The Minimum Every Cannabis CEO Must Understand About Finance
Running a cannabis business is tough. There is a lot to learn, especially if it’s also your first business. The financial side of things, in particular, can be really scary. You might even be tempted to ignore it until tax time. Protip: That’s generally a bad idea. But you know that, or you wouldn’t be reading this. You can’t go too far the other way either, though. You’ve got better things to do than trying to worry about every single tiny detail. So, here is my quick primer on the absolute minimum that you need to understand about the financial side of your business if you want to be successful. Because, that’s what we all want, right? We all want to be successful and grow our businesses….and maybe a little green too. So, what do you really, and I mean really really, need to know about finance in order to have a chance at success? Let’s start with a general one:
1. Financials Drive the Business, Not the Other Way Around
It’s easy to get lost in the motions of running a business: Plant, grow, harvest. Source, process, distribute. Order, stock, sell. Whatever it is for you and your business. You spent a lot of time and effort creating these processes, and now that you’ve got them going, you want to keep them going. Like that guy spinning plates, you can’t step too far away or it might all come tumbling down.
Babysitting these processes seems like the most important thing right now. But, it turns out, that’s the worst possible thing you can do. The most successful business people don’t get deeply, intricately involved in the running of their businesses. Or when they do, they don’t stay there.
That’s because it’s a heck of a lot easier to make decisions if you can see the whole picture at once. And you know the best way to see the whole picture??? Financial statements! ….You thought I was going to say something sexier, didn’t you? Sorry.
Financial statements give you big picture information on your business. You can then use that information to make informed decisions. And later, after everything has settled, you can use the changes that show up on your financial statements to find out if you goofed or not. You wouldn’t drive without looking at your car’s instrument panel, so why would you make decisions about your business without looking at its dashboards first? Of course, that’s true for any business. You also need to know the ways the cannabis industry is different from others. The biggest way is 280E.
What is 280E? It’s a small part of the IRS code that states that any business involved in the “trafficking” of a schedule I or II controlled substance cannot deduct its expenses the way that every other business can. And unfortunately, as of this writing, this includes all “legal” cannabis businesses. Yes, it sucks. But, “luckily” there is a small loophole hidden in 280E. Personally, I suspect that it was accidental and would have been too tough to fix, so they left it. But, they did leave it, which means we get to use it. Yay!? Should we be happy or not?
The loophole is that you can still deduct something called your “Cost of Goods Sold” (hereafter referred to as COGS, because that’s fun to say).
What are COGS? COGS are the costs specifically related to buying or producing the product that you are selling. So, if you buy something for $5, spend $10 processing it, and then sell it for $50, your COGS was $15 and your profit was $35.
You, as a cannabis business owner, get to pay taxes on that full $35. Every other business in the country gets to deduct any other business expenses they have. They only pay taxes on the true profit of the business. That’s not fair! Having to pay more taxes than any other business sucks, but at least you still get to deduct COGS. And, we can make it suck less by calling as many of your expenses COGS as possible. Now obviously you can’t do this with everything or 280E wouldn’t suck. So how do you know which expenses you can call COGS?
Who gets to say what you can include in COGS and what you can’t? Well, the IRS thinks they can, for some reason. There are two different parts of the tax code that list what you should include in your COGS: 263A and 471. Most businesses use 263A because the list in it is longer. But, as we all know, cannabis businesses aren’t most businesses. It turns out, 263A was written after 280E. So, if 280E applies to you, you don’t get to use 263A…boo. ?It’s a non copyright violating Boo. ?
Also, 263A has some language in it that the IRS has interpreted to mean that you can’t use it as justification to deduct something that you wouldn’t otherwise be able to deduct. So, even though 263A specifically lets you include certain costs, if 280E says you can’t, you still can’t, no matter what 263A says. That means cannabis businesses have to look to the older 471 section of the code to figure out what you can include in COGS. The code has sections for different types of businesses. Your cannabis business can be a ‘producer’ who grows or processes product and then sells it to a reseller/distributor (471-3 and 471-11 applies), or it can be a ‘reseller’ who sells product directly to the public (471-3 applies).
You and your cannabis financial expert will need to sit down to review the code and create your personalized plan, but as a rule of thumb:
- You can always include any costs directly related to producing, acquiring, or processing the product you are going to sell – seeds/clones/flower, growing supplies, labor to prepare product for sale, etc.
- You can pretty much never include any costs directly related to the actual selling of the product – sales labor, marketing, advertising, etc.
- You can sometimes deduct costs associated with generally running your business – licensing costs, insurance, executive salaries, etc.
The real magic comes from finding expenses in that third category and figuring out how to include them. You’ll want to sit down with a trained financial professional (à la moi) to create your plan, though, so that you end up with something that is both legal and workable.
There has to be a way to deduct more than just your COGS, though. Right?!? Well, maybe not. But if you are a reseller, and you sell both cannabis and non-cannabis products, there may be something else we can do.
A business called “Californians Helping to Alleviate Medical Problems” (CHAMP, get it?!?) went to court with the IRS over their deductions. CHAMP argued that while they did indeed sell cannabis, and thus would not be allowed most of their deductions due to 280E, they also sold another product, an entirely legal product: the care and training they provided to their clients. So, the IRS allowed them to separate their business into essentially two businesses, one that sells cannabis and one that provides treatment. AND the treatment part of the business was allowed to take all of the regular deductions! That’s huge!
There are a few requirements that you’ll need to meet if you want to take advantage of this strategy, though. The non-cannabis part of the business has to be able to stand alone as a real deal business. You have to prepare regular financial statements that show you treat it as such. And, you’ll need to have a written, justified reason for how you divide any costs that impact both parts of the business.
A few cases that went to court have gone against businesses that tried to do this because they didn’t do a good job of keeping up their bookkeeping. So, if you decide to go this route, make sure you’re going to do it right or it might all be a waste.
5. Uncertain Future
We all know that there are risks involved with the cannabis industry. At the least, you’re risking that your business won’t be profitable enough to pay the taxes it owes.
That right there is a higher burden than any other business has to carry. But, the whole industry has a very uncertain future. And, I’m not just talking about what if the feds decide to crack down. Though, there is still the chance that could happen.
Probably not, though. It’s looking like federal legalization is going to come at some point. But, there are several paths it could take, and most of them have some significant downsides.
For example, a first step many suggest is moving cannabis from a Schedule I to a Schedule II controlled substance. That would allow for more research to be done on the health benefits of cannabis. But, the real world result would be that current businesses would see an increase in the amount of federal regulation…and it wouldn’t even get rid of 280E!?!
What if they remove it from the controlled substances list entirely? That would get rid of 280E. But, cannabis will still be regulated as something…a drug? A food additive? It’ll be something. And that is going to come with additional regulations and requirements you will have to meet. Are you ready for FDA audits? This industry has an uncertain future at the moment, and you need to be fully aware of that. If you’re not comfortable taking the risk that things might go terribly awry before they get better, this might not be the right industry for you just yet.
Speaking of audits, you also need to know that an IRS audit is a real risk for a cannabis business. For most businesses, audits are relatively rare and often are triggered by specific suspected violations, but not so much in the cannabis industry. There are a few reasons for that. Due to banking issues, many cannabis businesses deal with lots of cash, which is always a red flag for the IRS. Also, you’re dealing with 280E, so you’re already admitting to doing something illegal (in their eyes at least). It’s not cool, but it does make sense that you’re going to get a little more scrutiny than other businesses. So, since the odds of getting audited are much higher, you need to have a plan in place to help you get through. Just in case.
What’s the best way to get through an audit? Have all of your ducks in a row. That means having documented processes, following them rigorously, and keeping everything up to date.
I know that might sound too simple. And you might be the type that thinks I’m a sucker for even suggesting such a thing. But, I assure you, the one real trick to surviving an audit is to already be following all of the guidelines that you’re supposed to and have proof that you do. That takes more than just figuring out the right numbers at the end of the year, though. That means you need to produce the monthly statements. You need to save the receipts. You have to really and truly justify all of your expenses. That might seem like a lot of busy work. But, if (when) you do get audited, you’ll be glad that it’s already done. There are lots of other great benefits to having your financials all lined out, too. Should you find yourself in a situation to sell your business, you’ll be all set. And, of course, you get to use the financial statements to make informed decisions for your business in the meantime.
Running a cannabis business does have its quirks, but at its heart, it is a business like any other. You need to use accurate financial information, in addition to your gut, to make decisions. If you don’t, you’re just guessing at the best moves to make.
But you’ll also need to understand the specifics of the industry. Particularly, 280E and how it screws you. If you understand it, you can make use of the legal ways to compensate for it. And in order to do that, you’ll also have to understand how to determine what you really can and can’t include in your COGS.
And, if you’re a reseller, you should understand the C.H.A.M.P. decision and how you might be able to leverage that in your own business. But, remember, don’t try to do it if you aren’t going to back it up with documentation and processes that you’ll actually follow.
While the future in this industry is uncertain, the chance of getting audited isn’t. But, if you’ve been creating, documenting, and following your processes all along, you’ll get through it just fine. And, maybe, your business will be one of the ones that succeeds and blazes a bright future in the industry.
If you’d like some help taking your business to the next level by setting up, streamlining, or maintaining your financial systems, let’s talk.
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