Capitalizing vs. Expensing: How to Handle Facility Build-Outs the Smart Way
Building out a cannabis facility is never cheap. When you factor in construction, equipment, license fees, consulting, and all the other sundry expenses you might incur, the total cost can be upwards of $500,000 or more.
Capitalizing build-out expenses can, in some cases, significantly reduce taxable income. Today, we’ll discuss how capitalizing might be a better accounting method to apply versus expensing such costs, and the likely impact on your bottom line.
What is Capitalization?
When a cannabis company capitalizes costs, they are entered on the balance sheet as assets rather than expenses. The benefit is that the cost is spread out over time due to depreciation or amortization.
Examples of build-out costs that can be capitalized include:
Construction costs
HVAC systems
Security systems
Leasehold improvements (renovations to improve suitability)
Large equipment purchases (i.e., grow light systems, irrigation, extraction machinery, etc.)
Why capitalize?
Simply put, capitalizing build-out expenses defers taxation and EBITDA over time. Additionally, it aligns costs with revenue more closely, such as in a grow room or storage facility that is in use for multiple years.
Now, as we all know, cannabis companies cannot deduct typical business expenses as they must comply with IRC 280E. Therefore, not all build-out costs can be capitalized to your advantage; however, many can, especially when they can be tied to the cost of goods sold (COGS). So, obviously, cultivators may make out better by this method, but there are ways to make it work for retail and manufacturing, too.
Capitalizing assets works best for assets that are used in production, as they can sometimes be attributed to COGS. If you expense these costs, you won’t have that advantage.
Since retail is mostly excluded from COGS, most dispensary build-outs won’t be eligible. The exception would be if the build-out were related to inventory, such as storage facilities or security systems specifically installed to oversee storage and inventory.
Expensing Costs Explained
If a company chooses to expense its build-out costs, it will show as an expense on statements and is applied wholly to the period in which it was incurred.
Examples of build-out costs you might expense include:
Professional fees (contractors, architects, lawyers, consultants)
Repairs and maintenance that are not significant improvements
Companies might choose this method because it’s simpler. Accountants won’t need to track depreciation, and it immediately reduces profits, which can be leveraged for budgeting or planning purposes.
However, you can only apply these costs as deductions if they are directly related to COGS. If they are eligible, choosing to expense vs. capitalize would provide a deduction in the year it was incurred, providing short-term benefits. Still, doing it this way can improve the balance sheet, which might be advantageous if you have investors or are considering going down that road.
Should You Capitalize or Expense?
To summarize:
Capitalization treats your build-out costs as assets, which can be very advantageous for major renovations. Costs are tax-advantaged if they are directly tied to production (and therefore COGS).
Expensing build-out costs allows you to immediately apply them to your balance sheet, although doing so won’t always reduce taxable income due to 280E constraints.
Here are a few examples:
Cultivation facility build-out
Capitalize these as they can be allocated into inventory and COGS:
Buildings, greenhouses, leasehold improvements
Irrigation, HVAC, lighting systems
Drying rooms, extraction, and fertilization equipment
The benefit here is being able to take advantage of depreciation rather than taking a big up-front hit. It also strengthens your balance sheet as it will show more assets. Cultivators can reduce taxable income because these costs are related to COGS.
Expense these (link to COGS as they are directly related to production):
Seeds, growing mediums, nutrients, etc.
Small hand tools and equipment
Temporary labor
The only direct benefit of expensing these costs is that it simplifies accounting. But in reality, what about cannabis accounting is simple? We’ll leave that right there.
Retail build-outs
Capitalize these (although they cannot be attributed to COGS):
Leasehold improvements
Long-term permanent signage
Safes, vaults
Expense these (although no tax advantage as they are excluded under 280E):
Professional fees
Marketing, rent, utilities, supplies
While capitalizing the above costs can improve EBITDA, there is no tax benefit, so it is really only good for investor optics.
Capital vs. Operational Equipment
We briefly touched on different types of equipment used in cultivation operations, but let’s drill down a bit deeper.
The most significant difference between capital and operational equipment is cost. Capital equipment is typically larger in scale and, as such, should be considered a long-term asset.
Therefore, any industrial-scale equipment or build-outs should be fully capitalized. IRC 280E allows for depreciation for equipment at this level. Operational equipment, on the other hand, will face more scrutiny when capitalized, so it should be classified as an expense for short-term taxable income reduction.
Fortunately, most equipment is deductible under Section 280E (so long as it can be included in COGS). Still, it’s up to the operator to consider what’s most advantageous to them, i.e., capitalization vs. expensing.
Capitalizing large equipment purchases allows cultivators to recover these costs over time through depreciation.
Smaller equipment purchases, on the other hand, such as small lab equipment, hand tools, chemicals, etc., should be expensed as there is really no advantage to capitalization. Plus, drawing the auditor’s attention is not something anybody wants.
Capital Equipment: Additional Benefits to Consider
Even though the federal government hasn’t yet stepped up to reschedule cannabis—which would effectively squash 280E like the pesky bug it is—adjacent industries are doing their bit to promote and encourage prosperity across the cannabis sector.
Utility companies, manufacturers, and some government agencies offer rebates and incentives for energy efficiency, economic development, green tech, and equipment trade-ins.
What you’re eligible for will depend on the state you’re operating in and the type of upgrades you’re investing in, but it’s certainly worth your time to find out. Anything that reduces costs in the cannabis industry is worth looking into. As always, we recommend working with a qualified cannabis CPA who can help you understand the tax and compliance pros and cons of any major business decision.
Set up a call with the experts at Growise today. We specialize in cannabis finance and can help you make the best decisions for your business goals.