Cannabis retailers can take several steps now to lower their tax bill next April
by Gary Strauss
Toni Savage Fox runs two marijuana stores in Colorado that netted a combined $3.8 million in revenue last year, but she’s looking to get out of the cannabis industry.
The main reason: Taxes are killing her bottom line.
“The federal taxes are crushing,” Fox said. “Because of the unfair treatment by the federal government and extreme sales and excise taxes at the state and city level as well as the inability to get fair banking, I’m selling my businesses.”
Cannabis retailers across the country face similar tax woes.
The main culprit, of course, is 280E, the notorious section of the federal tax code that blocks cannabis retailers from taking standard deductions traditional businesses use to lower what they owe the government. Medical dispensaries and recreational cannabis shops reel from an effective federal tax rate of up to 75% because the Internal Revenue Service considers marijuana an illegal drug.
While there’s no panacea at this point, dispensaries and rec stores can implement strategies to lower next year’s federal tax bill by up to 25%.
Reconsider Your Layout & Use of Space
Based on recent court cases involving the IRS, the best potential tax-cutting strategies revolve around cost of goods sold, or expenses tied to the purchase, storage and management of marijuana inventories.
With this in mind, many dispensaries and rec stores are devoting more space to storage and shrinking their retail space.
“If 10% of your space is inventory storage, you can allocate 10% of your rent for a deduction,” said Miami-based CPA Scott Levy, whose clients include medical marijuana dispensaries.
The key is to ensure the space for inventory storage is closed off from other areas.
There’s no rule of thumb about an ideal ratio of inventory to sales space. But the higher the amount of space you attempt to deduct, the more likely the IRS is to challenge it.
“Most of my clients’ inventory space is between 10% to 25%,” Levy said. “Whatever you can prove, I’d be comfortable taking the deduction. But the IRS will want a lot of detail. I’m working on one audit right now – they’re asking for a copy of floor plans and they want an on-site visit.”
Another tax-saving strategy: put a traditional business in part of your retail space, such as a yoga studio, T-shirt shop or counseling/education area. Many cannabis retailers claim this type of space as a standard business deduction.
“Inventory space is the No. 1 safe tax haven,’’ Levy said. “No. 2 is setting up separate retail space” for an unrelated business.
To lessen the chance of an IRS audit, tax professionals suggest creating separate entrances to secondary businesses.
Look to Utilities
Former pharmacist Margie Lemberger’s federal taxes were in the high five figures in 2014, when her Washington State cannabis store – Margie’s Pot Shop – pulled in just over $1 million. But she took no cost-of-goods deductions, leaving her with a lofty tax burden.
With revenue jumping to nearly $1.9 million in 2015, Lemberger expects a higher tax bill.
After learning of recent court cases that appear to clear the way for some deductions, she’s planning on filing an amended 2014 return and writing off her utility bills, which run about $4,200 a year. Her rationale? Without proper temperatures, her popular marijuana-infused candies and chocolates would be worthless.
“It’s totally reasonable to say these are perishable items,” Lemberger said. “If it’s 100 degrees inside, everything would melt.”
Lemberger’s also contemplating writing off most of the costs of her building, which she purchased after no one would lease her space.
“We’re all running by the seat of our pants, hoping we’re doing the taxes the way the IRS will accept them,’’ she said.
Generally, the utility bill write-off should be based on the same percentage as space devoted to inventory.
Again, tread carefully, tax experts say. For example, electric bills for a cooler containing perishables won’t qualify for a tax break if it’s located on a sales floor. But a cooler in a designated inventory area could be considered for a write-off.
Expense Salaries, Employee Wages
Under cost of goods sold, cannabis retailers can deduct a portion of the wages they pay themselves as well as expenses related to acquiring and handling inventory.
That could mean the cost of travel to purchase marijuana, as well as transportation and shipping expenses. So a business owner who spends 40% of her time on inventory might be able to expense 40% of her salary, said California CPA Hank Levy (no relation to Scott Levy), who’s worked with medical marijuana providers since the mid-1990s.
Likewise, employee wages paid for handling inventory are also deductible. But again, there are caveats and disagreements among tax professionals over employee-related deductions.
“If you try to claim a salary of an inventory manager, make sure 100% of their time is on inventory. If they spend 1% of their time behind a cash register, the IRS will disallow it,’’ Scott Levy said. “Their job description should be dedicated entirely to inventory.”
Revisit Your Company’s Structure
Switching corporation designations can cost thousands in legal and filing fees, but over the long term can save far more. Tax professionals say many early marijuana entrepreneurs continue to switch their business status to lessen tax bills or protect themselves from litigation.
Businesses set up as corporations typically require more legal advice (and costs) up front than a limited liability company (LLC). But generally, they pay less Social Security and FICA taxes than LLCs.
Moreover, registering as a corporation protects entrepreneurs since it establishes a separate legal entity, relieving owners, officers and stakeholders from personal liability for the company’s obligations, said California-based CPA Luigi Zamarra, a specialist in medical marijuana tax planning and compliance.
The two main types of corporations have advantages and disadvantages. Registering as a C corporation can result in higher tax bills because owners face both corporate taxes and additional personal income or dividend-related taxes. Under an S corporation, income is taxed only once.
Assuming two businesses with $200,000 in net income and an owner having no other income or itemized deductions, a C corp’s tax would be $61,250, for an effective tax rate of 30.6%. An S corp owner would owe $46,207, for an effective tax rate of 23.1%, Scott Levy said. Some of the S corporation’s tax benefits are lessened if the business owner is salaried, due to payroll taxes (15.3%).
“Without making it too complicated, I think it’s safe to say being an S corp vs. a C corp saves you around 10%,’’ he says.
Prepare for the Worst
One of the most important things a cannabis company can do is develop an audit strategy.
While this won’t help lower your tax bill, it will help potentially save money, time and effort if the IRS comes knocking.
The IRS audited about 8% of cannabis retailers in 2014, vs. 1.4% of all U.S. businesses that year, according to a Marijuana Business Daily survey. With an audit much more likely, your tax preparer should have an audit strategy before you file, whether to strictly abide by 280E or aggressively claim expense-related deductions. So pay up for beancounters and accountants, and don’t go cheap.
“This isn’t like running a mom-and-pop store,’’ Zamarra says. “You want the most sophisticated bookkeeper you can find.”