Tax planning is a critical consideration for any individual or business, but this is especially true if you currently operate or plan to start a cannabis business. While it is best to be proactive and incorporate tax planning with starting a cannabis business, most choose to hold off on this endeavor only to consider it before year-end. Nevertheless, an effective tax plan action can be implemented to help you avoid significant penalties and better prepare you to budget for the consequently significant tax obligations.
For first-year businesses, tax planning usually starts with determining which entity type to select and operate. Common entities used are C-corporations, S-corporation and Limited Liability Companies (LLC).
Determining What Entity Structure Is Best Suited for You
Tax planning considerations must be considered separately for those in the first year of business versus those with operating history. For first-year businesses, entity formation is one of the two most important things you can do in preparation for tax planning. Determining which entity type to select and operate involves the type of business (i.e., cultivator, manufacturer, distributor, retailer) and the risk that if the business is selected for audit, a higher tax liability may be assessed.
A corporation is an entity that exists separately from its owners (shareholders). A corporation may be utilized to provide asset protection for its stakeholders, as well as protection for managers, officers and directors. There are numerous types of corporate entities, including:
- Close Corporation: These corporations must meet the minimum statutory requirements and generally consist of family members as shareholders and operators.
- Subchapter S Corporation: A corporation electing Subchapter S regulation provides limited liability to its shareholders as well as pass through taxation to shareholders (meaning the corporation is not taxed but the corporations shareholders are taxed individually). In California, there is an annual fee to operate a corporation with a Subchapter S election and shareholders must consider and anticipate the business profitability before electing to be treated under Subchapter S.
- C Corporation: Any corporation that does not elect to be treated under Subchapter S of the Internal Revenue Code is a C Corporation.
Limited Liability Company
A domestic limited liability company generally offers liability protection similar to that of a corporation but is taxed differently. Domestic limited liability companies may be managed and operated by one or more managers, or one or more members. In addition to filing the applicable documents with the Secretary of State, an operating agreement among the members as to the affairs of the limited liability company and the conduct of its business is required. There is a minimum annual tax in California to operate a Limited Liability Company.
So Which Entity Is Best For Your Cannabis Business?
Generally, it is most favorable for a cannabis retailer or a cannabis distributor to operate as a C-corporation whereas cannabis cultivators and cannabis manufacturers may fare more favorably operating as an LLC or S-corporation.
While there is still some time left in 2018 to change the tax status of a new business or an existing business, now would be the time to meet with a cannabis tax attorney to evaluate this opportunity.
The Federal Controlled Substances Act (“CSA”) 21 U.S.C. § 812 classifies marijuana as a Schedule 1 substance with a high potential for abuse, no currently accepted medical use in treatment, and lack of accepted safety for use under medical supervision.
Generally, businesses can deduct ordinary and necessary business expenses under I.R.C. §162. This includes wages, rent, supplies, etc. However, in 1982 Congress added I.R.C. §280E. Under I.R.C. §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law. Cannabis, including medical marijuana, is a controlled substance. What this means is that dispensaries and other businesses trafficking in cannabis have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses.
If IRC §280E is not managed properly, the company’s profits can be eroded by the increased tax liabilities and, in some cases, wiped out completely making your “for-profit business” and “non-profit business”.
IRS Guidance On Cannabis.
The IRS issued a memo to provide guidance to its agents on conducting audits of cannabis businesses addressing whether an IRS agent can require a taxpayer trafficking in a Schedule 1 controlled substance to change its tax accounting to conform to I.R.C. §280E.
Not surprisingly that the IRS ruled that IRS agents have the authority to change a cannabis business’ method of accounting so that pursuant to I.R.C. §280E costs which should not be included in inventory are not included in Costs Of Goods Sold (“COGS”) and remain non-deductible for income tax purposes.
Cannabis Tax Audits & Litigation.
It is no surprise that cannabis businesses are proliferating as more States legalize cannabis and make available licenses to grow, manufacture, distribute and sell cannabis. The IRS recognizes this and it is making these cannabis businesses face Federal income tax audits. IRC §280E is at the forefront of all IRS cannabis tax audits and enforcement of §280E could result in unbearable tax liabilities.
Proving deductions to the IRS is a two-step process:
• First, you must substantiate that you actually paid the expense you are claiming.
• Second, you must prove that an expense is actually tax deductible.
Step One: Incurred And Paid The Expense.
For example, if you claim a $5,000 purchase expense from a cannabis distributor, offering a copy of a bill or an invoice from the distributor (if one is even provided) is not enough. It only proves that you owe the money, not that you actually made good on paying the bill. The IRS accepts canceled checks, bank statements and credit card statements as proof of payment. But when such bills are paid in cash as it typical in a cannabis business, you would not have any of these supporting documents but the IRS may accept the equivalent in electronic form.
Step Two: Deductibility Of The Expense.
Next you must prove that an expense is actually tax deductible. For a cannabis businesses this is challenging because of the I.R.C. §280E limitation. Recall that under I.R.C. §280E, taxpayers cannot deduct any amount for a trade or business where the trade or business consists of trafficking in controlled substances…which is prohibited by Federal law. What this means is that dispensaries and other businesses trafficking in cannabis have to report all of their income and cannot deduct rent, wages, and other expenses, making their marginal tax rate substantially higher than most other businesses.
A cannabis business can still deduct its Cost Of Goods Sold (“COGS”). Cost of goods sold are the direct costs attributable to the production of goods. For a cannabis reseller this includes the cost of cannabis itself and transportation used in acquiring cannabis. To the extent greater costs of doing business can be legitimately included in COGS that will that result in lower taxable income. You can be sure the IRS agents in audits will be looking closely at what is included in COGS. Working with a cannabis tax attorney can ensure that you receive the proper treatment of COGS versus ordinary and necessary expenses resulting in the lowest possible income tax liability.
In addition to IRS audits, state cannabis audits are also complex and thorough and generally include all taxes specific and nonspecific to the cannabis business. Potentially at risk is the cannabis license that enables the business to operate. State audits will focus on records regarding sales and use tax, excise taxes, and seed-to-sale tracking records.
Now if your cannabis IRS tax audit is not resolved, the results may be challenged and litigated in the U.S. Tax Court or Federal District Court. The U.S. Tax Court has jurisdiction to hear disputes over federal income taxes before final assessment and collections while the Federal District Court generally requires taxpayers to first pay the liability then seek repayment through a refund request.
What Should You Do?
Considering the tax risks of cannabis you need to protect yourself and your investment. Level the playing field and gain the upper hand by engaging the cannabis tax attorneys at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), San Diego County (Carlsbad) and other California locations. We can come up with tax solutions and strategies and protect you and your business and to maximize your net profits.