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Pot’s Special Problems

With heavy cash flows and strict, complicated tax structures, cannabis businesses are in dire need of specialized accounting services. But the instability that comes along with marijuana’s classification as a federally illegal Schedule 1 drug has led many CPAs to turn their backs on the industry despite high demand. While some national firms won’t work with cannabis clients at all, many firms in the Valley region are beginning to take on the challenge of accounting for this intricate and fast-growing sector. One is Hay & Associates, a seven-person unit with five CPAs based in Woodland Hills. President Andrew Hay has a background in the Internal Revenue Service that translated well to the tax-heavy work in cannabis accounting. “I’m used to tax controversy,” Hay said. “The complexity is interesting and it’s a unique niche.” The largely untapped cannabis market presents a lucrative revenue stream for Hay’s practice, which works with about 40 cannabis groups including standalone mom-and-pop retail shops, chains and a few vertically integrated pot companies. Hay said those 40 clients add up to about 250 legal entities for which his firm does tax consulting, bookkeeping, cash control and monthly financial statement reviews. “Cannabis is really entity-heavy,” Hay said. “Lawyers like to set up (intellectual property) companies, holding companies. More agreements and entities mean less liabilities normally and more protection – but that’s counterproductive for accountants.” Also in Woodland Hills, SingerLewak, No. 48 on the Business Journal’s list with 5 Valley-area CPAs, stood up its cannabis business in 2014 when Dean Fredgant, now a partner in the firm’s tax and accounting department, came aboard following a merger. “I started in 2005, working with medical marijuana back in its infancy. There weren’t a lot of accountants that would take it on,” Fredgant said. “When Prop. 64 came along … we thought we’d jump in with both feet.” He said his work today comprises consulting – especially for taxes – cash management, income tax returns, bookkeeping and IRS audits. Being an early adopter, Fredgant said, has worked out for SingerLewak in that its practice became well-known regionally, which gives it a leg up in attracting and retaining accounts. In 2018, the firm brought on Vanita Spaulding, a career valuations expert who now leads SingerLewak’s cannabis practice, which has about five full-time CPAs but occasionally commissions work from personnel in other divisions. Clients include dispensaries, distributors, cultivators and testing laboratories, as well as some vertically integrated startups and even a cannabis-centric real estate firm. “Accounting for cannabis companies has a significant impact on valuations,” Spaulding said. “Some companies have good underlying financial statements; they have tax returns done the right way … but a lot of them still don’t. That just makes it so much more difficult. In that way, I’m sort of a user of the (accounting) work Dean provides for cannabis companies.” In addition to these firms, big regional names like Squar Milner and Holthouse Carlin & Van Trigt, ranked Nos. 6 and 2 on the list, respectively, have also opened cannabis lines of business in recent years. Tough taxes Put simply, one of the biggest challenges to accounting for cannabis is “there are a lot of taxes in this industry,” Hays said. In addition to standard income and sales taxes, California, like many states with legal marijuana, has excise taxes paid by both the cultivator and consumer of marijuana products. Hay compared it to the microbrew industry, which also has heavy excise taxes. Then there’s 280E, a state-mandated income tax law where cannabis companies can only deduct the cost of goods sold. This tax applies to all businesses that trade in federally illegal goods. “Imagine running a business and you’re paying tax on gross profit,” Hay summarized. “You can’t write off any below-the-line costs not related to the cost of the product. You end up having phantom income and paying income tax at a higher effective rate … up to 50 percent or higher.” Fredgant said one of the most important parts of his job is identifying what can be written off as “cost of goods sold,” and filing those costs appropriately to keep his clients’ taxes as low as possible. Altogether, that’s a lot of financial review and paperwork, especially for businesses comprising multiple entities. Doing all that work correctly requires years of specialization. Cash control Banks and credit unions, like CPAs, are conservative by nature and tend to shy away from cannabis accounts because they trade in federally illegal products. That means most pot shops deal almost exclusively in cash – a daunting prospect for auditors and tax accountants. “What we help them do is set up cash controls,” Hay said. One of the biggest such controls is METRC, a state-employed track-and-trace software system used to follow cannabis products as they move through the distribution chain. Fredgant said he encourages his clients to set up additional internal inventory tracking systems within their accounting software for good measure. Sometimes that means going old-school and tracking transactions in Excel spreadsheets, then cross-checking that data against spending records and receipts from suppliers. Hay said that for several of his clients, including one in Port Hueneme, his firm does monthly cash counts. While “they’re never 100 percent accurate,” Hay said, they give an adequate sonogram of a business’ underlying financial health and help identify any bleeding. As for security, Hay said all of his clients hire armed security guards to watch over the premises and transport cash using armored trucks. Fredgant added many businesses install digital camera systems to monitor their safes and registers. Also important, both said, is diversifying employee duties to prevent misconduct. For example, some dispensaries require multiple employees to watch the transaction occur at the point of sale – one employee will make the sale while another handles the cash. Hay called these controls “standard for any high cash business.” Industry outlook According to Hay, the cannabis industry is at a “make it or break it moment.” He identified several public cannabis companies that recently announced layoffs of 10 to 20 percent of their staff, including Aurora Cannabis Inc. and Tilray Inc., both in Canada. He said some smaller firms will go out of business, which will open opportunities for new operators to buy out their cannabis licenses from the city at auction for cheap. “It’s all the taxes. That’s what’s killing the golden goose,” Hay said. “It’s hard to make money in this industry unless you’re vertical.” Though Hay and Spaulding both benefit from the finance industry’s reluctance to serve cannabis clients, both said they’re not scared of the competition federal legalization could bring. “There’ll always be a need for a specialist,” Hay said. – Andrew Foerch

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