As a cannabis reseller or producer, you may have the option to deduct COGS for certain expenses related to the operation of your business. These deductions can offer some substantial tax savings for your business, as the deduction options for cannabis businesses are limited to COGS due to § 280E of the Internal Revenue Code (IRC).
When the IRS Office of Chief Counsel issued Chief Counsel Advice (CCA) 201504011 in 2015, this memo was designed to clarify the COGS deductions that are available to cannabis businesses. The IRS determined that the specific IRC sections that govern the items that can be included as COGS for cannabis businesses are §1.471-3(b), in the case of a cannabis reseller, and §1.471-3(c) and 1.471-11, in the case of a cannabis producer.
While these regulations outline the general categories of deductions that are permitted for cannabis businesses, they do not detail what specific items cannabis businesses can deduct. To help you sort things out, here are some examples of the costs that you should include in your COGS basis for your canna-business so that you know exactly which items are deductible.
COGS for Cannabis Resellers
According to §1.471-3(b), the IRS has interpreted this section of the IRC to mean that cannabis businesses are permitted to deduct expenses related to inventory as COGS only. As result, cannabis resellers can claim deductions for:
●The invoice price for cannabis, less trade or other discounts
●Electric bills for designated inventory areas (electricity used in sales areas are not eligible to be deducted as COGS)
●Transportation (the cost of travel to purchase cannabis, transportation and shipping costs of the cannabis)
Cannabis resellers are permitted to take these deductions only as long as these charges are strictly related to the acquisition of cannabis for resale and the storage and handling of inventory. The best way to ensure that the IRS will not challenge these deductions is by creating an inventory space that is closed off from the sales area of your cannabis business.
COGS for Cannabis Producers
For cannabis producers, §1.471-3(c) and § 1.471-11 of the IRC define how these businesses should treat cannabis production costs and define which expenses they are permitted to deduct as COGS. The IRC advises the use of the "full absorption" method of computing COGS which takes into account both direct and indirect production costs.
Direct production costs are considered those costs which are necessary for the production of cannabis and the materials that are consumed as a part of the production process.
Per the IRC, the direct production costs that cannabis producers can deduct are the costs of:
●Raw materials and supplies (seeds, soil, clones, fertilizer)
●Expenditures for direct labor (hiring workers to clean, trim, cure, package and inventory the cannabis and the associated wages, payroll taxes, and insurance)
Examples of indirect production costs that can be deducted as COGS include:
●Repairs to production and storage facilities
●Maintenance costs for your production and storage facilities
●Utilities (water and electricity used to grow cannabis)
●Rent for your production facility
●Indirect materials and supplies (grow supplies and packaging)
●Indirect labor (supervisory wages)
●Costs of quality control and inspection
These indirect production costs are only deductible if they can be related to the production of cannabis. In addition, if the cannabis production business prepares financial statements that are in accordance with GAAP, some additional expenses can be deducted, which are outlined here.
Californians Helping to Alleviate Medical Problems (CHAMP)
In a 2007 case, Caregiving Californians Helping to Alleviate Med. Problems, Inc. v. C.I.R., 128 T.C. 173, the Tax Court determined that CHAMP could take business deductions for the patient care portions of the non-profit’s medical marijuana dispensary operations. CHAMP was a caregiving program that was designed to provide members with medical cannabis in according with the laws of the state of California. The organization also provided one-on-one counseling, medical supplies, yoga instruction, healthy meals, and Internet access.
As a not-for-profit entity per California law, the Tax Court agreed that CHAMP was actually two separate businesses. The ruling found that the CHAMP's primary business was actually caregiving services, which would permit the deduction of business expenses that were otherwise precluded by §280E.
The CHAMP case made it possible for cannabis businesses to operate multiple businesses under one roof. As a result, it is a good idea to add additional services onto your cannabis business so that you can take advantage of as many of these COGS deductions as possible.
Add patient services, such as counseling or advocacy, and make sure that all other businesses have real purposes and separate financial records to back up their operations. By expanding your business to include non-cannabis related services, you can improve your profits and increase the number of COGS deductions that your business can claim.