I-502 Accounting Basics: Avoid the Audit

By Anne Van Leynseele, NWMJ Law

WHO’S STANDING NOW; WHO’S STANDING TOMORROW

We keep getting the same questions over and over from different clients so to save everyone’s time; we decided to share the answers with all of you MJBA members.

GOALS OF THIS SERIES:

  1. To increase your business literacy.
  2. To help ensure that you fulfill all of the responsibilities of a small business owner.
  3. To clarify why outside professionals are essential to your survival and how to find and use the best fit for your business.

As a small business owner you are responsible for every part of the business. Understanding the stages of development can help clarify what is important at each stage of growth.

In small business offices around the country sits shoeboxes or file folders full of business receipts, invoices, and accounting data. As the months roll by and the data accumulates, your business is sitting on a growing problem. Learn before it is too late why your accounting system can cost your business and more.

For many start-ups and sole-proprietors, the shoebox or file box was a temporary fix prior to setting up an accounting system. But with procrastination the box can become the nemesis of your small business.

What is an Accounting System?

An accounting system for your business is not as simple as a shoebox or file folder. These items will collect and organize your important business information but you need to look at what the numbers are telling your business. An accounting system will take your business beyond record keeping and provide important financial indictors. An accounting system will have the following parts:

  • Data Collection: Includes business transactions and operations data.
  • Data Organization: A method of sorting data by date and transaction type.
  • Accounting Database: Data entry into a spreadsheet or accounting software program will form the basis of accounting information.
  • Financial Statements and Reports: Balance sheets, income statements, budgets, and timetables comparisons will aid in running your business.
  • Analysis: Regular review of main controls to avoid problems and capitalize on opportunities.

If your small business accounting system is focused only on collection and organization until year end than discover why you need to change over to a complete system.

8 Reasons for Accounting System Upgrade

  1. Expense Creep: It starts off innocently as you begin to add more regular expenses to your operations. Without monthly tracking of expenses and costs, you cash flow can quickly dry up.
  2. Overdue Accounts: Ignoring the need for an accounting system can make tracking accounts receivables a guessing game. Don’t be in the business of bank lending. Misplacing a 90-day overdue account is costing you money.
  3. Cash Flow Crunch: Every business will experience the highs and lows of cash cycles. To overcome periods of cash shortages or to get needed funding, an accounting system will help you identify who owes you money and places for expense cuts. Create a full financial summary every quarter.
  4. Lack of Data Security: How safe is your shoebox? Is it reinforced steel, fireproof and waterproof against major disasters? Important financial information needs to be stored on a removable disk and on a secured offsite location. Never take a chance assuming it can’t happen to you.
  5. Added Costs: Having an accountant or bookkeeper organize and compile your accounting data at year end can be costly. Organize your invoicing, accounts payable, accounts receivable and most important know your cash flow.
  6. Audit Risks: Surviving an IRS audit can be easier if all financial matters of your small business are in order. Providing an auditor with financial statements, organized files, and well tracked transactions will make everything easier for all parties involved.
  7. Bankruptcy is NOT an option in legal cannabis: With the majority of businesses failing in the first 5 years, poor financial management remains one of the top reasons for failure. It is your responsibility as a small business owner to maintain and regularly assess your financials. Not putting an accounting system in place early during your startup can mean the end of business. Proper accounting can help you see money losing strategies before it is too late.
  8. Financing Difficulty: Do not bring a shoebox of invoices and receipts to your banker or investor meeting. The professional appearance of your company’s books is part of a winning strategy to financing.

The price of business ownership comes with the responsibility of establishing an accounting system. On the plus side you feel more control over your business, less stress, and better profitability.

 

WHERE DO YOU STAND?

The accounting cycle for a small business begins with establishing the chart of accounts for that business and ends with closing the books for that business at the end of the accounting time period. The accounting cycle is a series of steps that the firm takes every accounting time period in order to take account of its financial transactions.

Here are the steps in the accounting cycle for a small business:

  1. Develop the Chart of Accounts for your Small Business
  2. Understand The Source Document in an Accounting Transaction
  3. Accounting Journal Entries
  4. Construct the General Ledger for your Small Business
  5. How to Prepare a Trial Balance
  6. How to Make Adjusting Entries in your Accounting Journals
  7. Prepare the Financial Statements
  8. Closing Entries as Part of the Accounting Cycle

Washington State Business Entities

You may operate your business under any one of several business structures in Washington State. Each type of structure has advantages and disadvantages that should be considered. The descriptions of the structures below are provided to assist applicants and are not intended to be legal definitions with the force of law. You should contact an attorney, accountant, financial advisor, banker, or other business or legal advisors to determine which form is most suitable for your business or organization.

  • A Sole Proprietorship is one individual or married couple in business alone. Sole proprietorship’s are the most common form of business structure. This type of business is simple to form and operate, and may enjoy greater flexibility of management and fewer legal controls. However, the business owner is personally liable for all debts incurred by the business.
  • A General Partnership is composed of two or more persons (usually not a married couple) who agree to contribute money, labor, and/or skill to a business. Each partner shares the profits, losses, and management of the business and each partner is personally and equally liable for debts of the partnership. Formal terms of the partnership are usually contained in a written partnership agreement.
  • A Limited Partnership* is composed of one or more general partners and one or more limited partners. The general partners manage the business and share fully in its profits and losses. Limited partners share in the profits of the business, but their losses are limited to the extent of their investment. Limited partners are usually not involved in the day-to-day operations of the business. Note: A limited partnership may opt to become a Limited Liability Limited Partnership* by including a statement to that effect in its certificate of limited partnership. Status as a limited liability limited partnership provides general partners with a shield from liability for obligations of the limited liability limited partnership.
  • A Limited Liability Partnership* is similar to a General Partnership except that normally a partner does not have personal liability for the negligence of another partner. This business structure is used most commonly by professionals such as accountants and lawyers.
  • The Limited Liability Company (LLC)* An LLC is formed by one or more individuals or entities through a special written agreement. The agreement details the organization of the LLC, including: provisions for management, assignability of interests, and distribution of profits or losses. Limited liability companies are permitted to engage in any lawful, for profit business or activity other than banking or insurance. Doing business as an LLC may yield tax or financial benefits.
  • A Corporation* is a legal entity, a corporation has certain rights, privileges, and liabilities beyond those of an individual. Doing business as a corporation may yield tax or financial benefits, but these can be offset by other considerations, such as decreased personal control. Corporations may be formed for profit or nonprofit purpose.
  • A Nonprofit Corporation* A nonprofit corporation is a legal entity and is typically run to further some sort of ideal or goal, rather than in the interests of profit. Many nonprofits serve the public interest, but some do engage in private sector activities. If your nonprofit organization is or plans to fundraise from the public, it may also be required to register with the Charities Program of the Washington Secretary of State.

Items marked with * must register with the Secretary of State, Division of Corporations and Charities.

See table below

LESSONS:

Set-up your company in a way that minimizes your tax liability

Make sure you understand your tax obligations

Keep a schedule of filing and payment deadlines

Do not fall behind

It is not too late to clean up the past

Money flows through a company and someone must keep track of it. A budget is a basic tool to understand the flow. A budget will inform your decisions by helping you decide how to allocate resources, control spending, and provide a way to plan for the next year.

Within an operating budget there are two major categories: fixed costs and variable costs. Each industry is going to have different forms or types of fixed costs.  In some industries, salaries are paid even if no work is accomplished. In 502 world, the insurance company has to be paid as a legal requirement for you to be in business. The sooner you offset the fixed costs within the accounting period, the sooner you will generate a profit, but to know what that number is you must have a budget. The rest I will leave to the experts on April 19th.

DRAFT OPERATING BUDGET

FIXED COSTS – Fixed costs are those cash expenses that must be paid whether the business produces or sells a single product. Some of these costs have a variable element, but you know the business will need to pay for the line item.
Building/location rent  
Equipment rent  
Advertising  
Website hosting/maintenance  
Insurance  
Software licenses  
Taxes  
License fees  
Utilities  
Dues and subscriptions  
CPA fees  
Legal fees  
Bank fees  
Security  
 
VARIABLE COSTS – A variable cost is a cost that changes in relation to variations in an activity. In a business, the “activity” is frequently production volume, with sales volume being another triggering event that increases variable costs.
Payroll  
Payroll taxes  
Benefits  
Contract labor  
Production supplies  
Packaging  
Commissions  
Delivery costs  
 

DRAFT CAPITAL EXPENDITURES BUDGET

Property purchase  
Computers/printer  
Tenant Improvements  
Buildout  
Farm equipment  
Equipment upgrades  
Emergency fund  
 

 

The 280e Cannabis Conundrum

By  Keith Richards 

If you are in the Cannabis industry and are not already familiar with IRS Code section 280e, then you are likely going to face a rude awakening this tax season.  Even with all the noise about this issue, it is still surprising to find operators that are not paying attention to some basic business principles such as knowing how costs (in this case taxes) will affect their business. It doesn’t mean that you have to become a CPA because the rules are fairly straight forward and there is significant literature addressing the topic.  However, using a trusted advisor to navigate areas of unfamiliarity (taxes and otherwise) would be the most beneficial way to insure that that you don’t go out of business due to the burden of unexpected taxes or worse, end up in jail ala Al Capone.

First, let’s understand the law:

Internal Revenue Code section 280e specifically 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.”

Whew….what does that mean? The IRS is a group of clever individuals whose job is to maximize revenue to the United States by taxing income.  They are not concerned whether the income was derived legally or illegally, but whether you pay your taxes on the income generated. Federally, Cannabis is still a controlled substance and illegal and therefore falls under the provisions of IRS Code section 280e. Per the provision, unlike “ordinary” companies that are able to deduct expenses in determining taxable income, 280e related entities (Cannabis being one type) cannot deduction normal and ordinary operating expenses.  The result is that a Cannabis related entity will be denied these deductions, will report higher taxable income and of course pay more taxes. This is where many operators are getting themselves in trouble.  They fail to realize and account for the additional tax burden that will be imposed and then either don’t have the cash to pay or simple didn’t know the law and fail under audit. Under 280e Instead of paying a tax rate of 30% or 40% a Cannabis business might end up paying 60% to 90% in taxes.

Second, understand your cost of goods sold:

From a retail standpoint Cost of Goods Sold (COGS) are the costs that a business incurs such as materials, certain labor and the wholesale price of goods purchased that are subsequently retailed.  From a grower standpoint, COGS can include additional components that are directly related to production such as seeds, nutrients, electricity for grow lighting, supplies etc.  COGS is considered an adjustment to revenue as opposed to an expense deduction and as such does not fall under the provisions of 280e.  Consequently, while a Cannabis company cannot deduct operating expenses, it can adjust revenue for cost of goods sold. Therefore, it would be prudent for an operator to have a good understanding all of the components of COGS.

 

Third, develop a strategy:

Given that Cannabis related entities are limited on expense deductions but can adjust for COGS, in order to minimize the tax burden, hiring professional advice is a relatively small expense when compared to the potential exposure.  That being said, here are a few tips that each Cannapreneur should consider and discuss with their trusted advisor:

Diversify your services – consider offering additional services such as Yoga, or meditation, or stress counseling.  You may be able to allocate some of your operating expenses to these other services and take them as deductions against these goods and services.

Use IRS Code 263a to capitalize costs to inventory – Code Section 263a allows an organization to capitalize certain expenses which then become a component of inventory.  Once the inventory is sold and run through COGS these previously disallowed expenses now become an adjustment to revenue (as opposed to a disallowed expense) as a component of inventory and COGS.

Correct legal entity – A regular S-Corp is required to pay a fair wage to the owners and operators of the entity, yet these wages would be considered a non-deductible expense under 280e. On the other hand, a Limited Liability Corporation (LLC) is not required to pay the owner a salary and instead the earnings of the LLC are the owner’s taxable earnings. The owners would report net income allocated as opposed to salary and therefore there is no salary expense that would be disallowed.

Fourth – Stay well informed of potential law changes

In 2011, a bill called “The Small Business Tax Equity Act” was introduced to congress.  Essentially, the bill attempted to resolve the difference between state and federal law allowing for an exemption from section 280e for medical marijuana entrepreneurs as long they were in compliance with State law. The 2011 bill died and was reintroduced in 2013 emphasizing all marijuana businesses but it died as well.  In April 2015, a pair of congressmen (Rep. Earl Blumenauer and Sen. Ron Wyden of Oregon) have reintroduced the bill for a third time. This legislation is gaining widespread support by organizations such as Americans for Tax Reform, the National Cannabis Industry Association, Drug Policy Alliance, Marijuana Policy Project, Americans for Safe Access, and NORML.  Given the amount of attention and support this topic has garnered, there is hope that “third time’s a charm” and marijuana businesses will finally become exempt from 280e.  However, with congress one never really knows.

Finally – change is a constant:

Cannapreneurs need to recognize that the Cannabis industry is going through growing pains in the same way that many other first time industries have developed. There are many factions, special interest groups and profiteers that are each trying to influence the future direction to their benefit and as such the rules to the game are continually changing. For that reason it is important to stay abreast of change and surround yourself with solid professional advice that can help along the way.  Be sure to consult with your tax and legal advisors and make solid informed decisions for the long term.

 

Keith Richards is a successful CEO/COO & CFO.  Currently he is a Partner with the Newport Board Group, a national professional services firm of strategic advisors. He’s also a Director with Integral Edge Partners focusing on high performance leadership transformation and corporate culture development. He is a regular commentator on a variety of business radio programs, keynote speaker and blog author. Keith can be reached at keith.richards@newportboardgroup.com followed on LinkedIn at www.linkedin.com/in/keitharichards and on twitter @KRLeadership.