Accounting Considerations for the Cannabis Industry
Presented at the West Michigan Cannabis Expo on October 5th, 2019. See the presentation outline here: WMCE Presentation
Operating in the cannabis industry requires considering many accounting issues and requirements. This presentation outlines a broad range of accounting considerations to plan for when operating a cannabis business in Michigan.
Internal Revenue Code Sections 280E and 471 (IRC §280E and IRC §471)
Operating a plant touching marijuana business means the business must consider the effects of §280E. §280E disallows expense deductions for federal income taxes. However, the code does allow an adjustment for cost of goods sold (COGS). Cost of goods means the costs required to produce or purchase inventory. Once the inventory is sold, the cost of the inventory sold may be subtracted from revenue.
Inventory costs capitalized into the value of the inventory are governed by IRC §471 for cannabis businesses. Producers, or cultivators and processors, follow a different subsection of this code than provisioning centers, or resellers. The Harborside Tax Court Case of 2018 further confirmed the IRS’s interpretation of the differentiation in §471-3.
IRC §1.471-3 Inventories at cost: 1.471-3c “Producers”. What is generally includible in COGS for cultivators and processors?
(1) The cost of raw materials and supplies entering into or consumed in connection with the product.
(2) Expenditures for direct labor.
(3) Indirect production costs incident to and necessary for the production of the particular article, including in such indirect production costs an appropriate portion of management expenses, but not including any cost of selling or return on capital, whether by way of interest or profit.
IRC §1.471-3 Inventories at cost: 1.471-3b “Purchasers”. What is includible in COGS for provisioning centers?
“In the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. To this net invoice price should be added transportation or other necessary charges incurred in acquiring possession of the goods.”
Provisioning centers can include the direct inventory purchase cost and the cost to transport the inventory to their location in COGS.
Record Keeping, Bookkeeping & Audit Trail Management
Marijuana businesses must ensure complete accounting records. Every transaction requires correct categorization and appropriate cost allocations. Thorough, compliant accounting practices help a business maintain conformance with §280E and requirements under the MMFLA and MRTMA. They also help ensure the business has reliable and useful financial information.
Consistently applying best practice record keeping and bookkeeping procedures will help ensure your business is successful in its financial regulatory obligations. Complete audit trails with all underlying source documentation and reconciliations for each accounting transaction should also be ready and available for review. Cost allocation assumptions and calculations must be reasonable and documented.
Additionally, vertically integrated businesses, including marijuana microbusinesses, also must account for separation of their activities and costs. Costs related to production of inventory in the cultivation and processing areas of the business generally are able to be included in COGS. Costs related to the provisioning or sales area of the business generally do not qualify as COGS. A marijuana microbusiness or vertically integrated facility can benefit from detailed cost separation in their bookkeeping.
Banks emerging as leaders serving the cannabis industry also require their clients to have accurate accounting records. Additionally, as cannabis banking reform works its way into law, banks are likely to require financial reviews and audits of cannabis businesses as a regular practice. Any business that does not have complete accounting processes will not pass a review or audit.
Michigan Regulatory Accounting Considerations
Michigan has three acts governing marijuana sales and use. The MMMA was enacted in 2008. Caregivers should file a tax return to claim the income they receive from their patients. Costs that can be adjusted from revenue received for a caregiver are similar to a commercial cultivator. A caregiver reports and files their income on their personal income tax return.
On the other hand, patients in Michigan pay a 6% use tax on all payments to their caregiver for their services. A patient reports their use tax due on their personal income tax return.
The Medical Marihuana Facilities Licensing Act was enacted in 2016. Under the the MMFLA, applicants submit a CPA attestation documenting capitalization. A CPA must be independent from the applicant to perform the attestation. The CPA must design procedures in conformance with AICPA statements on standards for attestation engagements. CPAs preparing attestations in conformance with these standards must participate in the state’s peer review program.
Also under the MMFLA, operating facilities undergo an annual financial statement review. Guidance released on October 3, 2019 for the annual financial statement review clarified this accounting consideration. An independent CPA will perform several procedures that require complete accounting records. The CPA will review information related to detail revenue and expense transactions. Additionally, the CPA will perform review procedures on employee payroll and tax submissions.
Finally, under the Michigan Regulation and Taxation of Marihuana Act of 2018, businesses consent to “auditing of books and records.” Reasonable accounting considerations for this requirement also justify the need for fully compliant accounting processes.
Business Risk, Longevity and Planning – More Accounting Considerations for the Cannabis Industry
Creating budgets and forecasts prior to beginning a cannabis business allows a business to consider costs and expected revenue. Always plan for the unexpected. The cannabis industry experiences higher costs in general compared to other businesses. These include additional licensing fees, compliance costs, and larger build out and capital asset expenditures. Testing compliance alone requires significant investment for a cultivator or processor.
Complete and reliable financial accounting information is necessary to properly manage assets and decision making. Cash flows for tax payments, payroll, and inventory purchases rely on accurate accounting information. Additionally, detailed reporting on financial trends and forecasts help a business determine its next steps for growth and business strategy.
Investors, lenders and banking partners also require increased financial reporting. Concerned parties like these may want to know where every dollar comes from and goes to. A thorough accounting system helps accomplish this objective.
Business exits also require full financial accounting records be in place. Additionally, marijuana businesses must have clean and reliable financial statements, including a balance sheet and income statement. An intelligent investor or financially savvy buyer will look at the financial statements and make a determination of the business’s financial strength and accounting practices.
About LC Solutions Michigan PLLC
At LC Solutions Michigan PLLC we put our focus on supporting complete and compliant accounting practices for cannabis businesses. Our firm understands the many accounting considerations and issues cannabis businesses must face. We can help you understand the complexities effecting the industry and how to best plan and react to them. Our CPAs and accounting professionals have helped hundreds of businesses manage their accounting needs while operating in the regulated marijuana industry. From CPA attestations, CFO services and business strategic planning, to bookkeeping, tax preparation and accounting system set up, our firm has the experience and knowledge to help your business implement and maintain a successful accounting environment.
Copyright by LC Solutions Michigan PLLC
October 6 2019