Illinois’ Cannabis Industry: What Accountants Need to Know
As more states move to legalize marijuana, accounting professionals must stay ahead of the curve to help serve this unique, complex niche.
By Andrew Hunzicker, CPA | Digital Exclusive - 2022
The U.S. cannabis industry is a growing, complex market with many different niches for accounting professionals and their firms to navigate. Currently, 38 states have legalized medical cannabis and 16 states have legalized its recreational use. Now’s the time to jump into this niche. Asserting yourself as an expert in this field offers a growing opportunity to gain clients that need and value your unique services. For 2022, here’s what accountants need to know about the latest updates in both Illinois and the United States.
Illinois’ Record Cannabis Sales
Illinois had a record year in 2021, selling $1.4 billion of cannabis. I expect this trend to continue. For context, Colorado—a state with less than half the population of Illinois—had $2.2 billion in cannabis sales in 2021. Therefore, Illinois can expect sizable growth in both revenues and tax dollars as its marijuana market matures, particularly now that the state has expunged crimes associated with marijuana.
On the flip side, Illinois’ “social equity” efforts have fallen short. There are 185 licenses that were awarded to social equity applicants that still aren’t operating due to lawsuits.
Federal Legalization Update
While cannabis remains a Schedule I substance and is still subject to Internal Revenue Code (IRC) Section 280e, it appears we’re closer than ever to full national legalization (just a few Senate votes short).
The Cannabidiol and Marihuana Research Expansion Act, or CMRE Act, was unanimously passed on Mar. 24, 2022, representing one of the few occasions that the Senate advanced a marijuana-related reform bill. The CMRE Act provides the Office of the U.S. Attorney General, rather than the U.S. Drug Enforcement Administration, the discretion to license scientists to engage in clinical trials involving the use of cannabis by human subjects.
Perhaps the next biggest piece of legislation on the horizon is the Marijuana Opportunity Reinvestment and Expungement Act, or MORE Act, which is a bill to decriminalize marijuana at the federal level. There’s also still optimism that banking reform will be completed in 2022, which would be a huge relief to the industry. And even more states are looking toward legalization—Arkansas and Hawaii are well on their way to legalizing, and Delaware continues to work toward legalization after failing to pass a bill earlier this year.
What Does This Mean for Accountants?
IRC Section 280e states: “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.”
The bad news: no deductions or credits for cannabis companies. The good news: inventory is a return of capital and not a deduction or credit. So, via IRC Section 471, cannabis companies can put costs into inventory and, when sold, the cost of goods sold is allowed to lower taxable income. Obviously, the more costs allocated to inventory via cost accounting, the less tax the client will pay.
Cultivators, chemical processors, and product manufacturers (e.g., food, beverage, lotions, tinctures, etc.), get to allocate sizable costs into inventory. IRC Section 471-11 lists direct costs and labor to allocate 100%. For indirect costs, IRC Section 471-11 lists:
- Costs that must be included.
- Costs that can never be allocated to inventory.
- Costs that can be allocated to inventory if, and only if, the client does cost accounting in their recurring financials (not just at year end) and if that accounting is in accordance with U.S. Generally Accepted Accounting Principles (GAAP).
In a recent case, Lord v. Commissioner, the petitioners were denied a deduction due to the inventory accounting not complying with GAAP. According to a case briefing:
“Section 471 requires an inventory accounting method to: (1) conform as nearly as may be to the best accounting practice in the trade or business and (2) clearly reflect income. Treas. Reg. § 1.471-2. ‘Best accounting practice’ is synonymous with GAAP, and GAAP-conforming methods satisfy the first prong of Section 471. Thor Power Tool Co. v. Comm’r, 439 U.S. 522, 532 (1979). Generally, an accounting method will be held to clearly reflect income if it has been consistently applied and conforms with GAAP. Reg. § 1.446-1(a)(2).”
Since cannabis companies are essentially penalized due to IRC Section 280e, it’s imperative that they implement IRC Section 471 correctly to minimize their tax burdens.
What Do Accountants Need to Succeed?
As an accountant serving cannabis clients, you’ll need to know how to allocate the different costs to the various phases in the grow cycles, for example, among other things. To provide effective cost accounting to your clients, you’ll need some very important tools to help them maximize their tax benefits. We recommend clients having:
- A very good cannabis chart of accounts. This should be ready for use with QuickBooks, Xero, or another accounting system and be specific to growing, processing, edibles, and retail operations.
- A client inventory template. This is for accumulating data for things like monthly/quarterly counts, weights, estimated yields, and percent complete. And you’ll need cost accounting templates to perform these calculations.
- Rock-solid, audit-proof books and records. With IRS auditors targeting this industry, I feel these are imperative for all clients to have. I recommend building a “permanent audit trail” every month, starting from transaction/event to source document, general ledger, trial balance tie outs, and financials.
The cannabis industry is still very new and complex with all its niches, and that’s before we even include accounting and finance issues like cost accounting, lack of accounting tools, lack of regulatory guidance, banking issues, software issues, and more. But with great difficulty comes great opportunity. I think 200,000 to 400,000 new cannabis-related companies will be created during the next two to five years, many of those with $5 million to $10 million in capitalization on day one (meaning they can, and should, pay six-figure fees for the world-class accounting and tax services we CPAs can provide).
Andrew Hunzicker, CPA, a frequent contributor to Insight, is the CEO and managing partner of DOPE CFO.