Cost Accounting for NY Cultivators:The Secret to Surviving 280E
As all cannabis operators are acutely aware of, IRC 280E is the bane of the industry. Without proper cost accounting strategies in place, already-tight margins contract into a painfully tight place, threatening continuity and weakening any opportunities for growth and expansion.
Under 280E, cannabis companies can only deduct costs related to cost of goods sold (COGS). While dispensaries are more hamstrung than most in this area, cultivators have an advantage, as most of their activities can be directly attributed to COGS.
That being said, there are some chicanes to be aware of.
Because of 280E’s strict rules, auditor scrutiny is intense. Every decision related to cost allocation must be thoroughly documented and detailed to ensure accuracy—and this can be complicated when certain expenses are shared with other aspects of the business.
Capitalizing Inventory Costs Under 471(c)
Cultivators must understand how to interpret Sections 280E and 471(c) legally and accurately.
While IRC 280E prohibits cannabis companies from deducting typical business expenses like rent, payroll, office, and marketing costs, Section 471(c) allows inventory-related costs to be capitalized. This means that certain expenses related to production, equipment, acquisition, rent, payroll, and storage can be added to the cost of inventory and hence deducted when the product is sold.
Although it might seem like a loophole, this approach is totally legitimate. However, successful filing under 471(c) requires precise cost accounting processes, meticulous documentation, and clearly articulated internal controls and accounting procedures.
Many consider this approach aggressive and risky, as it will almost certainly draw the attention of the IRS. But so long as your documentation is in order—meaning it should stand up to the most intense auditor scrutiny—you should be able to reduce your federal tax burden and come out ahead significantly.
Understand that if you do face an audit, there will undoubtedly be multiple rounds of document production followed by interviews in an effort to substantiate your claims. Staying on the right side of the auditors is essential, as if your documentation falls short, lacks authority, or reasonable cause, it may result in accuracy-related penalties under IRC 6662 (source).
What is Cost Accounting?
Cost accounting can be described as the process of documenting, categorizing, and analyzing costs associated with creating a finished product for sale. Costs are varied and can be fixed, variable, direct, or indirect. Beyond the obvious tax and compliance reasons for doing this, knowing such information is critical to inform business decisions and shape the future of the operation.
When it’s done right, cost accounting can help to predict cash flow, quantify margins, and reveal the profitability of specific products or processes.
Because the cannabis industry is still in a nascent stage, there is no standard or manual on how to accomplish this. Operators and accountants must work closely together to ensure documentation is accurate, up-to-date, and compliant with state and federal guidelines.
Cost accounting for cannabis cultivators revolves around three key points of reference:
Direct costs are any expense directly attributable to cultivation. These include seeds, plants, growing mediums, fertilizer, and all related labor. Cultivators require precise cost tracking in this area as it helps to determine accurate product pricing.
Indirect costs include peripheral costs related to the cultivation process. These include utility costs, facility overhead, maintenance, security, and other expenses. Operators must consider these costs, as they help determine the total cost of cultivation.
Inventory costs track raw materials, finished product on hand, and works in progress. In a high-compliance landscape like cannabis, accurate inventory tracking is essential for regulatory and tax purposes.
As you can see based on the descriptions above, accurate cost accounting is essential, not just for tax purposes, but also to quantify the profitability of different aspects of cultivation. When you know exactly what each process, tool, or product costs, you can optimize processes to reduce unnecessary expenses and boost profits.
Establishing and Maintaining a Solid Cost Accounting System
Creating a bulletproof cost accounting system requires pinpoint accuracy and a strong attention to detail. And while it’s not impossible to execute, we strongly recommend engaging a qualified cannabis CPA, as they can help ensure no detail is overlooked.
Your accounting system will need to be capable of:
Tracking expenses in real time. Costs fluctuate based on the market and other variables. Continuous real-time tracking ensures cost assumptions and pricing are accurate.
Segregating allowable costs from disallowed expenses. Some expenses are disallowed under 280E, although you may be able to allocate a portion of these costs to inventory under 471(c).
Meticulous documentation. Every transactional detail must be documented. This includes creating documentation of accounting processes and explanations of your rationale behind them. Auditors will want to see this, and the more thoroughly your processes are detailed, the easier it will be for them to understand.
Compliance with federal and state guidelines and reporting requirements. Off-the-shelf accounting platforms are not built for the complexities of the cannabis industry. It is to your advantage to deploy a cannabis-specific accounting application as it will enable detailed cost accounting and reporting, reducing time spent on the task and generally making your life easier.
If you are a vertically-integrated business, accurate cost accounting is especially critical as expenses can cross many lines. Working with a cannabis CPA can help to streamline the process, ensuring accuracy across all aspects of the business.
Cost Accounting Challenges for Cultivators in NY
New York cultivators have a couple of distinct advantages when it comes to taxation. First, most expenses can be attributed to COGS, which is great news as it reduces the impact of IRC 280E.
Second, New York has decoupled from 280E at the state level, which means that expenses normally disallowed under 280E are deductible on state returns.
But despite this relief, transactions can be challenging to track. Due to a lack of traditional banking options, the cannabis industry is cash-heavy, which makes it challenging to maintain accurate financial records.
Understandably, this is a lot to take in. However, by focusing on cost accounting, maintaining meticulous records, and establishing detailed documentation, cultivators can set themselves up to thrive.
Speak to the experts at Growise today to find out how we can help you grow.