As legalization continues to spread across the United States and around the world, the cannabis industry will continue to grow at breakneck speeds. In fact, the global legal cannabis market worldwide is expected to reach a stunning $146.4 billion by 2025.
Moreover, as money keeps flowing into all these new cannabis businesses, it’s crucial smart financial practices are in place. Those who fail to be in compliance with the strict, complex regulations will find themselves at risk of steep penalties or even a shutdown. As a result, knowledgeable accountants are in very high demand to ensure all these companies stay afloat.
While the cannabis niche can be very lucrative, it can also be difficult to navigate at times, as there are many intricacies accountants don’t have to face in other fields. Here are the top three pitfalls to watch out for.
1. Letting the CEO Call All the Shots Around Accounting
Cannabis businesses require world-class accounting and governance to properly navigate the complex and intricate regulations that surround them. CEOs may think they can handle it on their own and just hire a bookkeeper who isn’t trained in cannabis cost accounting, but this will come back to haunt them if they are audited.
The truth is, most cannabis businesses are handling their accounting wrong. Cannabis is one of the most tightly regulated industries in the US, and companies must be ready for an audit at any moment. That’s why it is so crucial to have high-quality accounting professionals take care of all the complicated financial tasks, including cost accounting, consolidations and GAAP (Generally Accepted Accounting Principles). Without this, the business could easily be shut down by the government for not being in compliance with local and/or national regulations.
2. Not Having Solid Financial Tools and Processes in Place
Cannabis businesses require proper accounting tools that are tailored to them specifically. Unfortunately, the most popular programs out there simply don’t have the tools or templates, making the accounting process more complex and confusing. Without the proper tools and processes in place, it is easy for companies to make a mistake and become non-compliant with state and federal accounting rules — and one little mistake could spell disaster for the entire business.
Cannabis businesses need plenty of tools and processes to keep them organized and compliant, including: proper cannabis chart of accounts, monthly counts/reconciliations of inventory and daily counts/reconciliations of cash, detailed month-end close workpapers, cannabis-tailored cost accounting workpapers and processes, tax return cost allocation workpapers, a system to collect monthly WIP percent complete, estimated yields and full cycle info.
Having these detailed systems in place means it will be easier to keep track of finances, take full advantage of available tax deductions and, most importantly, ensure the business is compliant with all industry regulations.
3.Thinking IRC 280E and IRC 471 are Codes to “Beat”
A lot of people in the cannabis industry believe they can implement strategies to “beat” the strict rules and regulations that businesses in this niche must follow, such as IRC 280E and IRC 471.
IRC 280E is a federal regulation that states legal cannabis businesses cannot claim normal business deductions like administrative costs, marketing expenses or rent, since cannabis is still considered a Schedule 1 substance at the federal level. The one thing these companies are allowed to deduct, however, is “cost of goods sold” (COGS), as COGS is part of the taxable definition of Taxable Income.
To try and reduce their taxes, businesses in the cannabis space often increase their COGS to absurd amounts, set up a web of related non-cannabis entities and move costs around and/or have a non-cannabis division of their operation that sells merchandise like T-shirts. While these strategies can bring value if done correctly by an experienced accountant, the reality is the vast majority of cannabis entities are doing them wrong — and many CEOs aren’t even aware of the big risks that come if these strategies backfire, such as getting hit with double tax income.
In short, accountants and CEOs in the cannabis sphere should not focus on “beating” the IRS, as the agency is well aware of these strategies and has been severely cracking down on cannabis entities that try and get around paying their taxes. With a high-level accountant, however, companies can reduce their taxes and save thousands of dollars each year without getting in trouble with the law.
Let’s face it — cannabis accounting is tricky, and the rules are always changing. This is a massively underserved market by large accounting firms, and there is a huge need to serve this industry right — literally billions of dollars are on the table.
For accountants looking to provide services to cannabis entities, as long as you are knowledgeable enough to avoid these pitfalls, you will be providing an invaluable service to your clients.
Andrew Hunzicker, CPA is President of CFO Bend, currently serving cannabis companies in every vertical, in 4 states. Additionally DOPE CFO teaches Accountants, Bookkeepers, and CPAs how to successfully enter this industry with a complete DIY "accounting practice in a box" training program.