If you work in the cannabis industry, you’re likely already familiar with section 280E. It’s one of the most important tax codes that cannabis entrepreneurs and businesses must factor into their operations. Although IRC 280E is a huge disadvantage, it’s not crippling for cannabis companies. You don’t have to “beat” 280E to be successful in cannabis, but you must comply to operate effectively.
There are oft-overlooked strategies that you can put into action to maximize your return of capital. 280E doesn’t allow deductions or credits, but it does permit return of capital deductions to reduce your gross income (i.e. cost of goods sold). Leveraging these untapped strategies will also help you remain audit ready and secure when the IRS comes knocking.
IRC section 280E points to Generally Accepted Accounting Principles (GAAP). While this is a tax requirement, it really is an application of GAAP. The good news is there are multiple ways to legally, within the confines of GAAP, increase your cost of goods sold (COGS). This is known as the “full absorption” method of inventory costing and is your best strategy to squeeze every dollar you legally can into COGS.
Breaking Down Indirect Production Costs
So, what can go into your COGS? The direct material and direct labor deductions are obvious. However, this article is meant to give an overview of the not-so-obvious deductions, the indirect production costs.
The IRC breaks down the indirect production costs into three categories:
- Costs that must be included
- Costs that must not be included
- Costs that can be included if they are consistent with the entity’s recurring financials and in accordance with GAAP (Hint: This is where you’re likely missing out and where Wolf can help you.)
Costs That Must Be Included
These must be allocated to inventory, COGS, and operations/non-COGS.
- Repair expenses
- Maintenance
- Utilities such as heat, power, and light
- Rent
- Indirect labor and production supervisory wages
- Indirect materials and supplies
- Tools and equipment not capitalized
- Costs of quality control and inspection
Costs That Must Not Be Included
- Marketing expenses
- Advertising expenses
- Selling expenses
- Other distribution expenses
- Interest
- Research and experimental expenses including engineering and product development expenses
- Depreciation and amortization reported for federal income tax purposes in excess of depreciation reported by the taxpayer in his financial reports
- Income taxes attributable to income received on the sale of inventory
- Pension contributions to the extent that they represent past services cost
- Operations-related general and administrative expenses
- Operations-related salaries paid to officers
Costs That Must Follow Your Financial Reports and Be in Accordance With GAAP
If your financial reporting shows these expenses as COGS, then so can your tax return. If they do NOT, your tax return cannot! These must be allocated to inventory, COGS, and operations/non-COGS.
Please note that all the below categories have to be “incident to and necessary for production or manufacturing operations.” Basically, if any portion of the below categories has anything to do with your cultivating, processing, or manufacturing, it can hit COGS.
- State and local taxes
- Depreciation
- Employee benefit
- Costs attributable to strikes, rework labor, scrap, and spoilage – this can be huge
- Factory administrative expenses
- Officers’ salaries
- Insurance costs
Conclusion
Besides the obvious tax benefits, by applying the above full absorption inventory accounting, you can obtain better insight into the true costs of manufacturing your product and become more competitive as you price the product. Although IRC 280E may present tax challenges for cannabis cultivators, processors, and manufacturers, breaking down your indirect production costs can help you maximize your COGS while staying compliant.
It may seem like a heavy lift to account for all these costs properly as your focus naturally tends to gravitate to your brand development and revenue generation. Fortunately, our team at Wolf & Company is here to help. We offer compliance, accounting, and advisory services tailored for cannabis-related businesses so you can operate effectively as you scale your business. Let us handle the back-office headaches while you focus on your craft – contact us to learn more.
