Cost segregation, Cannabis and IRC 280E – how are they related and why does it matter? First of all, any one of these subjects is a challenge to navigate on it’s own merits. I am about to deal with all three as they relate to each other.
What is cost segregation?
What is cost segregation? It is the process of identifying personal property assets that are grouped with real property assets and then reallocating those personal property assets for federal tax reporting purposes. This comes under MACRS – Modified Accelerated Cost Recovery System. So, why does this matter, you may ask? Simple. When you talk with your accountant, CPA or tax professional, do you ask them to find ways for you to pay MORE federal income taxes? Of course not – how ridiculous! You, like 99.9% of others, beg your tax professional to find every available tax deduction they can find. By the way, here is another important point to consider. Proper allocation requires engineering expertise to pass IRS scrutiny. What I mean is this – do you go to your family doctor to have your cancer status evaluated? NO, you go to your Oncologist. So why go to your accountant to have engineering work done? In fact, the primary accounting professionals publication penned an article on cost segregation.
The Journal of Accountancy states, “Cost segregation [studies] can provide real estate purchasers with tremendous tax benefits. Buyers of real estate should obtain an engineering report that segregates assets into four categories: personal property, land improvements, building components, and land.”
Cost segregation & the Cannabis Industry
Cost segregation is a complex tool that can be applied to any commercial real estate, especially the Cannabis industry. Here’s why. All Cannabis commercial real estate entities operating under the guidance of IRC Sec. 280E, in states where it is legal, qualify for accelerated depreciation treatment. That means assets that your CPA would properly book in at 39.5 years on your depreciation schedule (fixed asset schedule – FAS) would actually qualify for 5-year, 7-year and 15-year depreciation. Now, here are some examples of building components that might be identified as 5-year personal property versus 39.5-year building property: they include task-specific lighting (grow-lights to include LEDs), dedicated electrical/mechanical/plumbing systems supporting Cannabis propagation/growth, specialty mechanical systems used to climate-control “grow facilities”, removable floor coverings, hydroponics systems & irrigation systems, security systems, low-voltage data wiring, and much more. Furthermore, many land improvements including a parking lot, sidewalks, curbing, landscaping, fencing, site lighting, security system, fencing, stormwater management (drainage and collection basins), decorative site features like ponds, flag poles, and monuments, qualify for 15-year accelerated depreciation treatment. All of the above are in addition to the normal Fixtures, Furniture and Equipment (FF&E) your accountant books as 3-year, 5-year or 7-year assets – as well as Machinery and Equipment (M&E) for those same periods.
By way of example, a typical Cannabis facility with the necessary infrastructure, process-related systems and building envelope, will have approximately 18% to 30% of the entire project reclassified to 3-, 5-, 7-, and 15-year asset lives. That means $180,000 to $300,000 in additional depreciation per million dollars invested in the project – minus land cost. If you have a $3,000,000 facility (minus land), that’s $540,000 to $900,000 in additional depreciation in the early years of ownership. Imagine what that does for your cash flow. If you are in the 30% federal income tax bracket and 5% state income tax bracket (total 35%), that equates to $189,000 to $315,000 in tax deferral/savings. It’s your money. Why give it to the IRS if you can keep it?
New construction vs New acquisitions
Furthermore, cost segregation can be applied to both “new construction” and “new acquisitions” of older facilities regardless of when they were constructed. That’s correct. The IRS allows cost segregation to be applied to assets acquired as far back as January 1, 1987. The Internal Revenue Code allows a change in accounting method under (IRC) Sec. 481(a) and it is known as the “catch-up” provision of the tax code. What this means to you is now is the time to use cost segregation to mitigate, and perhaps eliminate, your federal and state income taxes to the extent allowed by the Internal Revenue Service tax law.
Internal Revenue Code Sec. 280E
Of course, as a Cannabis owner, you need to work within the law as written and as adjudicated under Sec. 280E. Let’s define it under the Controlled Substances Act. It forbids businesses from deducting otherwise ordinary business expenses from gross income associated with the “trafficking” of Schedule I or II substances. Cannabis – “marijuana” – is a Schedule I substance as applied to state-legal Cannabis businesses. Hey, don’t shoot the messenger here. I’m merely reminding you of what we are facing in the industry. Other than it being a pain in the rear, how do we work with what we’ve got? Well, we have the CHAMP v Commissioner case that facilitates how to navigate this business. However, it is not all-encompassing nor is it all-inclusive, at least when it comes to states without legalization. What types of business expenses are scrutinized under 280E anyway? Well, here’s a list, though not all-inclusive –
- Employee salaries
- Utility costs like electricity, internet and phone service
- Health insurance premiums
- Marketing and advertising costs
- Repairs and maintenance
- Rental fees for facilities
- Routine repair and maintenance
- Payments to contractors
Cannabis businesses that are “state legal” are allowed to deduct the Cost of Goods Sold (COGS) on their taxes. Additionally, Cannabis owners have made deductions of their non-Cannabis business activities. It is important to note that Cannabis owners have also followed guidance from Sec. 263A of the IRC, allowing the business to capitalize on indirect costs such as administration and inventory. This, in addition to the amount paid in state excise taxes.
Employ Qualified Tax Professionals
It is highly recommended that you consult with a tax professional who is exceptionally trained and knowledgeable in the Cannabis industry. This is NOT an easy, nor fully legal in all states, business to “play chicken” with the IRS over. Hire a professional tax person, CPA – tax attorney – Enrolled Agent, with direct Cannabis industry knowledge and who has successfully defended his work with the IRS.
The key to understanding and applying the benefits of cost segregation to your Cannabis facility is to engage professionals in their specific areas of expertise. Doing so will save you, not only money and headaches, but also will help you avoid a wrong turn with an entity (IRS) who has no problem putting you out of business. Capiche? So, the moral of the story is…
Don’t go to your dentist to get your prostate examined! Otherwise, you will!