As of right now, sixteen states and Washington, D.C. have legalized cannabis for recreational adult use. A whopping 36 states have laws on the books regulating medical cannabis usage. The green economy is no longer budding – it’s in full bloom.

But cannabis entrepreneurs are in a tricky situation. Though legal to produce or sell in their respective domiciled states, at the federal level cannabis is still considered a Schedule I substance. This classification presents complicated hurdles for cannabis accounting and compliance.

Additionally, cannabis companies are lightning rods for audits. We expect most cannabis businesses will be audited by local governments on revenues on an annual basis. Therefore, impeccable financial and compliance record-keeping is a must.

Bottom line: the rules are different for cannabis companies. Here’s what you should know.

Tax deduction limits under 280E

According to the U.S. government, cannabis is still a narcotic. Therefore, it is still enmeshed in federal legislation targeted toward “harder” substances. 26 U.S. Code Section 280E stipulates that businesses engaging in a Schedule I or II controlled substance (cannabis!) are barred from taking tax deductions or credits.

This means cannabis businesses must pay taxes on the entirety of their revenue. Owners are unable to claim business expenses to reduce their taxable income. 280E restrictions also extend to plant-touching subsidiary companies or those holding cannabis licenses, as demonstrated in a recent ruling against California’s Harborside, Inc. by U.S. Tax Court.

In short, cannabis entrepreneurs are locked out of valuable tax credits available to other businesses and should proceed with caution when it comes to business expense deductions.

Exclusion for Cost of Goods Sold (COGS)

According to the IRS, COGS includes the cost of the product itself, costs to ship the product, and expenses directly related to the product – it’s essentially equivalent to inventory costs. The federal tax code contains an exclusion enabling businesses to claim a deduction for the cost of goods sold, even if the goods themselves are illegal under federal law.

COGS is a valid deduction. However, the IRS definition narrows when applied to cannabis companies and right now there is no explicit definition as to what qualifies as COGS for cannabis.

Cultivators have a more clear-cut definition, including seed costs, labor costs for cultivation (which may or may not include the owner’s salary), rent, etc. But things get a bit trickier for dispensaries. In traditional industries, calculating COGS means including things like factory overhead expenses, storage costs, raw materials costs, freight costs, direct labor costs. Some states allow vertical licenses, which means a single entity is authorized to grow cannabis, cultivate the plants, then distribute an end product at a dispensary. Cannabis entrepreneurs should work closely with their accounting and legal partners to examine every element of business operations to determine where the COGS exclusion applies.

Business structuring opportunities & drawbacks

As a business owner, selecting the right legal corporate structure can minimize your tax liability and protect your assets. As with any business entity, there are pros and cons to LLCs, sole proprietorships, general and limited partnerships, C-corps, and S-corps.

Some businesses owners may choose to seek corporate taxation (either C-corp or elected as an LLC) for 280E purposes. Businesses elected as an LLC for 280E will benefit the business owner, as pass-through entities like LLCs are only subject to single taxation. LLCs are also only liable for taxes on partnership income, whether or not said income is distributed.

Cannabis entrepreneurs who anticipate an eventual IPO may find that C-Corporation status is the ideal structure. In the case of C-corps, the business owner will be taxed twice: once on the corporate income tax and again on dividends received. Investors in cannabis C-corporations should expect to pay taxes when stock is sold, or dividends distributed.

If you are establishing a cannabis company or planning to re-structure, ask your accounting partner to walk you through each corporate structure and what will mean for you and any applicable partners.

Additional important tips for cannabis entrepreneurs

Due to the limitations imposed by the federal government, cannabis entrepreneurs are subject to circumstances that do not necessarily apply to other industries. Here are some things to keep in mind:

Cannabis business license rules vary between states. For example, licenses cannot be transferred from one business entity to another. If your company operates across state lines, you will likely need to manage each state’s accounting and compliance requirements individually. Also, states have different rules governing how licenses can be transferred among business entities, so keep this in mind during expansion planning.

Circumvent the IRS’ cannabis conundrum by dividing your organization into two separate businesses. The first business would be directly responsible for producing and distributing cannabis (subject to Section 280E), but the second entity holds all activities that are legal under federal law, so as not to trigger Section 280E (ex. ancillary product sales, building management for the building in which the sister business operates, etc.)

Consider establishing a benefit corporation. Not to be confused with Certified B-Corporations (which are licensed by B Lab, an independent non-profit entity), a benefit corporation is a for-profit structure achieved by scoring high marks for social and environmental performance. Benefit corporation laws were originally established to meet the needs of business owners wishing to raise capital for growth without worrying about losing control over their business’ social or environmental mission.

Depending on your cannabis company’s purpose, there may be an opportunity to form a benefit corporation and receive the associated tax breaks as well as positive marketing shine for investors. However, benefit corporation certification is a complicated process and only available in 35 states and D.C. (not all of which permit legal cultivation or distribution of cannabis). Benefit corporations also tend to face higher levels of scrutiny (internally and externally), so pursue this path carefully with support from your accounting and legal advisory teams.

The rules are hazy by design

Though they are not directly standing in the way of states’ rights to legalize cannabis, the IRS has not made accounting for cannabis companies easy or straightforward. Much is yet to be defined and IRS guidance is still painfully slow. Unfortunately, cannabis businesses are subject to greater scrutiny, receive less guidance from the IRS, and have fewer precedents with clear conclusions. Until the rules and norms for cannabis accounting become more concrete, it’s always advisable to work closely with your accounting and compliance partners to ensure you are covering your bases as you go.

Guest Author – Ken Pun

Ken Pun is a CPA and managing partner of The Pun Group, one of the fastest-growing independent public accounting and advisory firms in the southwest United States.