calyxcpa, Author at Calyx CPA

HOW DOES INVENTORY INCREASE NET INCOME?

I had a client inquire about why an increase in inventory increased their net income. I explained that for most businesses purchasing products for resale, as well as supplies and materials, typically categorize these items as ‘Cost of Goods Sold’ (COGS). COGS directly offsets gross income and subsequently reduces net income.

However, at the end of the financial year, often accountants request clients to report their ending inventory. Once this is reported, accountants reallocate funds from COGS to the inventory on the balance sheet. This adjustment lowers the COGS, thereby increasing net income. This adjustment can often surprise business owners, particularly in their first year of operation when inventory is being accumulated for the first time.

A significant point to note is that businesses often have substantial funds tied up in inventory. However, they cannot deduct the cost of this inventory until it is sold, which might be in the following year. This leads to a situation where they might have to pay taxes on income despite having low or negative cash flow. A practical tip is to minimize inventory accumulation towards the end of the year and consider replenishing it at the beginning of the next year.

Notably, as of this recording, most businesses are not required to report inventory if their gross revenue is under $29 million. If your business falls under this threshold and your accountant still asks for inventory reporting, it might be wise to get a second opinion as to whether it is necessary to report inventory.

An exception exists for certain industries, such as the cannabis industry, which are subject to specific regulations like Section 280E. In these cases, businesses are required to report inventory as they use particular methodologies that capitalize COGS to inventory, allowing them to deduct otherwise non-deductible expenses.

Businesses with revenues under $29 million can generally employ the cash method of accounting, which permits them to write off purchases for resale, supplies, and materials as COGS and benefit from these deductions in the year they occur.

WHAT KIND OF ASSET CAN I WRITE OFF?

As a tax planning strategy, particularly towards the end of the year, a common question from clients is: “What can I buy to decrease my tax liability?” Many consider purchasing vehicles or making down payments on properties or building facilities. However, it’s important to note that there are limits. For example, buying real estate, including land and building, doesn’t usually offer immediate tax deductions. In fact, down payments on property in and of itself don’t qualify for immediate deductions.

The main category of assets eligible for immediate depreciation (sometimes called ‘bonus depreciation’) includes equipment that can be described as losing value upon purchase and is also not permanently affixed to a building or property. This category encompasses a wide variety of assets, from computers to tractors, dehumidifiers, trimming machines, and even essential building equipment like appliances.

For vehicles, to qualify for bonus depreciation or 179 deductions, they must have a demonstrable and primary business use. Purchasing cars for tax write-offs is often risky if they are not used exclusively for business. For instance, vehicles must be used over 5% of the time for business purposes to be eligible. If this percentage drops, the IRS may require you to recapture formerly deducted depreciation. If business use is less than 50%, consider opting for taking a mileage deduction (currently at $0.65 per mile), which is safer. For business owners, reimbursing oneself for mileage from the business for the use of a personal vehicle is recommended. This reimbursement is non-taxable and counts as a business expense. Remember that these business miles must be meticulously recorded for the deduction to be substantiated.

Land, on the other hand, is not depreciable. It generally appreciates in value, and the IRS doesn’t allow depreciation as it’s seen as a cash-for-property exchange without actual value loss. Residential rental properties can be depreciated over 27.5 years and commercial buildings over 39 years, but these are long-term deductions and don’t offer much immediate tax relief.

Remember, specific equipment, such as above-ground irrigation systems, that aren’t permanently attached to the property can also qualify for bonus depreciation. Investing in equipment can be a smart tax strategy, especially if these are items you plan to purchase regardless.

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THE MINDFULNESS EXPERIENCE PODCAST – IRS, 280E & PSYCHEDELICS Ideas

In this episode of The Mindfulness Experience Podcast, host Keith Fiveson interviews Botillier, CEO of Calyx CPA LLC, who has extensive experience working with small business owners and is a passionate advocate for the Cannabis and Psychedelic Industries. As a member of the psychedelic community, Justin is committed to assisting businesses in Oregon’s burgeoning psilocybin industry in navigating the financial implications of the 280E provision.

471(C) & 280E

Most business owners in the cannabis industry know of 280E and have at least a basic understanding of what it is. If 280E is still a mystery, one only needs to “Google it” to find information about it and its potential impact on a business’s tax liability. What isn’t commonly available is information on how to address it.

Years ago, as states started to legalize cannabis, the accounting industry went to work attempting to figure out what the cannabis industry would do about 280E because it made doing business in the cannabis industry painful, if not impossible. Most poignantly, dispensaries, especially those with a low gross profit whose overhead expenses were proportionately much higher than those with large gross profits whose overhead represented a smaller portion of their overall cost. Low gross profiting dispensaries would regularly experience effective tax rates in the 80 and 90 percentiles. This could quickly mire a business owner in tax debt within a year of starting their business. This scenario is still the story for most dispensary owners. Unfortunately, most accounting professionals are still unaware of these consequences, and new business owners often fall victim to uninformed decision-making by their accountants.

Well before the Tax Cuts and Jobs Act, accountants specializing in the cannabis industry quickly discovered IRC section 471. They developed a methodology allowing them to, at least in part, deduct overhead expenses that would otherwise be disallowed. Accountants would encourage their dispensary clients to incorporate manufacturing activities within their businesses, including weighing, packaging, and value-added processing, to tie their facility and payroll expenses to their inventory so that at least a proportion of their otherwise disallowed costs could be capitalized to inventory and deducted. Over the years, even in audits, IRS agents allowed reasonable use of this methodology. However, these companies continued to pay absorbent effective tax rates because the business could still not deduct most of their expenses.

In 2018, the Tax Cuts and Jobs Act was passed, and 471(c) superseded 471(a). 471(c) was Congress’s attempt to simplify the inventory requirements for small businesses, and simplify it, it did. For companies with a gross income of 25 million dollars (currently 26 million) or less, it allows management to choose whether it wants to track and report inventory. 471(c) further states that a company can calculate its inventory based on its “books and records.” Therefore, any business with a gross income under 25 million dollars can calculate inventory however it sees fit, including capitalizing overhead. For example, if a business wants to include 100% of its payroll and facility costs in its inventory calculation, it could do that if it is based on the company’s books and records.

When tax attorneys and accountants discovered the loophole, we high-fived and chest-bumped one another. Between 2019 and 2020, those paying attention had a free-for-all using 471(c) to deduct our clients’ expenses. For businesses operating in the cannabis industry, especially for dispensaries, 471(c) significantly reduces the impact of 280E. Unfortunately, some accountants were too enthusiastic and started making videos and blog posts stating, “280E is dead.” Then the “powers that be” started paying attention. The entity that oversees the IRS, the Treasury Inspector General for Tax Administration (TIGTA), got word that the cannabis industry was using 471(c) to avoid paying taxes. It pressured the IRS to do something about it. As a result, in January of 2021, the IRS passed regulations that “…nothing in section 471(c) permits the deduction or recovery of any cost that a taxpayer is otherwise precluded from deducting or recovering under any other provision in the Code or Regulations.” This translates to if you are subject to 280E, you can’t use 471(c) to avoid paying taxes.

Early on, attorneys and accountants in the cannabis industry explored another code section called 263A. This code section explicitly states that if a taxpayer is disallowed deductions under another code section, they are not allowed to use 263A to capitalize overhead expenses to inventory. Therefore, 263A is not used by the cannabis industry. The critical difference here is that the flush language of 263A was appended to the code, while the IRS wrote 471(c) language into regulation. Regulations are a form of guidance issued by the IRS meant to interpret and give directions on complying with the tax law. The IRS has the authority to issue regulations; however, they are essentially an opinion of the IRS. Fortunately, for businesses subject to 280E, the IRS does not write the tax code; Congress does. Therefore, many professionals in the cannabis industry believe the IRS may have overstepped.

Please note that the fastest way to ruin 471(c) for your clients and everyone else is by attempting to write off all overhead expenses, thereby avoiding the impact of 280E entirely. We do not recommend kicking the hornet’s nest. Instead, we recommend developing a narrative that justifies why you are capitalizing overhead expenses to inventory other than to avoid 280E.

So we will leave it up to you and your accountant to decide how conservative or aggressive you want to be with your deductions. According to 471(c), your cost of goods sold can include otherwise disallowed deductions if they reflect your books and records. One thing is for sure, doing nothing to mitigate 280E is a mistake and very costly. If your accountant is unwilling to take an approach, they are far more likely to end up miring you in tax debt before the IRS does. So rather than fearing the IRS, it would be best if you considered the accountant you are using.

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280E AND THE PSILOCYBIN INDUSTRY

Like cannabis, psilocybin is a schedule one drug subject to tax code 280E. This writing will not go into what 280E is because, as the cannabis industry has been subject to the code section since its implementation in the early 80s, there is an abundance of information about 280E that can be found online. The question is how it impacts the psilocybin industry and what the industry can do about it. We have identified service centers as being the entity in the supply chain that would be most impacted by 280E. Manufacturers are similar to cannabis cultivators in that they are less affected by 280E; most, if not all, activity is related to the product’s manufacturing and, therefore, the company can comfortably deduct their expenses under inventory-related code section 471.

On the other hand, according to 280E, psilocybin Service Centers are not allowed to deduct almost all of their expenses except for the cost of the psilocybin itself. If you do the math, you will see how this tax treatment will be impossible for the industry to absorb. Therefore, a methodology must be utilized to mitigate the impact of 280E for Service Centers.

As of this writing, two methods are being entertained. One is the CHAMP method, and the other is a 471C methodology. This writing will explore the most logical approach, the CHAMP method.

To learn more about (CHAMP), google “Californians Helping to Alleviate Medical Problems (CHAMP) v Commissioner.” Warning, as an approach has yet to be tried in court, there is no risk-free method to mitigating the impact of 280E. Psilocybin Service Centers are expected to start operations in September of 2023, tax returns will be filed in 2024, and audits will likely not be conducted for a few years after that. Therefore, we will not know what methodology will be allowed until a tax return is tried in tax court and litigated.

CALIFORNIANS HELPING TO ALLEVIATE MEDICAL PROBLEMS (CHAMP)

Californians Helping to Alleviate Medical Problems (CHAMP) was a 501c3 not-for-profit organization that provided medical services supplemented with cannabis. Unfortunately, they were audited by the IRS, their nonprofit status was stripped, and they were assessed tax at corporate rates of 35%. As a result of 280E, all of their expenses, except for the cost of their product purchased for resale (COGS), were disallowed. The tax treatment ultimately forced the organization to close. Fortunately for those in the psilocybin industry, CHAMP appealed the decision and eventually won their argument. Their attorneys successfully argued that the organization’s primary operation was to provide medical care, and selling cannabis was a secondary activity. As a result, the court decided to allow the organization to deduct its expenses related to caregiving. There are many more facts and circumstances related to the case, but for the psilocybin industry, it’s a start.

Along with most would-be business owners in the psilocybin industry, our firm also believes that, like the cannabis industry, psilocybin can be used for medicinal purposes. However, despite mounting support for the hypothesis, evidence is still inconclusive due to legal barriers. However, using psychedelics for therapeutic purposes does indicate a higher efficacy rate than talk therapy to treat mental illnesses, including OCD, PTSD, and addiction.

Please note that the strategy of having multiple business activities has been attempted by the cannabis industry numerous times but has failed many more times because their “services” or “other” business activities were deemed to be an attempt to circumvent 280E or were in the service of selling cannabis and were not legitimate revenue streams. However, I think the psilocybin industry can leverage the CHAMP precedence in that most Service Centers or business people in the sector intend to operate a business meant to help people, and selling psilocybin is in the service of caregiving.

Therefore, with proper accounting and recordkeeping, we, as accounts, should be able to argue that the industry is generating revenue by offering services and not necessarily selling psilocybin. But, of course, we will not allow all expenses; we must throw the IRS a bone and disallow the overhead related to “drug trafficking.” At that point, we can, however, implement the 471C approach to allocate costs associated with the sale of psilocybin.

Unfortunately, there is no silver bullet. Accordingly, the IRS has concluded that, along with ancillary, closely held companies, or businesses that do not have substantially different ownership, any trafficking within a company or a group of companies can taint their business activities and make them subject to 280E.

471C

It has also been proposed that the industry take a purely 471C approach and, under it, deduct all its expenses, besides those that would not otherwise qualify as a requirement to do business, as discretionary expenses. But that approach would hold up more, or even less, than a dispensary attempting to do the same thing. One thing is for sure, your biggest concern is your accountant not doing anything and getting mired in tax debt.

280E AND PROPER BUSINESS STRUCTURES

Businesses subject to Internal Revenue Code Section 280E must choose their business structure carefully. In this article, I will describe the pros and cons of each structure, and provide recommendations for specific business types within the cannabis and psilocybin industry.

LIMITED LIABILITY COMPANY (LLC)

The Limited Liability Company (LLC) is now the most recommended legal structure. Many people automatically confuse LLCs with being synonymous with partnerships and, at one point, this was true. However, about 20 years ago, awareness started to change and now LLCs are considered for multiple tax treatments. For example, the LLC can be taxed as a sole proprietorship or disregarded entity, partnership, S corporation, or C corporation.

PARTNERSHIPS

Partnerships should only be considered when holding assets for investment purposes or when the ownership structure necessitates it. Partnerships are the most flexible tax structure allowing diverse ownership types, capitalization, and distribution activities. However, it is a pass-through entity in which the business’s income is taxed at the partner level, the income can be subject to self-employment tax and, due to the relatively new Partnership Audit Regime enforced by the IRS, when partnerships are audited they can be charged tax at the partnership level at the highest individual income tax rates. For this reason, we don’t recommend partnerships unless it is necessary.

S CORPORATION

Most small businesses qualify to elect to be taxed as an S corporation if they choose. Like the partnership entity structure, the S corporation is a pass-through entity, meaning the business’s net income is taxed at the shareholder level. However, if appropriately managed, the S corporation can be more tax favorable than a partnership or C corporation. For example, the S corporation business entity must pay its officers a “reasonable wage,” subject to payroll taxes. But unlike partnership distributions, distributions paid from an S corporation are not subject to the 15.3% self-employment tax.

For this reason, the S corporation is the preferred entity structure for small businesses. For most companies in the cannabis and psilocybin supply chain, the S corporation is typically ideal. However, a pass-through entity is not recommended for companies with a significant 280E impact, specifically retailers or service centers.

C CORPORATIONS

C corporations should be considered before other entities operating in a federally illegal business, specifically those in which 280E applies. Tax is assessed at the business level, and business returns are prepared independently of the shareholders’ tax returns. In addition, due to its current Federal tax rate of 21%, it can be more tax favorable for business owners subject to higher individual tax rates. But most importantly, if a tax adjustment results in significant tax debt, the corporation is siloed from the shareholders. The corporation is responsible for the tax debts imposed by the taxing authorities, not the owners.

There is frequent pushback when suggesting the use of C corporations. There is a concern over double taxation in that C corporations pay tax on their earnings and then again when those earnings are paid out in the form of dividends. There is potential for double taxation, but those results are typically due to the mismanagement of the corporation funds or the lack of tax planning. The C corporation is only subject to the potential of double taxation when the ownership is attempting to extract value from it. Otherwise, the income of a C corporation will be taxed only once.

Most business owners intend to expand their operations and business holdings. The corporation’s earnings can be used to expand operations, purchase additional assets, or lend to other companies. Therefore, they are not likely to be subject to double taxation during the growth phase of their development. The risk of double taxation happens when the shareholders attempt to extract value from the company. Fortunately, with some planning, there are various ways that earnings can be paid out to avoid being taxed a second time. For example, value can be extracted as compensation through the payroll system or paid out as management or consulting fees; it is common for corporations to give bonuses to key employees that are also shareholders. Often the shareholders of a corporation will set up consulting or management companies that provide services to the corporation in return for fees; shareholders can be paid for simply being on the board. Finally, paying rent is a common way of extracting value without being double-taxed. The corporation leases real estate, human resources, or equipment from companies the shareholders may also own.

An ideal structure, we recommend, is to have your trafficking operations included as a C corporation and your real estate holding company structured as a partnership. Furthermore, I recommend that your real estate company do as little commingling of activities with your operating company as possible. For example, it is common practice for the real estate holding company to provide land and leasehold improvements to customize the property to address the operating company’s needs. This activity could cause the holding company to be considered “in the service of” trafficking. Therefore, to help reinforce the holding company’s position that it is simply a real estate investment company and not in the business of trafficking, we recommend that “build-outs” and other related activities be paid from the operating company and included in the operating company’s bookkeeping.

Selecting the proper business structure is vital for the success and growth of any company, especially for those operating in federally illegal businesses. While no one-size-fits-all solution exists, companies can optimize their structures with proper guidance and planning to balance their compliance, flexibility, tax, and risk mitigation needs.

Calyx CPA

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