Webinar: The Future of Cannabis Cultivation Operations and Costing

Date April 8, 2022

Highlights of the April 8, 2022 webinar hosted by Christopher Marrie, Director HBK Cannabis Solutions, and Warren Harasz, VP of Compliance, Cannaspire

As the cannabis industry grows and matures, better practices in operations and costing are necessary to remain competitive, balance quality with compliance needs, and keep your organization ready for long-term objectives, such as exits, expansion, and sustained profitability.

Webinar content includes:

• How to better identify commonly overlooked cost savings opportunities in your cultivation’s operations

• Achieving the goals of product quality and product compliance without sacrificing one for the other

• Lowering unexpected tax and compliance risks with better systems and SOPs

• Effective and time-efficient costing methods to identify inefficiencies and make better decisions than your competition

General cultivation costing issues

For cultivators in startup mode

• New Jersey is the most active state on the East Coast in licensing

• Key is being involved in the municipalities where you will be located; will need their verification to get licensing; attend municipal meetings

• Due to IRS rules on deductions for cannabis companies, you will not be able to deduct costs you incur getting licensing; also remember that in the pre-revenue stage, you can only deduct your cost of goods sold (COGS)

• IRS has mandated using full absorption GAAP accounting for your COGS, and your books must match your tax return in terms of accounting method.

• Some companies strategize positions like an agriculture business to stay out of the plant-touching side of the business as long as possible before they are licensed and ready to begin operations.

• In terms of startup costs, you can start small and build your way up easier with an outdoor facility. Indoor facilities, typically for mass distribution, are more costly. For example, some New Yorkers are converting CBD farms convert to cannabis licensing at minimal costs. Cost to get an outdoor product up and running may be limited to securing the license, start tracking as required, the labor to run it, and some marketing initiatives. Indoor involves a lot more moving pieces through facility which affects costs.

• Seed-to-sale software won’t suffice for tracking, like yield per strain, yield per square foot, cost per gram. None of that will be covered by seed-to-sale software.

• The overhead of the facility, while you’re ramping up, is COGS.

• Better to start with reasonable realistic production projections: under promise and over deliver. Need to anticipate startup cost through the entire life-cycle of the plant: ultimately an entire life cycle of 60 to 70 days through harvest, plus time to produce those clones, then the labor for the flip.

• There is going to be some period of trial and error where costs will be greater than anticipated. It takes two or three harvests in the indoor space.

• Have to track and quantify costs or you can’t make good business decisions, such as which genetics to choose. You have to track metrics to know what your costs are in case you need to change management, like a master grower. Need to work with an accounting firm to help with that; there are no good IT solutions. Seed-to-sale software is set up like the regulators are the clients, not the growers. It doesn’t really do costing – you can enter it but you have to calculate it.

• There are ways to track, especially with modern facilities set up with SOPs, handbooks, operating procedures and policies. You can track labor time for specific project assignments and check the job for satisfactory work. A key point is that time is of the essence when you’re talking about your crop. Tracking all costs will get you a realistic price of pounds per production down to the price per gram.

• It is best to implement cost tracking from the beginning. Once it is set up, it can be built on and maintained. It’s a good business practice in general, especially in the cannabis business where you are going to be audited by the IRS.

Out of startup space and into a fully functional facility – challenges to costing in real-time

• Industry is aplenty with master growers, but turnover is frequent, so the biggest challenge is having something like SOPs in place in case your management changes.

• Capital requirements are high, cash flow is always tight, margins are slim, labor intensive—sometimes SOPs fall by the wayside in the effort to get product out.

• Many master growers from the traditional industry are skilled but without resumes.

• Should you build out or retrofit a building? That is one example of the challenges for people moving from the traditional industry to legal development. Another is getting the number of employees you need, and what that involves, such as benefits packages. There is typically a disconnect between people who know the work side of the business and understanding the costing issues related to ensuring a profit.

• Have to proactively track your costs to make key decisions, such as whether to use labor to accomplish a task or invest in technology that will reduce your need for labor.

• You might want to let the distributors do the packaging.

• You have to diversify. You don’t want to do the same strain forever. Have to find your niche and determine what the market wants.

• Have to get cost accounting down to an SKU level. Knowing your costs of genetics and your return on that investment: if you can track that and gauge profitability by strain, you can maximize the value of your facility. But it is difficult to get there.

• We see people struggle with labor studies and equipment usage.

• How many watts of light are you using? You would like to know that on a daily basis. Need to keep a daily journal of light required, heat intensity, and humidity. It comes down to how tightly you are parameterizing your operations.

• Historically we’ve seen year-end costing being done. But the decisions that need to be made to improve the process are missed when you do it in hindsight. Setting up systems can be time-consuming but if you don’t have that expertise, it’s worth bringing in a consultant to take developing tracking SOPs off your master cultivator’s plate. By identifying inefficiencies you can save much more time and money in the long run as opposed to looking back at the end of the year to recognize costing issues.

• Operators are embracing opportunities to button up their business practices. Things are changing extremely fast, including production technology. Tracking is how you stay current on up-to-date practices and don’t get left behind by someone who can produce better quality and higher yield.

• Tracking will be essential to change from traditional cultivation to getting into the legal industry and complying with those requirements.

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Cannabis Companies Switching to GAAP Accounting

Date April 6, 2022
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.

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Recording Cannabis Inventory: From Seed to Sale

Date March 23, 2022
Article Authors
HBK CPAs & Consultants

Companies operating in the cannabis industry, especially cannabis cultivators, are no strangers to IRS Code Section 280E and its provision that businesses legally cultivating or distributing marijuana products can only deduct costs-of-goods-sold when calculating federally (and some state) taxable income. General and administrative expenses such as salaries, rent, and advertising aren’t deductible.

So, if costs-of-goods-sold is the only category of expense eligible to be deducted, how can businesses ensure they are maximizing their deductions? By accurately recording inventory from seed to sale.

All states that have authorized the production and sale of marijuana, whether for medical or adult use, require the use of seed-to-sale tracking software. The software is mandated by the states to ensure compliance with cannabis laws. While seed-to-sale software enables cannabis businesses to update inventory as it moves from stage to stage and maintains a log of all employees who have handled the inventory at each stage, the software has presented cultivators with challenges, including:

  • Accurately recording harvested plants moved to the drying rooms
  • Appropriately updating the weight of work-in-process inventory after it has been removed from the drying room and before it has been packaged as a finished good
  • Appropriately tracking inventory physically still in work-in-process inventory but moved to “finished goods” in the seed-to sale software prior to packaging
  • Producing historical reports

Such challenges can lead to the improper recording of inventory and non-compliance with relevant state regulations. The following procedures can be used to mitigate those risks:

  • Save reports from the seed-to-sale system daily.
  • Perform cycle counts of all inventories:
    • Once a week for all raw materials
    • Once a week for work in process inventory
    • Three times a week for finished goods
  • Keep a physical inventory sheet in each room to be signed by employees as they make updates and a digital copy outside the seed-to-sale software with the same information.
  • Reconcile reports from the internal spreadsheets with reports produced by the seed-to-sale system after each internal cycle count is performed.
  • In the rooms containing work-in-process inventory, physically separate and label the inventory being regarded as finished goods in the seed-to-sale system.

It is important to remember that while seed-to-sale software helps track inventory, the software is still subject to human error.

The importance of properly recording cannabis inventory should not be underestimated. It is the key to understanding operations and consumer patterns, and correct financial reporting, as well as compliance with regulations.

For additional inquiries or cannabis consultations please contact HBK Cannabis Solutions at 856-486-2299.

Register for the next cannabis webinar on April 8, 2022 here.

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R&D Tax Credit for Cannabis Businesses

Date February 28, 2022
Article Authors

Consider the legal landscape for cannabis businesses:

  • Cannabis remains a Controlled Substances Act Schedule I substance.
  • Cannabis businesses operating in states where they have been legalized are denied federal tax deductions for ordinary and necessary business expenses under Internal Revenue Code 280E.
  • The Agriculture Improvement Act of 2018 legalized the business activity of growing, selling, possessing, and transporting hemp-derived and cannabidiol (CBD) products.

Now consider a potentially favorable scenario for hemp and CBD businesses: a tax credit for companies engaging in qualified research and development activities (the “R&D Credit”). It is important to note that due to the federally illegality of THC, businesses involved in the production or sale of THC are not eligible for this credit.

Section 1.174-2 of the U.S. Treasury Regulations state that, “whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents.” Under the regulation, qualified activities include developing a new or improved product, developing new technology, creating a new production process, or improving current processes.

Notably, the efforts do not need to be successful to qualify for the R&D Credit. Nor does the product or process need to be unique to the industry. It only needs to be new or improved for the business conducting the research and development.

Qualifying Expenditures

Qualified R&D expenditures can include operating expenses such as wages, materials, and payments to third-party contractors if the activity that gives rise to the expenditure is a qualified research activity. Examples of qualifying activities include:

  • Cultivating new varieties and/or characteristics
  • Developing new growing methods and procedures
  • Devising new or improved ways to process and harvest plants
  • Experimenting to grow healthier, stronger, and better quality plants
  • Developing and testing new filtration or irrigation systems
  • Testing new farming methods to increase crop yield
  • Investigating new ways to use industrial hemp fibers
  • Developing new products
  • Formulating new topical creams and other absorption methods
  • Testing new CBD oil products and extraction techniques
  • Exploring alternative uses for hemp
  • Designing and incorporating new or improved processing equipment or systems
  • Developing custom enterprise resource planning (ERP) or inventory and production management software
  • Designing and integrating new or improved processing equipment, systems, and software, including custom enterprise resource planning (ERP) and inventory and production management software

Examples of qualifying costs include, but are not limited to, those incurred in performing the qualifying activities, such as:

  • Compensation paid to employees or contractors involved in the process or activity, whether directly or in a supervisory or management capacity
  • Raw materials and supplies consumed during cultivation
  • Solvents, testing materials, and materials employed during processing
  • Supply costs

Using the R&D Credit

Note a nonrefundable credit can only be used to reduce a taxpayer’s liability to zero. However:

  • Any credit not used in a current year can be carried back one year or carried forward for up to 20 years. Amended tax returns can be prepared and filed for years where qualifying activities can be documented.
  • Startup companies without an income tax liability may be able to take the R&D Credit against up to $250,000 in employer payroll taxes during the first five years of operations.
  • Most states conform to the rules for taking the federal credit. Some states conform, but they have their own rules that must be followed.

As with most deductions and credits taken by taxpayers, documentation and substantiation is imperative. Contact HBK for information and assistance.

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Cannabis, 280E, and Delta 8: A Discussion of Tax Issues Unique to Selling Cannabis

Date December 9, 2021
Article Authors

Highlights from the December 9, 2021 webinar hosted by Christopher T. Marrie, CPA, CCIFP, Principal and National Director, HBK Cannabis Solutions.

• HBK Cannabis Solutions has been working with cannabis businesses throughout the United States and abroad since 2018. It is a dedicated, all-in group of professionals counseling clients as the industry has evolved and governments’ positions change or remain steadfast.

• The history of governance over the industry indicates that you need to consider all possibilities anytime there is a new aspect of the cannabis industry, as is the situation with Delta 8 sales.

• Cannabis exists in two species: hemp and marijuana

– The Farm Bill of 2018 distinguished the two as:

— Hemp is defined as less than 0.3 percent THC, not pschyo-active, but high in CBD. It falls under compliance with the Farm Bill and is completely legal

— If it doesn’t meet that criterion, it is considered a controlled substance. Delta 8 was excluded from the Farm Bill, and has been addressed differently by different branches of government.

• The Controlled Substances Act categorizes Schedule 1 substances as having high potential for abuse, no current accepted medical use, and lacking accepted safety for use under medical supervision.

• Delta 8 THC has been specifically listed by the Department of Justice (DOJ) as a Schedule 1 controlled substance.

• Tax implications:

– As taxpayers, any trade or business is allowed to deduct ordinary and necessary expenses to conduct business. But that is not the case for the cannabis industry. IRC Section 280E regarding trafficking in controlled substances, even if legal in a state, denies deductibility for tax purposes of all but direct costs of inventory. Applicability and enforcement have expanded over the years.

– 280E has a particularly severe negative impact on retailers due to their required investments in operations, including employees. A retailer could end up cash-flow negative but still with a substantial tax liability. The impact is more severe for S corporation pass-through businesses.

– Hemp in not covered by 280E if the business has implemented an official agricultural pilot program allowing cultivation of “industrial hemp” or any part of the cannabis plant with less than 0.3 percent THC in dry weight.

• The CDC received more than 600 reports of adverse reactions to Delta 8 in 2021.

• The Drug Enforcement Agency (DEA) has issued its opinion that Delta 8 is a Schedule 1 controlled substance. Some states are outlawing it and others are considering legislation to change their position. The DEA and DOJ positions will clearly dictate the level of enforcement by the IRS.

• In November 2021, the DEA clarified its position on Delta 8, acquiescing that Delta 8 is covered by the Farm Bill if you are compliant with all other aspects of the Bill. Derivatives of Hemp are also covered protected by the Farm Bill assuming they’re produced exclusively from cannabis materials. But for most Delta 8 products, CBD is extracted and put through a conversion process, a synthetic conversion, so you are not using exclusively cannabis material. As well, Delta 8 remains listed by the DOJ as a Schedule 1 controlled substance.

• IRS enforcement relative to Delta 8 has been very aggressive and highly antagonistic to the taxpayer. They are taking a rigid, hard-line position in enforcing this aspect of the tax code. They’ve been selective about who they take to court so as to ensure favorable rulings. We are not optimistic that the IRS will act in good faith interpreting the DEA position.

• The IRS has been under-funded in recent years, but there is $88 billion in IRS funding in the Build Back Better bill, $45 billion of which is dedicated to enforcement. We are confident that a big part of that enforcement will target cannabis businesses.

• If you’re selling Delta 8, first understand the ramifications, what the IRS might do, and be prepared for subsequent audits. Comply as much as possible with the 280E code as written and proactively segregate any aspects of your business at risk from the rest of your business. Understand what the potential tax liability and penalties might be in case there is enforcement.

• The greatest concern is for standalone retailers. Two types of businesses are selling Delta 8. One is a compliant CBD dealer now selling Delta 8 products; for them, adjustments from the IRS could be substantial. The impact could be more onerous on people in completely non-cannabis retail businesses, such as convenience stores, that have entered the Delta 8 space.

• If you’re going to continue selling Delta 8 products, we recommend that you segregate that from your other business. Our recommendations include:

– A different sets of books and insurance policies

– Different locations

– Separate management and employees

– Businesses that operate independently of each other

• Implement procedures, processes and controls that demonstrate you’ve made every effort to segregate the businesses.

• Legal sellers of CBD products must also segregate Delta 8 sales as much as possible to insulate themselves from the potential of a substantial adjustment in taxes for your entire business.

• Until there is more clarity on what is or isn’t Schedule 1, we will continue to operate in an area of confusion.

• Approach any new CBD products that come to market by being prepared for the worst.

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Consequences Associated with Selling Delta 8, a Schedule 1 Controlled Substance

Date November 12, 2021
Article Authors

Delta 8 is a relatively new cannabis product that has been gaining popularity. It is derived from hemp, which was legalized by the 2018 Farm Bill and is used to develop CBD products. That has led to a misinformed assumption that Delta 8 is a legal substance, but it produces a “high,” and as such, the Drug Enforcement Authority (DEA) has made it clear that it considers Delta 8 a Schedule 1 controlled substance. Retailers not licensed to sell marijuana who are selling Delta 8 products should be aware of its legal status and the potential consequences associated with violating the Controlled Substances Act (CSA).

Of course, selling a controlled substance without a license could create severe legal consequences for those selling Delta 8, including arrest, conviction, and jail. But there are also financial issues to be concerned about, including the ever-watchful eyes of the IRS. Provisions of Section 280E of the IRS code limit tax deductions for expenses to the cost of goods sold for purveyors of Schedule I controlled substances. Much of Delta 8 is being sold through convenience stores, gas stations and other retailers who aren’t licensed to sell marijuana. As such, the IRS could deem those retailers’ entire businesses subject to 280E, thereby eliminating all other ordinarily tax-deductible costs, such as real estate and salaries.

Some retailers have argued that because the drug comes from hemp it should be legal. Some have even taken their cases to court. But the rulings have been clear. Delta 8 is a synthetic form of THC, and according to the DEA, which is charged with administering the CSA, a controlled substance. Given the serious ramifications of violating the CSA, no retailer should be selling Delta 8 products without a license.

For more information, or to talk with a cannabis industry accounting specialist, contact HBK Cannabis Solutions at 239-263-2111, or by email at cmarrie@hpkcpa.com.

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SAFE Act 2021 Promises Greater Access to Financial Services for Cannabis Businesses

Date November 1, 2021
Article Authors
Kurt P. Seifert

It is no secret that marijuana is currently one of the world’s fastest-growing industries. Nearly $20 billion of legal cannabis was sold in 2020, and with every passing year, a new company reports massive growth and achieves the status of “industry titan.”

As more and more states have legalized marijuana, the industry has been legitimized. Still, a major issue has gone unanswered. Marijuana is still illegal federally according to existing legislation, the Controlled Substance Act, which, most notably, has kept cannabis businesses from having access to banks. Without banking and related financial services, businesses in the cannabis industry must follow far more difficult routes to raise capital, acquire loans, or engage in a wide range of investing or financing activities. Additionally, these businesses must incur huge costs to secure their abundance of cash, the sheer amount of unprotected funds creating exposure to crime and other kinds of losses.

To mitigate these issues, the solution being proposed in recent years has been the Secure and Fair Enforcement (SAFE) Banking Act. SAFE seeks to improve safe harbor and protections for financial and depository institutions to make banks more confident about doing business with cannabis businesses. The Act accomplishes this by:

• prohibiting federal regulators from punishing banks for working with cannabis industry clients,

• assuring banks that legitimate, legally operated cannabis businesses are not taking in unlawful income,

• removing the right for regulators to terminate customer relationships based on any notion other than that of criminal activity, and

• limiting the tedious, lengthy, and expensive reporting requirements that financial institutions must follow to do business with a cannabis client.

SAFE, formally submitted as H.R. 1595, was originally passed by the House of Representatives on September 25, 2019, but it ultimately died in committee, never making it through the Senate. However, due to the continued push for the legalization of cannabis products as well as the success the industry has had despite regulations, the Act was brought to Congress and passed by the House of Representatives yet again on April 19, 2021, this time as H.R. 1996. Changes in SAFE from 2019 to 2021 were minimal, mainly serving to clarify wording and intent. Changes in wording, like “depository” institutions being altered to “financial institutions,” are immaterial in terms of any meaningful SAFE provision. They serve only to focus and clarify.

New sections have been added to further explain gray areas, such as a new “Business of Insurance” paragraph, designed to explain that nothing in SAFE will override existing laws regulating insurance companies. Should an insurance company take on a cannabis client, they should do so with the same consideration as any other client, the Act declares. As well, they are under no additional pressure to engage cannabis clients should those clients not accommodate their existing standards.

Additionally, the wording has been added to explicitly state that the current “Bank Secrecy Act Expectations Regarding Marijuana-Related Business” guidance issued in 2014 must be updated within 180 days of the SAFE Act’s passing to ensure that guidance is consistent with the changes made in the new SAFE Act. The definition of “financial services,” a term frequently employed in the body of both versions of the act, has been updated to specify whether the customer receiving the product or service is a consumer or a commercial entity.

Many believe the SAFE Act has a much stronger chance of passing than in 2019 due in large part to the increasing number of states passing legalization legislation, a Democratic party-controlled federal administration, and ever-growing bipartisan support for legalization. As well, the SAFE Act is currently included in the 2022 Defense Authorization Act, which is being debated in Congress. While detractors predict the SAFE Act’s language will eventually be removed from the Defense Act before it is passed, the fact that it is currently included dramatically improves the odds of the SAFE Act eventually passing. As well, such large, tediously debated pieces of legislation on major issues typically allow for smaller, if consequential, acts like the SAFE Act to “slip through” in their passing.

On the topic of the SAFE Act’s inclusion in the 2022 Defense Authorization Act, Representative Ed Perlmutter stated on Twitter: “(The SAFE Act) will strengthen the security of our financial system (and) keep bad actors like the cartels out. Most importantly, it will reduce the risk of violent crime in our communities. It’s passed the House five times. We cannot wait any longer to address this public safety threat.”

Considering the current environment favoring the passage of SAFE, and the substantial societal pressure for cannabis legalization, it is undeniable that we will see changes to the legal status of many cannabis industry processes in the near future.








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Are You Capturing Your Costs? Do You Know Your Margins?

Date September 14, 2021
Article Authors

You can excuse cannabis entrepreneurs for focusing on regulation and taxation. But to understand their productivity and profitability, they need to focus more on cost accounting—that is, on understanding their actual costs in real time.

You can’t make money if you don’t know your costs. And if you don’t know your actual margins, you don’t know the value of your business. Manufacturers need a cost accounting model that gives them a precise understanding of all the elements involved in their manufacturing process. But most are incorrectly reporting their costs to manufacture their products on their financial statements.

Understanding your costs comprehensively is critical. If you don’t know how much it costs to make your product, you can’t know how to price it. Cannabis manufacturers must be able to compile all costs, starting at the beginning of their process, from buying the raw material, and walking through every step of their process. But many tend to overlook costs, such as overhead, including the costs associated with operating their facilities, and the cost of labor, including idle and down time. To ensure you are including all relevant costs, you need a cost accounting model. Only then can you determine your actual margins and profitability.

A cost accounting model will also reveal anomalies and inconsistencies. Once your standards are established and implemented in a model or system, you can identify variances from those standards—resulting from more employee hours than predicted, a change in the process, etc.—allowing you to determine reasons for inefficiencies that can then be addressed and resolved.

Understanding your true costs and margins in real time is critical to your valuation should you decide to sell or if you are applying for credit. A buyer wants first to know what they can expect in return on their investment (ROI). In the manufacturing space, gross margin, or gross profit, is the most critical component for determining ROI. Many cannabis manufacturers have been determining gross profit by estimating their gross margins. But if they inappropriately allocated costs to their cost-of-goods-sold, they sacrifice their margins, and therefore their valuations. It is another call for a viable, comprehensive, and expertly developed cost accounting system.

A cannabis entrepreneur must be able sit with a buyer or, if you’re borrowing, a creditor, and explain how your business makes money. Too often manufacturers don’t know their actual margins until well after their year-end accounting. Investors want to know your margins in real time, and with a cost accounting model established for your business, you can produce real-time financial statements.

There are no standardized cost accounting models for the cannabis industry. Given the federal legal status of our industry and the hesitancy of some banks to do business with our companies, many of the major accounting software providers have chosen not to accommodate the cannabis industry; some are treating the industry with hostility. HBK Cannabis Solutions is building customized cost accounting models for our cannabis clients. We detail the client’s manufacturing process and every cost component in that process for the client to enter their numbers into their model each month. The models are detailed to the point of individual SKUs, so the manufacturer can make decisions about production based on real-time knowledge of the margins for each of their products.

Cost accounting is critical to your profitability and your valuation. For more information or to schedule a meeting an HBK Cannabis Solutions professional, call us at (239) 263-2111 or email me at cmarrie@hbkcpa.com.

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New York State Legalizes Adult-Use Marijuana; Cites Criminal Justice Reform

Date April 8, 2021
Article Authors

On March 30, the New York State Assembly and State Senate both overwhelmingly passed the Marijuana Regulation & Taxation Act, decriminalizing the use of adult-use marijuana and establishing an office for the regulation of cannabis. The Act permits adults 21 and over to purchase marijuana and grow the plant in their home. By decriminalizing marijuana, the Act is being heralded as criminal justice reform. According to the bill’s sponsor, Senator Liz Kruger, “New York’s program will not just talk the talk on racial justice, it will walk the walk.” Other key provisions of the law include:

  • 13 percent excise tax on retail sales: 9 percent to the state, 4 percent to the municipality
  • 40 percent of cannabis tax revenues to be spent on education, 40 percent for community reinvestment grants for communities harmed by marijuana prohibition, and 20 percent to drug treatment and public education programs
  • Marijuana arrests and convictions legalized under the law to be expunged, and law enforcement prevented from using the odor of marijuana as a pretext for a search
  • The opportunity for New Yorkers currently working in the illegal market to obtain one of ten different licenses to work in the new cannabis economy

That new cannabis economy is projected to create $350 million in taxes each year as well as 30,000 to 60,000 jobs statewide.

“The New York approach is interesting and very smart, I think, in terms of taking an assertive criminal justice position as part of the deal,” noted Christopher T. Marrie, HBK Principal and National Co-director, HBK Cannabis Solutions. “That is an element missing in the federal position on legalizing cannabis. It’s going to be difficult to do it without tying it to criminal justice reform.”

Marrie pointed out that, “New York was a very tight market, allowing the sale of extracts only, not flower. It will be interesting to see how the transition unfolds.”

That is expected to take about 18 months, Marrie said. “In the meantime, the State has likely created a huge black market. It’s legalized but not regulated. That’s what happened in Michigan where it was legalized in 2008 but not regulated until 2017. It wound up being regulated differently in every municipality.

“New York City will be a huge market,” Marrie proposed. “Some retailers in the big cities, like Chicago and Philadelphia, are doing more than $25 million in annual sales.”

Marrie also said that he expects the tax rates in New York will increase as marijuana is commoditized. “I expect to see the tax rate rise to 20 or 21 percent,” he said.

The new law comes in response to what has become a huge issue in the state. According to reports, in the 1990s and early 2000s, more than 800,000 New Yorkers were arrested or ticketed for marijuana, more than anywhere else in the world.

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Unique Considerations Challenge Cannabis Business Valuations

Date October 11, 2020
Article Authors

The cannabis industry currently looks a lot like a combination of the1940s advent of gambling in Las Vegas and the repeal of prohibition in the 1933. The status of the industry at this point in its evolution has added significant challenges and complexity to valuing cannabis businesses.

Arguably the biggest challenge in the cannabis sector from a valuation standpoint is assessing risk versus return, a practice that due to the unique nature of the cannabis industry, requires a thorough understanding of the industry and its inherent risks.

The following issues should be considered in any cannabis business appraisal engagement; they make industry experience critical to a meaningful and supportable valuation:

  • Internal Revenue Code Section 280e
  • Banking and cash management challenges
  • A relatively new industry
  • Jurisdictionally driven
    • Location
    • Lease
  • Regulatory environment
  • Lack of reliable market data
  • Lack of reliable financial forecasts
  • Risk/return challenges in developing cost of capital and market multiples

Internal Revenue Code Section 280e
U.S. Tax Code Section 280E states that, “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” 1

Cannabis is currently classified as a Schedule I controlled substance. Only cost of sales can be deducted for income tax purposes. The inability to deduct general and administrative expenses leaves cannabis businesses compromised in value compared to other businesses that are allowed to deduct those expenses.

Banking and cash management
As of June 30, 2020, of the nation’s 12,000 financial institutions, only 553 banks and 162 credit unions were servicing cannabis businesses. Because cannabis is a Schedule I substance, any transfer or deposit of money yielded from the sale of cannabis may be deemed “money laundering” in violation of the Bank Secrecy Act (BSA). The Treasury Department has provided guidance on providing financial services to marijuana-related businesses and due diligence practices to follow to avoid prosecution, but many financial institutions have decided it is not worth the cost of compliance. Operating with large amounts of cash creates numerous problems, including greater operating costs and risk of theft.

Traditional sources of capital are rare. Banks are unwilling or unable to lend due to the continuing federal constraints stemming from the Controlled Substances Act, leaving cannabis firms to investments by venture capital and private equity firms. When cannabis businesses find financing, they are often forced to pay significantly greater interest rates than non-cannabis businesses.

A relatively new industry
Dynamic changes continue to take place. Public company cannabis stocks are extremely volatile, as evidenced by the following:

Date Stock Price
January 31 13.13
February 14 11.10
February 28 9.69
March 13 7.21
March 31 5.82
April 15 7.22
April 30 7.17
May 15 6.38
May 29 7.61
June 15 8.98
June 30 9.71

For a smaller non-public company, fluctuating values are a significant factor in making a sound valuation.

Jurisdictionally driven
The mere location of a cannabis business poses multiple challenges. What are a certain jurisdiction’s requirements and limitations? Are there residency requirements? What are the restrictions on transferability? Can a license holder also hold other licenses or be involved in ancillary enterprises? What are the reporting provisions and how well is the enterprise positioned to comply?

Location. How many competitors are in the area and what is the outlook for new competitors? Can the facility be expanded or redesigned if needed to accommodate license requirements (e.g. medical and adult use sales in the same facility)?

Lease. How solid is the lease arrangement and relations with the landlord, if not operating in owned space? What are the restrictions on hours of business, signage, parking and the like? Who are the surrounding tenants and have they “bought in” to having a cannabis operation as a neighbor? What is the term of the lease and what are the renewal options?

Regulatory environment
Local, state, and federal laws and pending legislation require cannabis and their advisors to maintain a close watch on all this regulatory. What is the current and prospective outlook for regulatory change in the subject jurisdiction?

Lack of reliable market data
As opposed to fair market value, industry transactions made at investment or “synergistic” value where the buyer will pay more to get into a specific market, to acquire a competitor, or for another non-financial reason. The premium paid is difficult to quantify because the business may be worth different amounts to different buyers.

Lack of reliable financial forecasts
The anticipation of future legalization for adult use purposes and the unknown effect on prices adds several degrees of difficulty to forecasting. Knowledgeable industry appraisers understand how to develop realistic forecasts based on analyses of similar markets.

Risk/return challenges in developing cost of capital and market multiples
The greater the risk, the lower the value of a business. To illustrate: The value of a business deemed stable with a cash flow of $100,000 and a 15 percent appraiser-assessed rate of return is $667,000. A second appraiser considering the business riskier than the first and assessing a 17% rate of return results in a value of $588,235. Due to the lack of reliable forecasts, among other factors, cannabis businesses are assessed a much higher rates of return than established businesses in other industries.

Due to these challenges alone, it is crucial for owners and management of cannabis businesses to work with financial professionals with deep industry experience.

HBK Cannabis Solutions is a dedicated team of cannabis industry subject matter experts within HBK CPAs & Consultants, an Accounting Today Top 100 CPA firm. We were among the first accounting firms to specialize in the cannabis industry and have worked beside entrepreneurs in all industry segments—cultivators, processors, retailers—from single facility to multi-location and integrated operations. We counsel owners, management and investors in multiples states and countries, helping them with key financial activities: from planning start-ups to connecting operators with investment bankers to facilitating M&A; from pre-offering projections, state applications and licensing to management planning and operations.

1 – 26 U.S. Code § 280E – Expenditures in connection with the illegal sale of drugs

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