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.