Legalization: What's Ahead with Cannabis Accounting
Ballot initiatives relating to cannabis will be voted on in five states — Arizona, Mississippi, Montana, New Jersey and South Dakota — this November. Topics being considered are presented in Marijuana on the ballot.
If you are a CPA working with clients in the cannabis industry, or if you think you might in the future, you’ll want a firm grasp of the issues regarding cannabis accounting.
Cannabis? Marijuana? THC? CBD? Hemp?
Like most industries, the cannabis industry has its own vocabulary.
Cannabis and marijuana both refer to the genus of plant that produces THC and CBD. THC, short for tetrahydrocannabinol, refers to the psychoactive substance found in varying quantities in cannabis. CBD, the abbreviation of cannabidiol, produces no euphoric effect but is used for an assortment of ailments. Hemp, by legal definition, refers to various parts of the Cannabis sativa L. plant that contain no more than .3% THC by dry weight.
Federally, THC and CBD are Schedule 1 controlled substances — the same schedule as cocaine and heroin — defined as having no currently accepted medical use and a high potential for abuse.
However, as of this blog, 33 states have laws permitting the growth, sale, and processing of cannabis in different forms. While several states allow recreational use, some allow use for medicinal purposes only. To further confuse matters, certain states allow CBD preparations only, while others allow CBD and THC preparations for medicinal purposes. And while hemp-based CBD products are federally legal, some states still ban them.
In 2013, the U.S. Department of Justice (DOJ) issued guidance commonly known as the Cole Memorandum. While the memorandum did not legalize cannabis federally on any level, it did allow for the exercise of investigative and prosecutorial discretion in connection with marijuana businesses operating in states that have legalized its use. The Cole Memo provided a consistent nationwide federal policy on prosecution. However, the memo was rescinded in 2018. As a result, the industry is left with the prospect of enforcement policies that differ among the 93 existing U.S. Attorneys.
Banking considerations in the cannabis industry
Problematically, many banks will not open accounts for cannabis businesses. Strictly interpreted, doing so amounts to money laundering, making banks that do so technically in violation of federal law. As a result, many cannabis businesses must operate on a cash basis. This complicates the accounting issues and reporting complexity that CPAs are best positioned to address.
A taxing question
For businesses operating in states where cannabis is legal, federal income tax will need to be paid on any profits. This tax is in addition to any state income, sales or excise taxes paid.
Because of its illegality on the federal stage, cannabis is subject to Internal Revenue Code Sec. 280E restrictions that disallow deductibility of certain regular business expenses for operations trafficking in controlled substances.
Recently, the Treasury Inspector General for Tax Administration issued a report recommending relief to legal cannabis businesses under Sec. 471(c). However, to date, there is no guidance from the IRS and no available court rulings to test this strategy. As it stands, IRC Sec. 280E can result in a federal income tax burden that exceeds net profit.
Legal, taxation and banking issues make cannabis business valuation a challenge.
Being legal or illegal based on geography, licensure and permits, medical vs. recreational sales, and the lack of good metrics for comparable businesses make clear valuation difficult. One-time startup expenses can be high, necessitating careful analysis of what’s recurring and what isn’t.
To attract buyers or investors, valuation of cannabis businesses must be carefully executed and documented with evidence.
If you want to engage in this work, explore strategies and methodologies meticulously to produce the best results.
The industry is expanding.
Due to the increasing number of states legalizing cannabis in one form or another, the industry is evolving rapidly. Some estimates put the legal market for cannabis at more than $70 billion — more than corn and wheat combined — by 2027. CPAs will be needed to provide sound financial advice and support to cannabis businesses.
(Source: AICPA – CPA Letter Daily – October 20, 2020)