Costly landmines and pitfalls in the cannabis business are everywhere. Here’s how to avoid them.
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The cannabis business is plagued with a vast array of financial hurdles and regulatory hoops that are seemingly impossible to navigate — coming at all too high a cost for many, with possible long-term consequences that can put you out of business. To add insult to injury, the industry is largely void of qualified financial professionals such as CPAs and bookkeepers, who can help companies adhere to stringent regulations while mitigating the high risk of fines and penalties.
Related: 5 Things You Absolutely Need to Know About Cannabis Taxes
Here are the most common financial woes plaguing cannabis business owners today, and how to avoid falling victim to them:
1. Misunderstanding or Ignoring IRC Section 280E
Under this section of the Internal Revenue Code, cannabis companies are prohibited from deducting typical business expenses due to the federal status of marijuana as a Schedule I substance. This code dictates that businesses in the space areonlyallowed to write off the Cost of Goods Sold (COGS), which significantly increases taxes. As a result, companies must carefully balance the tightrope of correctly doing cost/absorption accounting without violating 280E and IRC 471 — a mistake that could end up in large fees and penalties or even a full shutdown of the operation. The best way to work around this complication:
- Keep your books fully accurate and up-to-date, with robust supporting documentation for receipts and allocation methods.
- Keep tied out monthly accounting work papers
- Make sure to have a trained professional who can perform cost accounting and knows generally accepted accounting principles (GAAP) inside and out.
Related: This is How to Navigate the Dreaded 280e Tax Code
2. Not Being Transparent with Investors and Lenders
For many cannabis companies, investors are crucial to getting the business off the ground — and eventually off to a successful exit. So it’s essential that these key stakeholders see that your company is operating efficiently and in full compliance with state and federal laws, as well as IRS, OSHA, and FDA regulations.
However, many cannabis companies fall short in being fully transparent. One of the most common mistakes is not including a clause in LLC Operating Agreements that indicates your company will make tax distributions to the investors quarterly. Failure to do so can lead to a scenario in which the investors accrue a tax liability with no cash to pay it.
Another issue arises when cannabis companies neglect to regularly share up-to-date financial reporting with their investors. Your books, legal documents, financials, internal controls, accounting policies and procedures, and state filings should be maintained and accessible so that they’re audit/investor/lender-ready any time, and all the time. While many cannabis companies don’t consider this, it’s essential for communication with investors and lenders (and future auditors).
Down the road, when you’re ready to sell, you will be glad you implemented this system. It will add value to your company, make for a faster, more seamless process, and result in fewer surprises in due diligence. If you wait until exit to think about getting supporting documents in place, it will already be too late, and there will likely be holes in your records. Ultimately, proper accounting allows CEOs better access and communications with lenders and investors, which is paramount in the cannabis space.
3. Improperly Transitioning from the Black Market to the Legal Market
Companies evolving out of the black market are often unaware of all the different ways they could be out of compliance with complex state and federal laws. Suddenly operating in one of the most tightly-regulated industries in the nation, with complex tax and banking restrictions, these business owners often find themselves entirely unprepared for the pressures of keeping a legal operation afloat. This can be especially difficult when the companies weren’t exactly rule-followers in the first place. Now, for the first time, they must keep detailed financial and accounting records, as well as maintain compliance.
For this reason, you’ll want to hire a qualified accountant or bookkeeper to help organize and maintain these materials. It also makes sense to consider hiring a compliance officer, who is in charge of overseeing compliance with state, OSHA, and FDA rules. A qualified CFO can often take on this role, or it can be an entirely separate employee. Either way, they must learn the many red flags to be wary of — even something as simple as the height of a fence on a farm can lead to a temporary shutdown, potentially resulting in the loss of thousands of investor dollars.
No matter what vertical you operate within — from grow to extraction, product formulation to retail — you could be sitting on a ticking time bomb without even realizing it. We’ve seen many incorrect tax returns cross our desks, and the IRS has won significant victories and levied fines on unaware CEOs. For this reason, when the auditors inevitably come knocking make sure you’re ready.
By implementing these key tips and seeking guidance from experienced financial professionals, you will be able to navigate the cannabis industry’s unique hurdles and operate a compliant and sustainable business that is set up for long-term growth, while avoiding costly and often business-ending fines.
Related: Some Tips for East Coast Cannabis Entrepreneurs From Colorado’s Industry Leaders