Tax Savings for Cannabis Businesses with Cost Segregation Study
AAFCPAs would like to remind cannabis clients that placed in service in 2019 (or will soon be placing in service) capital expenditures (CAPEX), often in excess $10 million, to have a cost segregation study performed to provide tax savings and additional benefits, including reduced property taxes, improved property management, and improved ability to identify investments classified as repairs (rather than depreciable assets) for income tax purposes.
AAFCPAs provides cost segregation studies to assist cannabis clients with maximizing the net present value (“NPV”) of tax depreciation deductions related to the construction or improvement to cannabis production facilities (cultivation, manufacturing and distribution) and dispensaries. Further, AAFCPAs’ Cannabis Industry Practice has the expertise with applicable Code sections, including 280E, to ensure the intended tax results are achieved and income tax exposure is mitigated (e.g. the benefit of accelerated tax depreciation deductions are recognized by the proper taxpayer and are allowable).
This guidance is intended to assist cannabis clients with weighing the normal and cannabis-specific cost and tax benefits of having a cost segregation study performed, when to have it performed, and how it is performed.
Cost Segregation Study – benefits and costs
Cannabis companies often invest millions of dollars in hard and soft costs, including debt costs, to buildout their indoor cultivation and infused product manufacturing facilities. Identifying depreciable buildout costs that are properly characterized as tangible personal property (“Section 1245 property”) rather than tangible real property (“Section 1250 property”) is the difference between recovering the investment via tax depreciation over as little as six years rather than 40 years. Identifying depreciable land improvements rather than land is the difference between recovering an investment over 15 years rather than upon sale. Cost segregation studies are the tool that cannabis and non-cannabis companies use to do this.
Further, cannabis companies enjoying temporarily higher gross profit margins due to current supply and demand dynamics can realize an additional benefit from front-loaded tax depreciation includible in COGS–leveling taxable income. In exchange for front-loaded depreciation, two potential future costs to consider are greater depreciation recapture income (related to accelerated tax depreciation in excess of the economic depreciation), and less tax-deferred gains for qualified like-kind exchanges of real property under Code Section 1031.
Cost Segregation Study – additional income tax considerations
Often, cannabis and non-cannabis companies use separate entities for legal and tax purposes to own the real estate and the operating business. Cannabis companies that own the production facility or dispensaries separately from the legal entity that holds the cannabis license must consider three general tax issues, and as always Code Section 280E to ensure the intended tax results are achieved and income tax exposure is mitigated. If the legal owner and the tax owner are not the same, cannabis companies should ensure the lease payments (as with any controlled transaction) are arms-length under Code Section 482, the timing of the income and deductions (as with any related party transaction) are matched under Code Section 267, and tax depreciation under Section 168 is recognized by the proper taxpayer as determined under the tax principles of benefits and burdens of ownership rather than legal ownership.
Cost Segregation Study – when to do it
In general, a cost segregation study should be done after the buildout costs are fixed and determinable and the property is placed in service. This minimizes the cost and will meet the IRS’s contemporaneous recordkeeping requirements. Further, completing the analysis timely will assist with calculating more accurate quarterly estimated corporate tax payments or partnership tax distributions.
Cost Segregation Study – three key steps
A cost segregation study involves performing procedures (e.g. gaining an understanding of the project, reviewing construction documents, reviewing accounting records, and conducting a site visit) to complete three key steps:
Step 1 – Classifying assets into property classes: The focus is identifying depreciable land improvements (rather than non-depreciable land) and building costs classified as Section 1245 property (rather than Section 1250 property). Under Rev. Proc. 87-56, as modified by Rev. Proc. 88-22, land improvements are a specified asset category (regardless of the trade or business activity it is used in) whereas Section 1245 property can fall into a specified asset category, a specified (trade or business) activity category, or a catch-all category.
Step 2 – Explain the rationale (including legal citations) for classifying assets as either § 1245 or § 1250 property: A significant degree of judicial and IRS guidance related to Section 1245 vs 1250 property is based on the former investment tax credit (“ITC”). Cost segregation studies were performed because Section 1245 property was ITC-eligible whereas Section 1250 property was not. Section 1245 property generally includes components (e.g. wiring and plumbing) that relate to a particular function or particular piece of property and structural components that do not relate to the operation and maintenance of a building. Other factors include an asset’s movability (“inherent permanency”), and whether it is an essential requirement for the operation of equipment or processing of materials (“sole-justification test”).
Step 3 – Substantiate the cost basis of each asset and reconcile total allocated costs to total actual costs: Cost allocations are based on Construction Documents, Blueprints, Construction Drawings, Specifications and Contractor Payments. Complete and accurate actual cost records are critical.
As usual, the IRS guidance and caselaw are necessary considerations for a complete and accurate analysis. Although a significant number of situations have been addressed, the unique situations for cannabis companies have not.
Steps to take to prepare for a Cost Segregation Study
Whether a decision to perform a cost segregation study has been determined, AAFCPAs recommends cannabis clients take these four steps to prepare for one because the information prepared in Steps 1 and 2 will not only assist with performing the cost-benefit analysis but will also assist with capital budgeting and particularly capital management.
Step 1 – Create a fixed asset schedule to identify and accumulate CAPEX: We recommend identifying and accumulating project costs, in detail, in a fixed asset schedule. The fixed asset schedule should record costs based on the Construction Specification Institute MasterFormat divisions. Marginal project costs (e.g. additional electrical demand load) should be separately identified.
Step 2 – Create a budget column: After soliciting bids and choosing construction contractors, fill-in the budgeted amounts, based on the construction contracts and bid documents.
Step 3 – Record actual costs incurred and maintain a file to support the cost allocations: After construction payments are made, record the actual cost. Note: construction payments should be made based on applications and certificates for payment (after project submissions are approved to ensure the item or product is in conformity with the technical specifications).
Step 4 – Record the date the property is placed in service and add supporting documentation to the existing file: Tax depreciation can begin once the asset is placed in service for its intended use. Using the effective date of the Certificate of Occupancy is, generally, the placed-in-service date.