Accounting for cannabis companies is more than just tracking expenses—it’s about ensuring compliance, maximizing deductions under IRS Code 280E, and making informed business decisions. With cannabis still classified as a Schedule I controlled substance, having a well-structured chart of accounts is critical for managing your finances effectively.
In this post, we’ll explain why a tailored chart of accounts is essential for your cannabis business and how it impacts everything from tax planning to investor relations. Understanding this foundational aspect of your accounting can prevent costly mistakes and streamline your financial operations.
Chart of Accounts Defined
Financial statements are produced by recording transactions in various accounts within a company’s general ledger system. The collection of these accounts is known as the chart of accounts. The chart of accounts is a listing of all the accounts set up in your business to capture and categorize transactions as revenue, expenses, assets, liabilities, or equity. These categories are further broken down into more specific classifications.
For example:
Revenue could include revenue from dispensary sales and a separate revenue stream from apparel or accessory sales.
Expenses are categorized into Cost of Goods Sold (COGS) or operating (non-COGS) expenses.
Here's a quick breakdown of typical cannabis business expenses:
COGS
Direct labor
Seedlings/plants
Supplies
Operating/Non-COGS
Indirect labor
Rent
Utilities
Travel
How the Chart of Accounts Impacts Your Cannabis Business
In accounting, a "roll-up" refers to the process of consolidating one or more sub-accounts into a parent account. For example, under a "Travel" parent account, you might have sub-accounts for flights, hotels, meals, and taxis. This structure gives business owners more visibility into how funds are spent and helps identify performance trends.
It’s also beneficial for lenders, investors, and your CPA when filing tax returns. Auditors, in particular, will appreciate the transparency, as they must attest to the accuracy of your financial statements in accordance with U.S. generally accepted accounting principles (GAAP). The easier it is to understand your business transactions, the smoother and less expensive your audit will be.
Internally, the chart of accounts is equally important. Without a well-structured chart of accounts, your accounting team may not have enough detail to properly categorize transactions. For example, if a purchase is recorded as an operating expense when it should be classified as COGS, it creates financial misstatements. This would mean your COGS are understated, and your margin is overstated.
Suppose this misclassification involves several million dollars—now your margins are inaccurate, and you’re making business decisions based on bad data.
For cannabis businesses, COGS expenses are the only deductible items under IRS Code 280E. If your margin is inaccurate, as in the example where it’s overstated, you could end up paying more in taxes. Businesses not subject to Section 280E typically deduct operating expenses too, but because cannabis is still a Schedule I controlled substance, you lose the benefit of deducting traditional business expenses. This makes accurate classification of expenses in your chart of accounts essential to minimizing your tax liability.
The Chart of Accounts Challenge for Cannabis Companies
When starting a business, most companies select an accounting system like QuickBooks or NetSuite for general ledger management. These systems come with a standard chart of accounts that includes the five categories of accounts: revenue, expense, asset, liability, and equity. However, cannabis companies have a unique structure that requires a customized chart of accounts.
The importance of having a proper chart of accounts for your cannabis business comes down to the fact that cannabis is a Schedule I controlled substance. Despite society’s overwhelming approval of legalized marijuana, it is illegal to the federal government, so many expense deductions and credits are lost. This impacts your taxable income since only costs directly related to producing cannabis products are deductible for federal tax purposes.
Consider these two scenarios:
Scenario 1: Cannabis Company A has $5,700,000 in revenue and $4,500,000 in COGS, resulting in gross income of $1,200,000. The company will pay federal income taxes on the $1,200,000 at a 21% effective tax rate.
Scenario 2: Cannabis Company B has $5,700,000 in revenue and $2,000,000 in COGS, resulting in gross income of $3,700,000. The company will pay federal income taxes on the $3,700,000 at a 65% effective tax rate.
The 44% difference in tax rates between the two companies is due to the recognition and classification of COGS expenses. Without the proper setup in the chart of accounts, a cannabis company could be liable for millions in additional federal taxes.
Optimizing Your Chart of Accounts for Success
The roll-up of the chart of accounts is key because it provides visibility into what’s happening in your business. If you operate a dispensary but also sell apparel, you’d want to know how the dispensary performs compared to apparel sales. To evaluate these separately, the related transactions need to be distinguished from others in the financial statements. Since the transactions must be recorded regardless, why not ensure they’re recorded for maximum benefit?
For example, instead of recording one line for COGS, break it down into subcategories like supplies, labor, and other costs. By doing this, you can determine whether hiring more labor is necessary. If your COGS is growing over time, you might consider increasing your staff. You can then evaluate this decision alongside a look at revenue to determine if there is sufficient organic growth to justify the labor increase.
Frequently Asked Questions (FAQ)
Q: How does IRS Code 280E impact my cannabis business?
A: IRS Code 280E prevents cannabis businesses from deducting ordinary business expenses, significantly increasing your taxable income. However, you can still deduct the cost of goods sold (COGS), so proper expense tracking is essential.
Q: Why is a customized chart of accounts important for cannabis companies?
A: A customized chart of accounts ensures that all transactions are accurately categorized, which is crucial for reducing tax liabilities under IRS Code 280E. It also provides better visibility into your business performance and simplifies audits.
Q: How does the roll-up of sub-accounts improve financial visibility?
A: Rolling up sub-accounts into parent accounts gives you a clearer view of how funds are spent and helps identify trends in different business areas, such as comparing revenue from dispensary sales versus apparel sales.
Q: What challenges do cannabis businesses face with standard accounting systems? A: Standard accounting systems, like QuickBooks or NetSuite, may not accommodate the unique needs of cannabis businesses, especially when it comes to separating deductible COGS expenses from non-deductible operating expenses. A customized chart of accounts tailored to your business ensures accurate financial reporting.
Q: How can I optimize my chart of accounts to reduce tax liability?
A: By breaking down COGS into detailed subcategories, you can ensure all deductible expenses are accurately reported, minimizing your tax liability. Working with a CPA who understands cannabis accounting is essential for optimizing your chart of accounts.
The content of this blog is for informational purposes only and should not be taken as legal or accounting advice. Winston CPA Group is not responsible for any losses or damages incurred by relying on the information provided here. Book a consultation with a member of our team for guidance on your specific business needs.
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