Cannabis Accounting Cleanup & 280E: Preparing for the Rescheduling Revolution

As Cannabis businesses rush to prepare for potential rescheduling, a harsh reality is emerging: most aren't ready for the scrutiny that's coming. While the industry celebrates this historic shift, many Cannabis operators are sitting on a powder keg of messy books, questionable 280E positions, and incomplete documentation that could explode under increased regulatory attention.

After a decade of helping Cannabis businesses navigate these waters, I can tell you this with certainty: the difference between thriving and merely surviving in the post-rescheduling era will come down to two critical factors - clean books and proper 280E documentation. With the DEA's final hearing set for December 2024, the window for getting your house in order is closing fast.

Consider these sobering realities:

• Most Cannabis businesses lack proper audit trails for their 280E positions
• Few maintain adequate documentation to support COGS calculations
• Many comingle funds across multiple entities, clouding 280E compliance
• The majority aren't prepared for the level of scrutiny rescheduling will bring
• Almost none are positioned to take advantage of potential retroactive relief

In this comprehensive guide, we'll break down exactly what you need to do to get your Cannabis business or clients audit-ready. We'll cover:

• Essential steps for proper accounting cleanup
• Strategic approaches to 280E compliance
• How to build and maintain a bulletproof audit trail
• Critical preparations for the rescheduling transition

Whether you're a Cannabis CFO, accountant, or business owner, the decisions you make in the coming months could determine whether your business thrives or struggles once rescheduling happens. Let's dive into the exact systems and processes you need to implement today to ensure you're ready for tomorrow's opportunities.

Understanding 280E in Today's Context 

Let's start with the single sentence that has shaped Cannabis accounting and tax for decades. Section 280E of the Internal Revenue Code states simply that businesses trafficking in Schedule I or II substances cannot deduct business expenses or claim credits on their tax returns. This one sentence has spawned massive litigation, complex compliance strategies, and billions in tax implications for the Cannabis industry.

As a reminder, here is what 280E states in full: 

“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 phrase “any trade or business” is broad. Let’s unpack what it means.

The Current State of 280E

280E is so impactful because it doesn't just affect one part of your business. It touches everything. The IRS has interpreted "trafficking" broadly, meaning if you're involved in Cannabis commerce in any way, you're likely subject to these restrictions. This applies whether you're:

• A single-dispensary operation
• A multi-state Cannabis enterprise
• A vertically integrated business
• A cultivation facility
• A manufacturer or processor

The restrictions are comprehensive: no deductions for rent, utilities, marketing, salaries, or any other normal business expense. The only allowable reduction from gross income is Cost of Goods Sold (COGS) - and even that must be calculated following specific rules.

Key Updates from Recent IRS Guidance

At the recent 2024 AICPA Cannabis Conference, Luke Ortner, Senior Chief Counsel of the IRS, made several critical points about 280E compliance:

• 280E remains fully in effect while Cannabis is Schedule I
• The IRS is actively preparing for potential rescheduling impacts
• Current compliance is essential, regardless of pending changes
• Businesses should maintain detailed records of all COGS calculations

Remember - and this is crucial - until rescheduling is official, 280E remains in full force. Any premature attempts to ignore or circumvent these restrictions could trigger serious consequences.

The Risk of Non-Compliance

The stakes of improper 280E handling are significant. In this section, we’ll explore each of the following:

• Substantial penalties and interest on underpaid taxes
• Increased likelihood of IRS audit
• Personal liability for responsible parties
• Potential impact on future banking relationships
• Complications for M&A activities or capital raises

Substantial Penalties and Interest on Underpaid Taxes

The IRS doesn't just collect the taxes you should have paid - they add layers of penalties that can cripple a Cannabis business. We're talking about penalties that can reach 20-25% of the underpayment, plus interest that compounds daily. A $100,000 tax underpayment can quickly balloon to $150,000 or more. For Cannabis businesses already operating on thin margins due to 280E restrictions, these penalties can mean the difference between survival and closure.

Increased Likelihood of IRS Audit

Cannabis businesses already face higher audit rates than other industries, but improper 280E handling raises even more red flags. The IRS has specialized teams focused on Cannabis industry compliance, and they know exactly what to look for. Filing questionable returns or attempting aggressive 280E positions doesn't just invite scrutiny of the current year - it often triggers a multi-year examination that can expose your entire operation to intensive review.

Complications for Future Banking Relationships

As the industry moves toward mainstream banking access, your tax compliance history will matter more than ever. Banks conducting due diligence will scrutinize your tax records, and a history of 280E issues can derail banking relationships before they begin. With rescheduling on the horizon and more traditional financial institutions eyeing the Cannabis space, clean tax compliance could be your ticket to better banking options.

Impact on M&A Activities or Capital Raises

The Cannabis industry is heading into a period of consolidation and significant capital investment. Buyers and investors are becoming increasingly sophisticated in their due diligence, and 280E compliance is always high on their checklist. A history of aggressive or questionable 280E positions can:

• Reduce your company's valuation
• Complicate deal structures
• Increase escrow requirements
• Lead to personal indemnification requirements
• Kill deals entirely

We've seen these implications play out repeatedly across the industry. That's why proper 280E compliance isn't just about following rules - it's about protecting your business's future opportunities in a rapidly evolving market.

As we move closer to rescheduling, proper 280E compliance becomes even more critical. Why? Because the transition period will likely bring increased scrutiny, and your historical compliance will be under the microscope.

In the next section, we'll dive into exactly how to clean up your books and build the robust financial systems needed to withstand this scrutiny. But first, remember this: while 280E poses significant challenges today, proper preparation now positions you to capitalize on the opportunities that rescheduling will bring.

The Art of Cannabis Accounting Cleanup

Getting your Cannabis books in order isn't just about reconciling accounts - it's about building a financial foundation that can withstand both regulatory scrutiny and support strategic growth. In our decade of Cannabis accounting experience, we've found that true clean-up requires both systematic processes and industry-specific expertise.

Building Rock-Solid Foundations

The complexity of Cannabis operations demands more than standard accounting practices. Here's what makes Cannabis accounting uniquely challenging:

• Multiple Verticals Under One Roof: Most Cannabis businesses aren't just single-operation entities. They often combine cultivation, manufacturing, retail, and distribution - each with its own accounting complexities. Your systems need to track and segregate these operations while maintaining cohesive financial reporting.
  
  
• State-Specific Compliance Requirements:: Every state has unique Cannabis regulations, and some directly impact accounting practices. Missing these requirements can jeopardize your license - a risk no Cannabis business can afford. In some jurisdictions, penalties for non-compliance can reach 50% of revenue.
  
  
• Complex Entity Structures: We often see Cannabis businesses operating through multiple entities - sometimes unnecessarily complex structures created by well-meaning attorneys. This complexity increases your accounting costs and complication exponentially.

Example of a Dispensary Sample Transaction & Complexity Issues:

That is why we recommend beginning your cleanup whenever you onboard a new client. There are two key things we want to set up whenever we onboard a new client: their perpetual data room and a permanent audit trail, 

Let’s explore what each of those is in more detail.

The Perpetual Data Room: Your Financial Command Center

One of the most powerful tools in Cannabis accounting is what we call the "perpetual data room." Think of it as your business's financial fortress. Here's how to build one:

1. Cloud-Based Organization

• Set up a dedicated server space (Dropbox, Box, or Google Drive)
• Create a logical folder structure for all financial, operational, and organizational documents
• Establish clear naming conventions and access protocols
  
  

2. Essential Documentation

• Organizational documents
• Investor agreements
• Insurance policies
• Legal and lease agreements
• Debt and equity documentation
• Monthly financial records
• Tax returns and supporting documents
  
  

3. Monthly Maintenance

• Bank statements and reconciliations
• Invoice documentation
• Journal entry support
• Internal control documentation
• Maintain “Permanent Audit Trail” report (so company is always audit ready)
• Compliance certificates
• Tax payments and filings

The perpetual data room isn't just about organization - it's about creating value. When investors, regulators, or potential buyers come calling, having this system in place can mean the difference between closing a deal and missing an opportunity.

Building Your Permanent Audit Trail

Every transaction in your Cannabis business needs to be traceable from source to financial statements. Here's how to create an ironclad audit trail:

1. Transaction Documentation

• Link each entry to source documents
• Maintain clear supporting evidence
• Document business purpose
• Track compliance requirements
  
  

2. System Integration

• POS system records
• Seed-to-sale tracking
• Accounting software entries
• Bank transactions
• Tax reporting
  
  

3. Monthly Verification

• Balance sheet account reconciliations
• Significant P&L account analysis
• Inventory counts and valuations
• Intercompany transaction review and reconciliations

Remember: In Cannabis accounting, your work isn't just about accuracy - it's about proving that accuracy to others. Every financial assertion you make needs to be backed by clear, organized documentation.  Also, financials must be complete, and timely.

Let’s explore a successful cleanup strategy in more detail, beginning with client onboarding.

Implementing Your Clean-Up Strategy

A successful Cannabis accounting clean-up isn't a one-time event - it's a systematic process that builds the foundation for ongoing compliance and growth. 

Here's your roadmap for implementation.

Phase 1: Initial Assessment and Planning

Before diving into the details of your clean-up strategy, you need to establish a solid foundation through careful planning and assessment. This initial phase sets the tone for your entire engagement and creates the framework for success. Think of it as building the blueprint for your Cannabis accounting house - get this right, and everything else will fall into place more smoothly. Let's break down the essential components of this crucial first phase.

Engagement Setup

The foundation of any successful Cannabis accounting engagement lies in a properly structured engagement letter. This isn't your standard accounting engagement - Cannabis work requires specific considerations:

Engagement Letter Requirements: The foundation of any successful Cannabis accounting engagement lies in a properly structured engagement letter. This isn't your standard accounting engagement - Cannabis work requires specific considerations:

• Cannabis-Specific Language: Include explicit language about the unique challenges and requirements of Cannabis accounting. Reference 280E compliance, state-specific regulations, and the current federal legal status of Cannabis. This protects both you and your client by setting clear expectations about the industry's complexities.
• Scope of Services and Limitations: Clearly outline what you will and won't do. For example: "We will perform monthly reconciliations and provide GAAP-compliant financial statements, but we do not provide legal advice regarding Cannabis regulations." Be explicit about services that require additional fees.
• 280E Considerations: Include specific language about 280E compliance requirements and limitations. State clearly that you'll follow IRS guidance regarding non-deductible expenses and COGS calculations. Explain that your work will be based on current regulations, which may change with rescheduling.
• Communication Protocols: Define how and when you'll communicate with the client. For example: "We will provide weekly status updates during the initial cleanup phase and monthly reports thereafter. Emergency issues will be communicated within 24 hours."
• Deliverables and Timelines: List specific deliverables with deadlines. Instead of vague promises, use concrete language: "Monthly financial statements will be delivered by the 15th of the following month, provided all required documentation is received by the 5th."

With your engagement letter signed and scope clearly defined, the next crucial step is establishing a sustainable and clear fee structure. The complexity of Cannabis accounting demands careful consideration of both initial cleanup costs and ongoing maintenance fees.

Retainer Structure:  Your pricing model needs to account for both the intensive initial cleanup work and ongoing maintenance while protecting your firm from scope creep and payment issues.

• Fixed Monthly Fees: Set clear monthly fees for ongoing work based on the company's size, complexity, and number of entities. For example: "$10,000 per month covers standard monthly closing procedures, reconciliations, and financial reporting."
• Historical Cleanup Rates: Establish separate hourly rates for historical cleanup work. Be clear that messy books will cost more to clean up: "Historical cleanup work will be billed at $100 per hour due to the intensive nature of the work."
• Payment Terms: Define when payments are due and consequences for late payment. For example: "Monthly retainer due by the 1st of each month. Work will pause if payment is more than 15 days late."
• Scope Changes: Outline the process for handling additional work: "Changes to scope will be documented in writing and billed at our standard hourly rate after client approval."

With your foundation established through careful planning and comprehensive documentation, it's time to build the systems and controls that will support your ongoing operations. This second phase is where theory meets practice - where we translate our planning into actionable processes that will keep your Cannabis business running smoothly and compliantly. Think of it as building the engine that will power your financial operations for years to come.

NOTE: Engagement letters are legal documents so make sure to consult your attorney before implementing above.  This is not legal advice.

Phase 2: Systems and Controls Implementation

Establishing robust systems and controls is crucial for maintaining clean books and ensuring compliance. This phase focuses on setting up the infrastructure that will support ongoing operations.

Control Documentation: Creating clear, comprehensive documentation of all control processes and procedures.

• Process flowcharts: Visual guides showing workflow from start to finish
• Control points: Key checkpoints where verification occurs
• Review procedures: Steps for checking work accuracy
• Exception handling: How to deal with unusual situation)

Segregation of Duties: Establishing clear separation of responsibilities to prevent fraud and errors.

• Cash handling controls: Different people count, deposit, and record
• System access limits: Restricted access based on role
• Review requirements: Independent verification of work
• Backup procedures: Cross-training to cover absences

Phase 3: Historical Clean-Up

This phase involves methodically reviewing and correcting historical records to ensure accuracy and completeness.

Starting Point Verification 

We’ll begin by establishing a reliable foundation for your cleanup efforts by confirming beginning balances.

• Last filed return review: Confirm accuracy of starting point
• Opening balance verification: Prove beginning numbers are correct
• Documentation gaps: Identify missing support
• Adjustment documentation: Record needed changes

Account-by-Account Review 

Then we’ll do a systematic examination of each material account to ensure accuracy and proper documentation.

• Materiality assessment: Focus on significant items first
• Support verification (Confirm backup exists for entries
• Reconciliation completion (Match all accounts to support
• Adjustment recording (Document necessary changes

Inventory Clean-Up 

Next we’ll do a detailed review and correction of all inventory-related records and processes.

• Physical count verification: Confirm actual quantities on hand
• Cost documentation: Support for inventory values as well as GAAP cost accounting
• System reconciliation: Match physical to recorded amounts
• Adjustment recording: Fix identified discrepancies

Fixed Asset Verification 

Finally, we’ll do a comprehensive review of all fixed assets to ensure proper recording and valuation.

• Asset existence: Confirm assets are still in use
• Cost documentation: Support for recorded values
• Depreciation review: Verify correct depreciation applied
• Disposal recording: Document removed assets

With your foundation established and historical records cleaned up, it's time to focus on maintaining this high standard going forward. Remember: Clean books aren't a destination - they're an ongoing journey that requires consistent attention and proactive management. The next phase will ensure your systems and processes continue to serve you well in the evolving Cannabis industry.

Phase 4: Maintaining Clean Books Going Forward

Clean books in the Cannabis industry aren't a "set it and forget it" proposition - they require constant attention and proactive management. This phase establishes the routines and procedures that will keep your financial records accurate, compliant, and audit-ready. By implementing these systematic approaches to ongoing maintenance, you'll not only protect your business from compliance issues but also position it to capitalize on opportunities as the industry evolves through rescheduling and beyond. Let's explore each component of a robust maintenance strategy.

Monthly Close Process 

Establishing a systematic approach to closing your books ensures accuracy and timeliness.

• Closing calendar: Detailed schedule with clear deadlines
• Task assignments: Specific responsibilities for each team member
• Review procedures: Multi-level verification process
• Documentation requirements: Standards for supporting materials

Regular Reconciliations 

Consistent account reconciliation prevents small issues from becoming major problems.

• Bank reconciliations: Daily cash position monitoring
• Inventory counts: Weekly cycle counts for retailers and monthly full counts for farms and manufacturers
• Account analysis: Review of all balance sheet accounts
• Variance investigation: Prompt research of unexpected differences

Compliance Monitoring 

Staying ahead of regulatory requirements prevents costly violations and penalties.

• License tracking: Monitor renewal dates and requirements
• Tax filings: Schedule of all required filings and deadlines
• Regulatory updates: System for tracking changing requirements
• Audit preparation: Maintaining audit-ready records

Quality Control Procedures 

Regular quality checks maintain the integrity of your financial records.

• Data entry review: Verification of transaction accuracy
• System checks: Regular testing of software integrations
• Error correction: Standard procedures for fixing issues
• Documentation updates: Regular review of procedures

Financial Reporting 

Timely, accurate reporting provides crucial insights for decision-making.

• Standard reports: Core financial statements and metrics
• Management dashboards: Key performance indicators
• Budget Vs Actuals
• Forward Cash Rolling Forecast
• Investor reporting: Required disclosures and updates
• Regulatory reporting: State-specific requirements

Team Training and Development 

Keeping your team sharp ensures consistent execution of procedures.

• Onboarding procedures: Training for new team members
• Ongoing education: Regular updates on industry changes
• Cross-training: Backup coverage for key functions
• Process improvement: Regular review and refinement of procedures

With your systems running smoothly and your team well-trained, you've built a financial infrastructure that can withstand scrutiny and support growth. But in the rapidly evolving Cannabis industry, the work is never truly finished. Let's wrap up with key takeaways and action steps to ensure your business stays ahead of the curve.

Conclusion: Positioning for Success in the Rescheduling Era

The journey to clean books and proper financial controls isn't easy, but it's essential for survival and success in the Cannabis industry. As we approach the historic rescheduling of Cannabis to Schedule III, businesses that have done this foundational work will be positioned to thrive, while others may struggle to catch up.

Don't wait for rescheduling to force your hand. The time to prepare is now.