By: Scott F. Roberts
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How to Increase Profits at a Marijuana Dispensary: 280E Considerations
With the Michigan medical marijuana industry set to take off over the next few years, most Michigan marijuana entrepreneurs are focused on making sure that their state MMFLA license application was properly submitted and approved. In our conversations with clients and prospective entrepreneurs alike, we’ve noticed that a lot of business owners seem so enamored by massive growth potential in the Michigan marijuana market they overlook some of the pitfalls associated with operating a cannabis company.
Talking to some prospective clients, their eyes light up when discussing the profit potential of Marijuana facilities. Sometimes, I swear I can literally see dollar signs in their eyes. They want to dive in with a huge operation (whether it be a multiple Class C grow facility, a mega-provisioning center, or a large processing center) and are expecting massive profits, just by way of getting into the industry early.
As a Michigan marijuana business attorneys, our job is not only to help our clients compile a solid application packet for LARA’s review, but also to advise them on investment opportunities, obtaining municipal approval, and ongoing business decisions. While a lot of the legal work on the front-end is related to the MMFLA application, we also advise clients on issues such as how to set up their business to maximize profitability. As business lawyers, much of our advice goes beyond strict legal interpretations of statutes and regulations. It also oftentimes touches upon business operations, strategy, and general discussions on how to best position the client’s company for success in the Michigan medical and soon-to-be legal recreational marijuana markets.
One key aspect of planning for profitability is creating a strong business plan, even if you do not need investors for your business. We’ve written about the importance of getting the right location for your provisioning center, and we cannot stress that enough. A good location can make or break your provisioning center, but there are other considerations that a business owner needs to consider early in their business planning stages in order to maximize profitability. Such considerations include the size of the dispensary they wish to run, how many people need to be employed, and estimating overall operating costs for running the store. While some who are just entering the market may consider these suggestions to be overkill in the initial brainstorming sessions, spending time mapping out your expected profits and expenses now will pay dividends in the future.
Now let’s assume you’ve put together a business plan and have run some projected numbers showing you will make boatloads of money. While this is a great first step, prospective dispensary owners need to be aware that provisioning center numbers often look great when done on the back of an envelope. However, this does not mean that dispensary owners won’t face significant hurdles in maintaining profitability.
You may be asking yourself: I am projecting massive profits, why are you telling me to be cautious? The answer: IRS-imposed limitations on the deductions a marijuana business can claim under IRC Section 280(E).
Usually just referred to in the industry as “280E”, this provision of the tax code states that an entity cannot claim any deduction or credit on their taxes if they engage in trafficking controlled substances (such as marijuana)…with one big exception. This has huge ramifications for medical marijuana provisioning centers, as it is a common business strategy to deduct as many business expenses as possible to decrease your overall federal tax liability. Effectively, Section 280(e) means that unlike businesses in other industries, a marijuana dispensary cannot claim its normal operating expenses as a business deduction.
The one exception to 280(e) available to those in the marijuana industry is Cost of Goods Sold. Claiming the Cost of Goods Sold means that a marijuana provisioning center can claim the purchase price of their inventory as a deduction for their taxes. While this is a small benefit for dispensaries, it is much more beneficial for grow operations, where the company can deduct the costs for cultivation (such as electricity, labor costs, fertilizer costs, water costs, etc.) as part of their Cost of Goods Sold. Marijuana dispensaries, on the other hand, can only claim the wholesale costs of the product purchased by the dispensary for sale to the consumer under the Cost of Goods Sold exception.
To illustrate this concept, let’s assume a dispensary takes in $1,000,000.00 in revenue on Marijuana it bought for $250,000.00 wholesale. Now lets assume that between rent, labor, utilities, insurance, license fees, and other costs, the dispensary incurred another $500,000.00 in costs, leaving $250,000.00 left over for the owners. Under 280E, you pay income taxes based on the revenue minus cost of goods—or $750,000.00. That means that if you pay a rate of 33%, the dispensary would make any money since you would be paying $250,000.00 tax bill.
The compounding effects of this onerous tax structure cuts into the net profitability of a dispensary quickly. As a result, all potential dispensary owners need to have a frank conversation about 280E before planning a dispensary’s operations and projecting future profitability.
So how does a dispensary plan for profitability in the face of a higher tax liability? Here are three suggestions.
First, you need to keep a tight control on your non-Cost of Goods expenses. This means you may want to consider a smaller location for your dispensary or find a way to apportion part of your space to another related business, such as a “head shop”. Since you can’t claim your operating expenses as a deduction, it doesn’t make sense for you to have high operating costs since this would quickly eat up your net profits. A smaller retail space generally means lower monthly rent or mortgage payments, smaller utility bills, and fewer employees needed to run the retail operations. If you market your business effectively, site your retail space in an area with heavier traffic/pedestrians, and keep your expenses reasonable, you could end up having higher net profits than the bigger players at the end of the year.
Related to this, just as you can “apportion” part of your rented dispensary space to another business, you can also apportion the time and cost of your employees to the other business. By apportioning employment and other costs to a second business that can take normal business deductions, you can realize substantial savings on your tax bill.
The key here is to keep your costs tightly controlled, and to the extent possible, share operating costs with a second business that can take normal business tax deductions. While many potential dispensary owners dream of opening up a huge retailer outlet—a proverbial Walmart of Weed—this is usually a bad idea. Such a store could very well be extremely profitable, but maintaining solid profitably with high operating costs is like walking a tightrope without a net. It can be done, but it is best left to experienced players who are able to bear the risk of loss.
Second, you may want to consider “vertically integrating” your dispensary with a commercial grow. As mentioned above, growers (and processors) are given much more favorable treatments under 280E. They are able to include many costs in their Cost of Goods number—e.g. utilities, rent, employment costs—that dispensaries simply cannot. By integrating your dispensary with a low cost grower you can realize significant tax savings by taking your profits on the “grow entity” instead of the dispensary. For smaller provisioning centers, an inexpensive Class A license will supply more than enough Marijuana to your dispensary while also allowing you to realize substantial tax savings.
Third, consider getting a good bookkeeper and CPA firm that is familiar with cannabis businesses and Section 280(e). This point can’t be stressed enough, especially if you are considering apportioning costs to other businesses since this involves complex calculations and considerations. The IRS is paying special attention to medical marijuana businesses. Many are surprised to hear that the IRS can use Michigan’s MMFLA licensing system as a literal directory of businesses to be audited, which it has done in other states. The IRS also has a special division with experience in 280E issues to conduct these audits of marijuana businesses, so having an equally experienced CPA is vital. Given the scrutiny the IRS is paying to cannabis businesses, especially stated licensed ones, a good cannabis CPA can not only save you money on taxes but also to keep you from being subject to an IRS criminal fraud action.
While an industry-specific CPA is important, if not crucial, to your success—and we work with several—having a bookkeeper with industry knowledge and experience is also important. Not only will a bookkeeper be able to help you stay on track with your expenses and keep a pulse on your profitability, but they can also assist the state if your business is audited and provide your CPA with all the necessary documentation when it comes time to file taxes. Because this industry is so heavily regulated, maintaining accurate books and financial records is essential.
While some may think that a bookkeeper and a CPA sound like overlapping job functions, it is important to remember that a bookkeeper can do many of the lower-level functions a CPA performs for a fraction of the cost. This saves you money in the long run by not having your CPA go through receipts or do monthly accountings, instead focusing on higher level issues like effective 280E tax planning. While we recommend your CPA do your initial tax planning, it is often much more cost effective to have a bookkeeper do the day-to-day accounting. Ideally, your CPA and bookkeeper can work together to provide your business the best possible tax treatment. You can think of a CPA and bookkeeper like a physician and a nurse. The physician sets the course of treatment and periodically reviews your charts to make sure your treatment is on track, whereas the nurse handles creates and maintains your medical records and handles your day-to-day treatment regimens.
It is important to remember that running a marijuana business takes a team of professionals, not just good business sense. As marijuana business attorneys, we work with individuals in many different practice areas, including cannabis CPA firms, cannabis bookkeepers, cannabis consulting companies, and more. If you are interested in learning more about how a marijuana business attorney and our network of cannabis professionals can help your dispensary maximize profitability,
Mr. Roberts is the founder and managing member of Scott Roberts Law, a Detroit-based Cannabis Business Law Firm founded in 2014. Scott has spent his entire career representing businesses and helping them comply with municipal, state and local regulations, as well as assisting on transactional corporate and real estate matters. Scott is an accomplished attorney, author and public speaker, having spoke at CannaCon, Cannabis Industrial Marketplace, CannabisAid, and 420 Canna Expo, to name a few. He has also taught Continuing Legal Education on Marijuana business matters, meaning other attorneys see him speak to learn about the nuances of cannabis business law.