I have heard the following statement many times in the cannabis industry, “I don’t want any inventory at year end because then I have to pay taxes on it.” I understand how this statement can be believed, but I want to dispel this misconception. To begin with, taxes are not levied on inventory, taxes are levied on the sale of inventory.
Most people have always been cash basis taxpayers: when cash comes in, it is recorded as income and when cash goes out it gets recorded as an expense. Pretty simple. However, because of IRC Section 280e, businesses in the cannabis industry cannot afford to be cash basis taxpayers; they must become accrual-based taxpayers.
The difference between the two types of taxpayers is when income and expenses are recorded. For accrual-based taxpayers, income and expenses are recorded based on when the economic transaction takes place rather than when cash is exchanged. In this post, I am going to walk through a simple transaction to demonstrate how a cash basis taxpayer would end up paying considerably more taxes in the cannabis industry.
For simplicity, lets assume that payment is made immediately when a sale or purchase is conducted. When inventory is purchased, cash goes out. To a cash-basis taxpayer, that cash outflow becomes an immediate expense. Conversely, for the accrual-based taxpayer, that cash outflow is recorded as an asset called inventory. To demonstrate how the difference appears on two of the financial statements, income statement and balance sheet, let’s assume the following facts:
You will notice that I have 2 columns for allocations: percent allocated to preparing product for sale and percent allocated for Sales and Admin. In accrual accounting, some expenses get allocated to the cost of inventory (these percentages are made up for this example – in real life there is a method to determine these percentages). In cash accounting, 0 expenses get allocated to inventory because inventory is expensed right away rather than recorded as an asset.
This is a crucial calculation in the cannabis world, and you will see why. Remember, the only expenses a cannabis business may deduct is the Cost of Goods Sold (CoGS is technically considered a return of capital rather than an expense or deduction). The columns to the right, are the allocation calculations determining how much of those expenses may be allocated, and capitalized, to the cost of the inventory. A cash basis taxpayer does not make these calculations because they expense the inventory right away.
Lets look at how the difference in recording methods impacts the income statement, balance sheet, and taxable income.
Assuming the IRS does allow the entire product purchase of $2,000,000 to be written off in year one, which they will not, it appears as though the cash-basis taxpayer is much better off with taxable income of only $500,000 as opposed to the accrual-based taxpayer with taxable income of $1,154,068. In year 1, the cash-based taxpayer pays $150,336 less than the accrual-based taxpayer.
Lets see what happens in year two. In order to keep this example simple, we will also assume that no other inventory is bought. Assume the company sells the remaining product in year 2 and that all other facts remain the same:
In year two, the cash basis company has $0.00 cost of goods sold expense because 100% of it was expensed in year 1. The accrual-based taxpayer again allocates additional allowable expenses to the cost of their inventory. Now look at taxable income. In year 2, the cash basis taxpayer has taxable income of $1,500,000 whereas the accrual-based taxpayer only has $674,953 in taxable income. In year 2, the cash-based taxpayer pays $173,260 more in taxes than the accrual-based company. Over the two years, the cash-based taxpayer ends up paying $22,924 more in taxes.
So, even if a cash basis taxpayer would be permitted to deduct 100% of their inventory in year one as a Cost of Goods Sold, in they long run, this taxpayer would still end up paying more in federal income tax. This is an extraordinarily simplistic model, but it demonstrates the point of how a business can pay much higher taxes without proper accounting techniques. It pays to work with a financial professional who understands the impact of IRC Section 280e and who knows how to implement IRC section 471 (inventory accounting) in order to minimize your cannabis business income tax.