Green Frontier

November 20, 2018

What CPAs Should Know About Cannabis Clients

By Matthew Martin, CPA
Cannabis is a more than $5 billion industry in California—and is expected to grow to as much as $23.3 billion in the first five years, post-recreational legalization. Nationally, some sources say this could easily be a $1 trillion industry in the near future. There are 33 states that have legalized the use of cannabis in some form, and the Food and Drug Administration recently approved Epidiolex to be the first pharmaceutical drug composed of an active ingredient derived from the cannabis plant. 
Practitioners considering working with this industry have many specific items to consider when offering services.

Brief History
On Nov. 8, 2016, California passed Proposition 64, known as the California Marijuana Legalization Initiative, or the Adult Use of Marijuana Act, which allowed for cannabis use by adults (21 and older) without the need for a medical recommendation. The law was designed to give local jurisdictions a large amount of control by requiring a local license before a state license could be applied for. Each locality has developed its own licensure policy and basis for determining local taxes.

Federal Regulation, Case Law & IRS Guidance
Cannabis is a Schedule I drug as defined by the Federal Controlled Substances Act. As such, any trade or business connected to the sale of cannabis is subject to IRC Sec. 280E, which states: “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”

IRC Sec. 280E essentially eliminates the deduction for all ordinary and necessary deductions incurred by businesses deemed to be trafficking a Schedule I narcotic. The recovery of capital doctrine protects cost of goods sold from being subject to this code section. Therefore, inventory accounting and determination of the correct cost of goods sold is extremely important for tax purposes in the cannabis industry. It’s important to note that the IRC does not include any definition of trafficking and that the courts have looked to the dictionary definition for clarity.

There are five major court cases that practitioners must look to for guidance: 
  • Californians Helping to Alleviate Medical Problems, Inc v Commissioner; Martin Olive v Commissioner: Centered on establishing separate business activities, specifically cannabis and noncannabis activities, for purposes of 280E and tax deductions.
  • Alpenglow Botanicals LLC v Commissioner: Challenged whether the IRS could enforce 280E without a criminal conviction.
  • Alterman v Commissioner: Centered on a lack of records and substantiation. 
  • Loughman v Commissioner: Revolved around an S corp and compensation paid to the shareholder. The shareholder argued 280E would result in double taxation, but the IRS argued, and the court agreed, that the income was of different sources and types. The taxpayer tried to argue for potential relief under IRC Sec. 530, but to qualify, the taxpayer would have needed to have never treated its officers as employees and to have had a reasonable basis for not treating its officers as employees. Since the taxpayer had classified its officers as employees for payroll tax purposes, relief under IRC Sec. 530 did not apply.
Beyond these cases, the only other guidance available from the IRS is Chief Counsel Advice memo (CCA) ILM 20150411, which outlines IRS guidance of how a state-legal cannabis business should calculate its federal income taxes. 

This memo outlines the IRS position on how 280E should work with Sec. 263A, uniform capitalization rules, and Sec. 471, general rules for inventory. It defines Sec. 263A as a timing provision that cannot change the deductibility of an item or, in other words, 263A cannot be used to turn a deduction subject to 280E into a deductible item. The memo further outlines that a taxpayer should implement Sec. 471 as it stood just prior to the enactment of 280E in 1982. 

Note that the CCA is only the IRS’ interpretation of the law and does not provide any court precedent and can be challenged. An updated CCA is expected soon.

Department of Justice and FinCEN
On Aug. 29, 2013, the Department of Justice issued the “Cole Memorandum,” which laid out eight enforcement priorities the DOJ would use when pursuing cannabis related activities. These priorities dealt mainly with maintaining public safety and preventing the black market. Outside of these priorities, the DOJ would take a hands-off approach. 

On Jan. 4 then-Attorney General Jeff Sessions rescinded the memo, allowing each U.S. attorney to determine their enforcement priorities.

Prior to any guidance it was difficult for most banks to bank the cannabis industry because doing so would be subject to seizure by the FDIC. The Financial Crimes Enforcement Network (FinCEN) issued guidelines allowing banks to handle cannabis related accounts as long as those businesses did not fall into the priorities outlined by the Cole Memo. Once the Cole Memo was rescinded, FinCEN’s position remained unchanged. 

Banking is still difficult to find within the cannabis industry because FinCEN guidance was a policy change, not a change in the law, and the cost of compliance is cumbersome for most banks. Even if a business does find a banking relationship, it can expect to see high bank fees to cover additional reporting costs. 
There’s a bill in Congress addressing this issue, but if and until it is passed, these businesses will be operating on hard money loans or large private investment funds.

Accounting Issues
As with all cash basis businesses, tracking of income and expenses can be difficult in the cannabis industry. Couple this with the fact that individuals in this industry had been told to maintain as little documentation as possible, but are now required to document everything. It’s imperative that good internal controls be established, particularly surrounding cash and inventory management. A good chart of accounts and an understanding of cost accounting, along with detailed bookkeeping, will make a huge difference come tax time.

Cannabis Industry Considerations

The California Board of Accountancy does not have an official position for CPAs providing services to the cannabis industry. The AICPA issued guidance in 2015. The IRS has stated that practitioners servicing cannabis clients would not be in violation of Circular 230 and subject to discipline is the practitioner was assisting in compliance within the meaning of the tax laws, particularly Sec. 280E.

Still, practitioners should use caution when servicing the cannabis industry and ensure they have knowledge of all related tax and accounting issues. It’s recommended, too, that practitioners know their prospective clients to ensure they are in compliance with state and local laws, as one misstep could cost a practitioner their license. This includes knowing how a client received their license to. Furthermore, practitioners should reach out to their insurance carrier to ensure coverage when working with the industry and prepare an industry specific engagement letter with additional warrants from the client.

Payment of Taxes
IRS guidance states that the 10 percent failure to pay electronically will be waived if a taxpayer can show that a reasonable effort to obtain a bank account was made. To qualify, a business must submit a statement explaining and documents showing the attempts made. If approved, the IRS will waive the penalty. The FTB, Employment Development Department and California Department of Tax and Fee Administration allow for electronic payment requirement waivers. They also allow for cash payments, but require advanced notice. 

As long as cannabis remains a Schedule I or II drug within the meaning of the Controlled Substances Act, the industry will have a need for competent representation. This allows for a significant opportunity for practitioners willing to enter the market. 
Mattthew Martin, CPA is a director of taxation at PDM, LLP.
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