cannabis companies. These agencies are OSHA (Occupational Safety and Health Administration), EPA (Environmental Protection Agency), and State environmental agencies.

Cannabis Business Valuation

The cannabis industry is proliferating, as are related business mergers and acquisitions. As a result, understanding the cannabis industry continues to expand; business owners should consider third-party valuations of their companies to prepare themselves for the future in case of financing needs, capital raises, and sale opportunities. 

Obtaining a valuation will assist businesses in attracting investments, making better business strategies, and mitigating risk factors. Moreover, a valuation will provide ownership insight into the marketplace, factors influencing the market, and the actual company value. In addition, valuations will help them understand their competitors and compare their profitability with theirs. Finally, valuations include an in-depth analysis of the company’s finances, operations, and regulatory and tax compliance.

Preparation of a meaningful cannabis business valuation is challenging due to the volatile industry nature.  Hence, it is essential to engage a knowledgeable industry specialist.  A professional valuation expert should have an in-depth knowledge of the cannabis industry, its verticals, and nuances like manufacturing, retail, and more.

A valuation specialist analyses financial statements to understand forecasted profits and revenue. They also review assets, licenses, quality processes, risks, and regulatory compliances. In addition, a valuations specialist understands external factors, market sentiment, and other conditions that might affect the company’s performance.

To come up with an accurate valuation, the specialist reviews several company documents like financial statements, tax returns, legal documents, licenses, customer lists, staff rosters, business plans, and records of physical assets. Once they have gathered all the information and data, they might also ask for meetings with the company’s stakeholders and executives. 

The valuation specialist then moves forward to analyze the data, typically utilizing  three valuation methods:

Income approach – Based on the predicted future earnings of the company

Asset approach – This strategy is based on the fair market value of all the company’s assets, less its liabilities.

Market approach – The stock prices of publicly traded corporations or recent selling prices of similar businesses are used to determine value.

The valuation specialist might take 4 – 6 weeks to provide a detailed report. The detailed report contains findings, a  business value expressed in dollars, and factors that led to the value conclusion. 

Internal Controls For Cannabis Businesses

Internal controls are processes and procedures a company implements to ensure financial credibility, better accounting, avoid fraud, monitor employee integrity, improve operational efficiency, and address regulatory concerns.

Unfortunately, many cannabis businesses overlook the value of maintaining strong internal controls as they focus more on expanding their business. However, there is also a lack of consistent government regulations that necessitate the need for an internal control mechanism. 

Internal controls, if implemented appropriately, will help cannabis businesses enhance their performance, update accounting and on-time financial reporting, safeguard their assets, and increaseprofits. 

There are several controls that a cannabis business can implement in business operations. However, these controls can be time-consuming and costly. 

Alternatively, there are some cost-effective controls as well that can benefit cannabis business owners. They are physical audits of inventory, monthly trail balance reconciliations, and three-way matches.

Physical Audit of Inventory

Legalized marijuana businesses must utilize mandatory state tracking software to track their inventory. It is a “seed to sale” software where cannabis companies input data regarding the manufacture and sale of goods. 

Often this software is outdated and difficult to use, frustrating company employees charged with its proper use. Unfortunately,  any misstatement or wrong info entered into the software could lead to license cancellations, fines, and penalties. 

The mandated software complements regular physical inventory audits to manage inventory and assets adequately. Combining internal physical audits and software management also adds to employee accountability and an internal understanding of the business model. 

Inventory audits assist in accurately preparing the cost of goods sold and inventory entries to help with  IRS 280E compliance.  That is why it is crucial to get these numbers correct. 

Monthly Trial Balances

A general description of monthly trial balances would be frequent reconciliations of primary accounts. The trial balance is a financial statement that shows the final balance for each general ledger account. Accordingly, it gives the sum for each account’s asset, liability, equity, revenue, expense, gain, and loss.

The month-end closing procedure includes running the trial balance. The report’s primary purpose is to check that all debits and credits add up, indicating that there are no unbalanced journal entries in the accounting system that would prevent the production of correct financial statements.

There are several benefits of running monthly trial balance reconciliations. Firstly, it ensures that your account history matches perfectly. Secondly, it equips the accountants to prepare accurate accounts, including depreciation schedules.

Depreciation is a crucial factor to consider while deducting taxes. Companies in the cannabis industry are only permitted to depreciate “non-cannabis” assets. Management can facilitate depreciation expense by preparing accurate monthly reconciliations,  providing visibility into the assignment of “cannabis” and “non-cannabis” fixed assets.

Three-way Method

The three-way method is another effective control procedure in the cannabis industry. It is a preventive control that helps in avoiding fraud and theft. The three-way method verifies the received goods and handles the accounts payable function. 

The three-way method includes the analysis of three key documents: the purchase order, packing slip, and vendor invoice. The simple theory behind this control is that accounts payable do not release payment to the vendor unless it matches the before documents. 

Though the three-way method seems a simple and small step in managing accounts, employing it ensures that your business does not easily fall prey to fraudulent invoices.

Regular audits, internal controls, and accurate valuation are vital in running a successful cannabis business. However, these are the bare minimum procedures that business owners must employ to ensure government regulatory compliance, financial credibility, smooth business management, and growth.

Steve Andrews

I ardently advocate for banks of all sizes’ positive role in supporting and building local communities, funding businesses, and supporting local economies. Currently, I am acting as an adviser to Beacon Business Bank.

As an advocate for the financial industry, I believe raising your voice for a cause or a policy you believe in is important. Over time the changes we want to see in the financial industry often transpire or are accompanied by changes in legislation. Therefore, it is important to advocate for the change you want to witness and experience.

The industry is actively innovating and experiencing social change. It is an exciting time to be a participant in the process. As the financial landscape changes, I look forward to experiencing the innovation created by both banks and new FinTech entrants pushing financial evolution. I plan to be an active participant in the exciting times that lie ahead for the global economy and the ensuing ride of change.