Tax Advice for Cannabis Entrepreneurs

David McNew / Getty Images

Businesses in the medical marijuana and cannabis industry face unique and often daunting tax problems. Tax problems can be dealt with, as long as cannabis entrepreneurs take some time to implement and strengthen their bookkeeping and accounting practices.

What are the Primary Concerns that Medical Marijuana Entrepreneurs Have on Their Minds?

"They want badly to come over the table," says Henry Levy, a certified public accountant in Oakland, California, who has specialized in serving the cannabis industry for over 15 years.

More often than not, the client needs to do some homework before they can start digging into tax issues. While they may be very sophisticated about marijuana, entrepreneurs usually "know nothing about business." In fact, most marijuana entrepreneurs, when they come in for a meeting, ask, "Tell me about how I operate a business in my field."

What Do Cannabis Entrepreneurs Need to Do First to Get up to Speed?

Get organized. Medical marijuana entrepreneurs need to "understand the importance of bookkeeping," Levy says. Get set up with accounting software, learn how to set up a chart of accounts, and reconcile bank statements each month. These are core business skills that apply to all businesses, not just businesses in the cannabis industry.

Ask your accountant for help setting up these tools and processes. Then actually start to do those accounting processes. Then follow up with your accountant in a couple of months.

That way you'll have a lot more to talk about.

"How good your accounting is, is critical," says Levy. It is the core foundation on which we can do tax planning.

Next: Choosing What Kind of Legal Entity You Want Your Business to Be

Here, cannabis businesses need to do their due diligence. This involves:

  • Reviewing state laws and policy guidelines,
  • Knowing city and county laws,
  • Figuring out what permits or business licenses they need,
  • Check what your state's Secretary of State or local city is saying about running a cannabis business.

Sometimes, a city or state will make definite recommendations or requirements about what form of entity a cannabis business must be. So understanding those state and local requirements is crucial.

Of all the factors that go into choosing the right legal entity, "the most important is state guidelines, which emphasize operating in a 'not-for-profit manner,'" Levy explained. "So this would indicate either a non-profit corporation or a cooperative.  However, we are also now seeing 'B' corporations in this space.   As long as Internal Revenue Code Section 280E exists, the entity chosen should definitely NOT be a passthrough entity." (A "B" Corporation is a benefit corporation, which is a special type of corporation authorized at the state level.)

Tax Issues Around Executive Compensation

Understandably, business owners are concerned about how to pay themselves for their hard work and investment in the business. Depending on the legal structure of the business, owners can get money out of the business through a combination of salary, dividends (in a C-corporation), or distributions of profits (in S-corporations and partnerships).

I note that Mr. Levy is advising cannabis entrepreneurs to stay away from passthrough S-corporations and partnerships. Even so, a large part of business tax planning revolves around designing how to compensate the business owners in a tax-efficient way.

For marijuana entrepreneurs, the same questions and issues exist. But there is an additional factor to consider. If the business is required to operate as a non-profit organization, for example, the entrepreneurs need to be careful about how much salary they earn. That's because too high of a salary could violate state-level tax laws against personal inurement.

(Personal inurement occurs when too much of the non-profit's income goes to benefit specific individuals).

"There are no clear guidelines how much executives can make," Levy explained by email. "The state guidelines do not want executives to make unreasonable compensation, but no one knows how much that is. Retail businesses are difficult.  But there is definitely money to be made in this industry."

What federal tax issues are specific to the cannabis industry?

Now, after having sorted all this out accounting processes and choice of legal entity, cannabis owners need to be aware of the following special rules.

  • They can deduct the cost of goods sold.
  • They cannot deduct any other type of business expense.

Most Expenses are Not Tax-Deductible

Unlike any other type of business, marijuana-related businesses cannot take a tax deduction for any of their ordinary and necessary expenses.

They can deduct their cost of goods sold. This includes the cost of all inventory sold during the year.

But other expenses, such as rent and supplies and professional fees, cannot be deducted against their federal income tax. The relevant tax law is section 280E of the Internal Revenue Code. "280E is an exception to the general rule of writing off their ordinary and necessary business expenses," Levy said. This code section applies only to persons or businesses engaged in the trafficking of controlled substances, namely Schedule 1 and Schedule 2 substances.

In summary, here's what to talk to your accountant about:

  • How to set up your accounting and bookkeeping system.
  • What rules and regulations (federal, state, county, city) apply?
  • What permits and licenses do you need?
  • What fees and taxes are you responsible for (income tax, sales tax, city business licensing fees, payroll, and so forth)?
  • What forms of legal entities are possible?
  • Which of those forms of legal entities make the most sense?
  • How do you structure compensation and benefits?
  • What accounting and tax reporting responsibilities do you have?
  • What do you need to see an attorney about?
  • What sort of year-round and year-end tax planning tactics work best for you?