A Tax Trap for Cannabis Businesses, and How Not To Get Snared

A Tax Trap for Cannabis Businesses, and How Not To Get Snared

For a cannabis business, section 280E of the Internal Revenue Code sucks. But here’s how to make it suck less.

Normally, businesses deduct the “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business[.]”  But section 280E of the Internal Revenue Code prohibits any deduction of business expenses if the taxpayer’s trade or business consists of trafficking in controlled substances.

Unfortunately, selling cannabis constitutes“trafficking” in a controlled substance, even when it is medical cannabis recommended by a doctor or otherwise legal and licensed under state law.

So, licensed cannabis businesses are expected to file federal tax returns and to pay tax on gross income instead of net income.

Here are the learnings from the important section 280E tax cases involving cannabis businesses:

You can subtract cost of goods sold.

Gross income is gross receipts minus the cost of goods sold.  Section 280E does not prevent cannabis businesses from subtracting the cost of goods sold.

You will want to calculate cost of goods sold correctly.

The tax regulations tell us how different kinds of costs need to be accounted for.  There is a section of the Internal Revenue Code and its accompanying regulations that normally apply to put more kinds of costs into the category of costs of goods sold, but those regulations do not apply to cannabis resellers.  Section 263A talks about including indirect costs in the cost of goods sold. However, a cost that is not otherwise deductible cannot be part of COGS under 263A. That limits the usefulness of section 263A to cannabis businesses. The takeaway is that it is well worth the effort and expense to work with bookkeepers and accountants who know these rules well.

If a licensed cannabis business has more than one trade or business, it can deduct business expenses of the non-cannabis business – but only if they are separate!

The U.S. tax court is willing to let cannabis businesses separate cannabis sales from other types of business transactions and deduct business expenses as usual for the non-cannabis business activities.  This requires an analysis of whether the non-cannabis line of business stands on its own, separate and apart from the cannabis business, or whether a claimed separate business is really just “incident to” the cannabis sales.

In one example, a medical center provided numerous benefits for its patient members, including meals, hygiene supplies, and social activities.  These other benefits were substantial when compared with its medical marijuana sales. All of the facts of the case convinced the court that these other benefits stood on their own as a separate trade or business, and the organization proved the expenses with good record-keeping.  Although the organization charged one membership fee, without separating the cost of medical cannabis from the costs of the other benefits, the tax court allowed the organization to deduct the costs of the non-marijuana activities.  In contrast, in a case where a dispensary sold a few books, t-shirts, and smoking supplies, but made an overwhelming percentage of its revenue from cannabis sales, those sales of non-cannabis products were just “incident to” the business of dispensing medical marijuana.

The determination of whether a non-cannabis line of business is separate or not might have to stand up to IRS or even tax court scrutiny.  The tax court has considered:

  • Is there a separate profit motive to this activity?
  • Is there a separate legal entity?
  • Is the activity carried on by different employees?
  • Is the activity carried on in separate spaces?
  • Are the activities accounted for separately?
  • Are the activities under separate management?
  • Is the non-cannabis activity just there to attract cannabis customers?

The learning is: If there is a separate line of business, keep it separate.  Consider using a separate legal entity, separate management, separate staff, separate space, and account for the activities separately.  An entity that has a cannabis business can deduct business expenses from a non-cannabis line of business if they are separate. The separateness must be documented, and the business expenses must be documented, because there is a likelihood of audit.

The IRS is auditing cannabis businesses, so keep good records.

The IRS is auditing entities that it suspects to be trafficking in cannabis and improperly taking business deductions contrary to section 280E.  One business that got audited stated that its business was “medicine sales.” This did not prevent the audit.

And, of course, if you have a business that will be subject to section 280E, don’t take those business deductions! Instead, focus on cost of goods sold and on keeping any separate lines of business separate.  Make sure costs of goods sold are well documented, for the peace of mind that in the event of an audit, the business will be able to meet its burden of substantiating those costs.  Back up your financial records. (In one case, one computer crash was supposedly responsible for the loss of all financial records for certain years, and the records had to be reconstructed for audit.  This was not a good way of substantiating costs.) Keep receipts.

Don’t use a pass-through entity.

There is a higher likelihood that a cannabis business will be audited, and that in event of an audit, the IRS could find a deficiency.  If the business is taxed as a partnership or an S-corp, the business’s income and loss flow through to the owners, even if no cash is distributed. This means that if the IRS finds a deficiency, the IRS would go after the owners personally for a deficiency in their personal tax payments. This is why the owners of businesses affected by section 280E typically opt for corporate taxation, even though it may result in more tax liability overall.

Don’t use a management company just to separate employee compensation if employees are processing or selling cannabis.

There is a rumor that it’s a good idea to form a separate legal entity to provide “management services” to a cannabis business, and that the management company can avoid section 280E because it is providing management and is not itself in the business of selling cannabis.  The U.S. Tax Court addressed this in December 2018. The plan backfired. The court held that the management company was trafficking in a controlled substance for the purpose of section 280E because the management company’s employees were “directly involved in the provision of medical marijuana to the” members of the related dispensary.  The dispensary could not deduct business expenses, which included the management company fees.  Then the management company also could not deduct business expenses. This meant that the management company structure actually resulted in more tax because both the dispensary and the owners of the management company paid tax on the amount of those non-deductible business expenses.  The learning is that it can make sense to set up a separate entity that can deduct business expenses, but only if that business is not “trafficking in” cannabis, while remembering that having your employees process and sell cannabis is part of “trafficking.”

Of course, the information above should not be taken as tax, legal, or investment advice. If you would like to speak with one of our consultants, contact us here

 

 

 

 

Lower Your Taxes with Economic Democracy

Lower Your Taxes with Economic Democracy

Many business people know that S corporations and limited liability companies (LLCs) are tools to skip tax on a business’s income. But did you know that Subchapter T allows certain enterprises to benefit from the corporate form AND pass profits through to members tax-free?

Subchapter T of the Internal Revenue Code[1] allows qualifying corporations to subtract “patronage dividends” from the corporation’s taxable income. Patronage dividends are NOT dividends on stock, despite the confusing use of the same word. Patronage dividends work like this:

The enterprise does business with patrons: selling to them, buying from them, and/or employing them and making profit through their labor. Then the profit is shared among the patrons in proportion to the quantity or value of business each patron did with the enterprise.

This arrangement is appropriate for worker-owned business, and potentially any type of enterprise that shares its profits with its customers, users, or suppliers in a meaningful way. This arrangement will NOT work for any business that wants to return profits only to investors.

How to qualify:

First, the business must be “operating on a cooperative basis.”[2] This means:

  • Most transactions are with “patrons.” Patrons are people with whom there is a pre-existing, legally binding agreement to share profit. Patrons could be customers, suppliers, and/or workers.
  • Most profits are returned to the patrons. The profits of investors, if any, cannot take precedence. The business may have loans and outside investors, and it may pay its investors first, but benefiting patrons must be the primary goal.
  • The corporation must be democratically controlled by its members. This generally means one member, one vote. Members cannot give control away to investors. The business can be run by a board and managed by managers, but they are ultimately accountable to members.
  • Profits must be shared with patrons on the basis of patronage, which means in proportion to the quantity or value of business each patron does with the enterprise.

Next, the patronage dividend must meet all of the tax code’s requirements. Here’s a summary of how to do that:

  • Patronage dividends must come from “patronage net income,” which derives from business done with or for patrons. Patronage dividends cannot come from “profit” from business with non-patrons.
  • Patronage dividends must be allocated on the basis of relative patronage – again, in proportion to the quantity or value of business each patron transacted with the co-op.
  • The patronage dividend must be paid in cash, or a specific type of written notice of the patronage dividend must be given within 8 ½ months after the close of the fiscal year, and at least 20% of the dividend must be paid in cash no matter what.[3]

If all of these requirements are met, the business can subtract all of the patronage dividends from its own taxable income.

How this is the best of both worlds:

Corporations offer certain advantages. When members come and go from an LLC, the accounting can be complex and thus expensive. Corporations make it much simpler.

A member’s income from an LLC might be business income, and might be self-employment income. The member might need to do quarterly estimated tax payments, and complete Schedule C on their tax return. The member might need to file a tax return in another state, if the LLC operates in one state and the member lives in another. On the other hand, receiving a 1099-PATR from a corporation, and a W-2 in the case of a worker, are much easier to deal with on the member’s personal tax return.

The income of an LLC or an S corp “passes through” to members and becomes part of the members’ taxable income … even if the business needs to build a reserve. This is the “phantom income” problem; LLC and S corp owners must pay tax on money held in reserve, even if they do not receive the income in cash. Members must pay tax out of pocket, or the business must carefully pay out to each member just enough for the members to pay their taxes. In a corporation using Subchapter T, only the corporation pays tax on income that is kept in reserve.

A democratic corporation enjoys these conveniences, AND it is a pass-through entity to the extent that its income comes from transactions with “patrons” and it shares that income with the patrons on the basis of the relative value each patron contributed.

Please note that there are some reasons that a worker-owned business, particularly a startup, would not want to organize as a corporation right away; I would be happy to explain those reasons via email or over the phone.

If you read to the end, you may have noticed that this article is about the tax advantage for cooperatives. I love Subchapter T and can talk about it all day.

Cutting Edge also supports cooperatives by helping to design structures that meet their goals, providing legal documents, and consulting and legal documentation for raising capital. We also help retiring business owners sell businesses to their workers. If you have a legal or funding question about a cooperative, let us know about it by clicking here or emailing us at info@cuttingedgecapital.com.

 

[1] I.R.C. §§ 1381 – 1388.

[2] I.R.C. § 1381(a)(2).

[3] I.R.C. §§ 1382(b)(1) , I.R.C. § 1388(a)(3).