Cannabis Companies Switching to GAAP Accounting

The Internal Revenue Code (IRC) contains a provision limiting tax deductions for cannabis companies to the cost of goods sold (COGS). To maximize COGS, companies must comply with the relevant tax accounting rules. To complicate matters, book accounting (best practices employ generally accepted accounting principles, GAAP) has its own rules for inventory accounting.

A March 2022 U.S. Tax Court ruling limited a cannabis company’s deduction for COGS to direct costs since that company’s tax accounting method did not reflect income because it failed to conform with GAAP. Consequently, cannabis companies not using GAAP for reporting purposes risk the IRS reducing their COGS deduction, thereby increasing its income tax with assessable penalties and interest.

According to the Court’s ruling, the accounting system used to report COGS deductions must accommodate two directives: it must conform to best-practices accounting for that business or industry, and it must “clearly reflect income.” To clearly reflect income, the business’s accounting system must pass another two-part test, it must: be applied consistently and conform with GAAP.

The inventory tax accounting regulations allow cannabis companies to treat certain indirect costs as inventoriable costs, increasing inventory and COGS resulting in a decrease in gross profits for tax purposes. Since cannabis companies compute their Federal income tax based on gross profit and other income, reducing gross profit reduces Federal tax liability.

Businesses keeping records for tax purposes that don’t accommodate the new court ruling, upon IRS audit, likely will see their COGS deduction reduced. The result will be increased income taxes with potential penalties and interest.

Cannabis businesses are advised to move to GAAP accounting and maintain their financial records in conformity with the GAAP rules most appropriate for this industry. This can yield the lowest legitimate Federal tax liability with the highest probability for success against the IRS.

HBK Cannabis Solutions can help. We were among the first CPA firms to specialize in the cannabis industry and have worked beside entrepreneurs in all industry segments—cultivators, processors, retailers—from a single facility to multi-location and vertically integrated operations. We can assess your current accounting system, advise and install accounting that complies with GAAP and IRS rules.

About the Author(s)

Christopher Marrie has years of experience providing financial reporting consultation and cost accounting analyses to cannabis companies throughout the United States. He specializes in working with cultivators, manufacturers and vertically-integrated cannabis businesses to structure standard operating procedures and best practices as part of their financial reporting process.

Steven Gotsdiner has decades of experience providing tax consulting and compliance to a diverse clientele including cannabis since its legalization in CO. He specializes in serving clients with multi-generational, multi-entity and multi-state business structures through a proactive, year-round and holistic approach to client service.

Hill, Barth & King LLC has prepared this material for informational purposes only. Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.