As cannabis operators know, the federal 280E regulation places a huge tax burden on legal adult-use cannabis businesses. Under the 280E, any business connected with a Schedule 1 drug (as regulated under the Controlled Substance Act) cannot claim normal business tax deductions.
Cannabis operators are only permitted to deduct the cost of goods sold (COGS), which is a very specific expense that must be considered carefully before claiming that deduction.
However, there is a way cannabis business owners can reduce their tax liability. The § 1.471-1 can be used to help allocate indirect costs, which can reduce your margins and reduce your tax liability.
Here’s what you need to know about 471 allocations.
What is the § 1.471-1?
The § 1.471-1 is a tax code that defines inventory capitalization rules for businesses.
This section defines what you can put into your inventory costs – and, if something counts as an inventory costs, it can be considered a COGS. This increases the deduction you can take which reduces your tax burden.
How do you know what can be reallocated as inventory, and therefore COGS?
There is a certain methodology accepted by the IRS that operators must use to assign costs under COGS. If you assign costs randomly, you will be penalized. The experts at GreenGrowth CPAs can help you by offering an analysis and full implementation through our outsourced CFO service.
How does § 1.471-1 work?
When you outsource your CFO service to GreenGrowth CPAs, we will take you through an initial setup and analysis, and provide an ongoing allocation of costs on a monthly basis.
There are three main outcomes which you will benefit from:
- Get a financial model for budget planning. This model can be easily manipulated and customized for your business depending on many different variables. This budget can help improve your business planning, and give you the ability to run a sensitivity analysis if you were to change a few inputs of your business model.
- Understand strategies to save money and allocate costs. We will deliver a projected analysis of how much of the costs that you are able to allocate to COGS, thereby driving how much you can save in taxes.
- A projected tax liability estimate. Learn ahead of time how much you will likely be responsible for paying in taxes. This understanding helps you plan to put aside a certain amount each month; it’s tough to come up with $350k in April, so we help you budget and plan for taxes accordingly.
The 471 for Resellers vs. Processors
Allocations under the 471 apply differently for cannabis resellers vs cannabis processors.
As a reseller, you have direct costs like product and material costs; indirect costs include things like rent, utilities, payroll, licensing, and insurance. Keep in mind that if you are a reseller of other brands’ cannabis products, then you do not get to capitalize your indirect costs – only your direct costs.
As a reseller, unfortunately, you will have the largest tax burden of anyone in the cannabis industry because your taxable base is that much higher. This is one of the biggest takeaways we learned in the Harborside vs. IRS case – and the federal government is not shy about penalizing cannabis resellers.
Cannabis processors, on the other hand, are allowed to take indirect costs and allocate a portion to COGS, taking a tax deduction as a result.
This puts processors in a more powerful tax position.
If you’re in a position to do cannabis extraction, make edibles, or perform other light manufacturing, this can qualify your business as a processor – you don’t need to be a large-scale manufacturer to be considered a processor.
In our experience, we have seen some businesses do something called “value added processing.” In this scenario, a processor gets one cannabis product, adds something to it, and then repackages it. This is still manufacturing and can help you gain a better tax position.
How do you become a processor?
Interested in qualifying as a cannabis processor? Here’s how.
First, check your license type. If it allows for manufacturing, continue to read on. If it doesn’t, see how much a cannabis manufacturing license costs and if it’s in your financial interest to apply for one. Factor in the potential deductions you can take over the long-run from qualifying as a processor into your financial calculation.
Your decision will vary based on the state in which you operate; for example, in Oklahoma, it’s cheap for a manufacturing license – so why not apply for one?
Next, look at your capabilities and space. Are you able to do some heavy or maybe even light manufacturing? Here are two potential options for dispensaries:
- Buy bulk flower and make pre-rolls and package them in your own branded packaging.
- Buy cartridges in bulk, remove from the package, and put them into your own branded packaging.
You don’t need a big investment to add processing to your cannabis business! Be creative or speak to our experts to find a way to make this work for you.
471 Allocations Impact on your Tax Payment
Is it really worthwhile to apply for a new license or add another operational step to your cannabis business?
Well, let's walk through a quick calculation shows the potential ROI you may expect from qualifying for the 471 allocation.
Many cannabis dispensaries see a margin of around 50%.
That means that if your sales are $2 million, your margin is $1 million. You pay tax on that margin.
With the new Tax Cuts and Jobs act, the capped tax rates for a C-corps is 21%. That means at 21% tax, you will pay $210k in taxes.
Now, if you allow us to help you with these 471 allocations and we could potentially bring your margin down to 37% for example.
This would mean that you would only pay $155k in taxes.
That’s $55k tax savings on an annual basis!
With that kind of money, you can reinvest into your business, grow revenue, and improve your operations. Ultimately, this means we could save you more and more money every year in taxes and deliver a great competitive advantage.
The 471 allocation makes it possible to expand the number of costs you can legally claim under the COGS deduction. However, to maximize your deduction, cannabis operators should seriously consider expanding their operation to qualify as a “processor,” as processors have more indirect costs which qualify as tax liabilities.
Speak to an expert at Green Growth CPAs to see how you can best add processing to your business and take full advantage of the 471 allocation.