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

 

 

 

 

How Any Company Can Have a Positive Impact

How Any Company Can Have a Positive Impact

Over the past couple of decades we’ve heard a lot about “social enterprises,” a term usually applied to companies that are visibly making the world a better place. Those are the good guys, the heroes of our time. We would all like to be one of them, to do something positive for at least our corner of the world.  Yet, not every company is curing cancer, feeding the hungry, or solving some environmental problem. What about the rest of us?

The good news is that regardless of your industry or the product or service you offer, your company can have a positive impact in the world – not just because of what your company is doing, but because of how you do it. But it requires that you challenge some of the conventional wisdom that you may have taken for granted. Here’s how:

  • Re-think your ownership. In the conventional wisdom, a corporation is owned by its shareholders and is solely responsible to its shareholders, with all other considerations being secondary. In fact, whether shareholders can truly be said to “own” a corporation is subject to some legal debate. Individual shareholders do not have the “bundle of rights” that is generally understood to comprise what we call “ownership.”

Some legal scholars argue that a corporation, as a person under the law, cannot be owned by anyone but simply has contractual relationships with shareholders, just as it has contractual relationships with employees, customers, suppliers, lenders, and other constituencies – all of whom in some sense invest in the corporation. In other words, what a stockholder owns is simply stock that confers certain rights, not the corporation itself.

  • Re-think your responsibilities. With an expanded view of a corporation’s owners and investors as including multiple constituencies, it follows that a corporation bears a responsibility to all of those constituencies. A corporation that prioritizes the interests of stockholders at the expense of all others is essentially a predatory corporation: It preys upon its community in order to extract wealth from the community and concentrate that wealth in the hands of its stockholders.

That is not what the law requires. A corporation’s board and management should recognize that the corporation owes a responsibility to all of its constituencies. Since the interests of its various constituencies are not always aligned, it is one of the core duties of a corporation’s board and management to balance all those interests in a way that is fair to all of them and does not unduly burden any of them.

  • Re-think your capital-raising strategy. In the conventional wisdom, a company that isn’t big enough for an IPO must raise capital from banks, angel investors, or venture capital firms. In each case, that involves putting your fate in the hands of a small number of people who already hold wealth and power. And if you succeed, your profits will further bolster their wealth and power.

Instead, you can raise capital from your own community, including the non-wealthy, using “community capital” strategies like crowdfunding, direct public offerings, and community investment funds. Members of your community invest because they want you to succeed, not merely because you offer the highest financial return on their investment. And when you succeed, the profits will continue circulating in your community and will build wealth right where you want it. As a bonus, when the investors of capital are part of the same community as the company’s employees, customers and suppliers, it is easier to balance their interests because at some level they all want the same thing: a peaceful, healthy and thriving local community.

  • Re-think the growth imperative. Our culture’s obsession with growth – at both the micro- and macro-economic levels – is unhealthy and destructive. At the level of the broader economy, it is increasingly clear that an economy cannot continue to grow indefinitely; it will eventually hit limits at which collapse is inevitable. At the level of individual companies, the problem with big companies is that they concentrate wealth, which leads to a concentration of political power that is fundamentally anti-democratic.

We are told that every company should aspire to go big and go global, untethered from community, and opportunistically locating wherever the most profits can be extracted. But if we think of a company as existing to serve its community – including all of the constituencies that make up its community – then it becomes clear that each company should aspire to grow only to the size that will allow it to most effectively serve those constituencies. Growth, then, becomes a means to an end, not the end in itself.

  • Re-think where your money goes. In the conventional wisdom, spending decisions are based on a simple calculus that balances cost against the quality of goods or services. Similarly, investment decisions are based on a balancing of risk and reward. It is often assumed, if rarely articulated, that these decisions are values-neutral.

And yet, none of those decisions are actually values-neutral. Every spending decision, every investment decision, and every choice of a supplier or professional provider is effectively a vote for someone’s set of values. Any company can greatly magnify its positive impact in the world by choosing to do business with others who share a similar commitment to a better world.

It requires that there be an inquiry into the values and social impact of any potential supplier, provider or investment target. That inquiry can become part of a company’s routine decision-making process. For example, before purchasing supplies from a big-box retailer, consider the impact of that retailer on the local economies in which it operates. Before sending legal work to a big law firm, find out whether that firm supports extractive industries at odds with your company’s values such as fossil fuels and weapons manufacturing.

You’ll notice that the changes described here start with changes in our underlying assumptions; and when those changes take root and become widespread, we will have a change in culture. It’s the broader culture that needs to change. But, of course, changes in assumptions and culture are not the end game. Rather, those changes will compel changes in behavior that will lead to a healthier and more equitable world.

When companies across the country recognize their responsibilities to all of their constituencies, when everyone has an opportunity to invest in their own communities, and when the economy is dominated by locally-rooted companies that deploy their resources in a values-conscious way, we will have an economy that is very different from the one we have today, one that is truly sustainable, and with opportunities for everyone to thrive. That is our vision at Cutting Edge Capital.

 

An Interview with Sonoma West Publishers, a Local Newspaper’s Experience with a Direct Public Offering

An Interview with Sonoma West Publishers, a Local Newspaper’s Experience with a Direct Public Offering

What is Sonoma West’s mission?

Sonoma West Publishers is a small newspaper group devoted to local community news coverage, a mission we have been following for 154 years. Each of our four newspapers is actually older than the incorporated cities they cover.

 

Why did you choose to do a direct public offering (DPO) to raise capital for the fund?

The DPO funding model allows for a broad base of local and smaller community investors. Readers and local businesses gain an extra connection and added sense of pride in the local newspaper. The DPO structure is superior to seeking a commercial bank loan or taking on larger minority partners. The structure also allows for continued independence for our editorial voice.

What were the long-term benefits of a doing a DPO?

New community investors will become better connected to our local journalism efforts via a series of live events, investor-only meetings and periodic reports from the publisher. Long term, we may seek another DPO campaign in the future, depending on the successful growth and sustainability the current investments produce or support.

 

Did any of the outcomes surprise you?

We weren’t too sure what to expect, since we were the first newspaper in the country to launch a DPO. We experienced some slow periods of acquiring investors, but lately as we reach our expire date, we are gaining investors almost daily.

How much are you raising and how long will it take to raise that amount?

Our goal was $400,000 with the 12-month stock offer that expires Jan. 30, 2019. We are currently at 70% of that goal with almost 100 investors.

What were some of the challenges you faced and how did you overcome them?

We are a small corporation, owned by a husband and wife. We did not hire or do any outreach for marketing or other support. We relied on our own website and newspaper announcements and some word-of-mouth from early investors. We never encountered any opposition or criticisms. Quite the opposite, we met with lots of enthusiasm and encouragement, but not everyone who said they would invest has ended up writing a check.

What were your favorite aspects of the DPO process?

We received very personal testimonials in support of our journalism and our journalists. Many investors said we are invaluable in defending democracy. Journalism is hard work, with low pay. The DPO campaign allowed us to explain our roles in the local community and a free society.

Could you share 3 pieces of advice for other groups considering a DPO?

1) Be ready with your marketing plan early. Don’t wait for state approval because the 12 months can go very fast. 2) Enlist marketing and campaign help form your best friends or local associates. Test your messages early and often. 3) Don’t be afraid to ask for money and don’t be afraid to ask multiple times of the same people.

How do you hope to see Sonoma West grow in the next few years?

The DPO community investment has shored up our basic business foundation and will provide for a stable staff. Newspapers must be very innovative right now in this disruptive Digital Age. We seek to grow stronger at our core of publishing local news, and we seek to expand into new journalism ventures like our “reader-powered” newsroom, series of live community events and more enterprise and investigative journalism.

How can people get involved and support you?

Our DPO campaign and new newspaper business model was featured in a New York Times article in August, 2018. We received lots of national and newspaper industry attention. We aim to be a successful trendsetter for our industry and hope we can help other small newspapers stay in business and better serve their own communities through the many new innovations we are putting together. It would be great to attract some foundation or grant support, added to a Lenfest Foundation grant we already have received.

Reimagining the Pooled Income Fund: A Community-Scale Mutual Fund

Reimagining the Pooled Income Fund: A Community-Scale Mutual Fund

At Cutting Edge Capital, we think a lot about the possible legal strategies that can advance community capital. There are the often-used (if not well-known) strategies like crowdfunding, direct public offerings, and charitable loan funds. But then there are strategies that have been on the books for decades but have seldom, if ever, been used as a vehicle for community capital. Sometimes innovation isn’t about doing something new, but rather doing something old in an innovative way.

Years ago, I helped a charitable organization set up a pooled income fund (a “PIF”). The idea of a PIF is that a contributor puts money or assets into a trust, where it is pooled with the contributions of other contributors and jointly invested. Income from the investments is distributed to the contributors (and often their spouses or other beneficiaries) for their lifetimes. Upon the death of each life beneficiary, the pro rata value of the fund at that time is removed from the trust and given over to the charity that sponsors the trust. A portion of the amount contributed is tax deductible to the contributor in the year of the original contribution, based on a formula that measures the actuarial value of the remainder interest that will eventually go to the charity.

Many foundations, universities, and other (usually large) charities have established PIFs as a planned giving device. From the point of view of these sponsoring charities, the purpose is to eventually receive the remainder interest upon the death of each contributor, though the charity may have to wait years, and sometimes decades. But with enough contributors in a PIF, it is inevitable that one by one they will pass on over the years, and those assets will come into the charity, as planned.

Meanwhile, the assets of the PIF are typically invested as most charitable assets are – in Treasuries, bond funds, perhaps some socially screened equity funds, but nothing that looks too risky. Big charities are a pretty conservative bunch. From the sponsoring charity’s point of view, the goal is to preserve and grow principal, while generating just enough income to fulfill the promises made to contributors.

So we went to work at this charitable organization, thoroughly researching the topic, developing a plan for how we wanted the PIF to work, and carefully crafting all the necessary legal documents, including a declaration of trust, a contribution agreement, and a disclosure document that explained everything. There was no discussion of using the PIF to make place-based investments – by which I mean investments in small ventures rooted in a local community that could contribute to a healthier and more resilient local economy. But I’ll come back to that in a moment. This PIF, like others, was to invest its assets fairly conservatively. And the charity would take a fee off the top for managing the fund.

When it was all finalized, we put it out there. And it flopped. The feedback was that anticipated annual returns, after deducting the charity’s management fee, just weren’t enough to make it attractive. Ultimately, the PIF attracted only a small handful of contributors before the organization pulled the plug and went through another hassle to unwind the PIF. It seemed like a lot of wasted effort.

Fast-forward to the present. Recently we at Cutting Edge Capital have focused on community investment funds as a critical tool for moving the needle forward significantly toward a more inclusive and equitable society. (We wrote about that here.)

But there are gaps in the legal landscape for community investment funds – a landscape dominated by the Investment Company Act of 1940. That law imposes a heavy regulatory burden on any investment fund that doesn’t qualify for an exemption, a burden so heavy that it is not financially feasible for a community-scale fund.

But, the 1940 Act includes a number of exemptions. It’s fairly simple to set up a charitable loan fund or a community-owned real estate fund, because each of those is exempt from the 1940 Act. However, there is no simple exemption strategy for a fund that makes equity investments in small businesses and is open for investment by the non-wealthy. There are a handful of exemption strategies that could work, but each of those strategies requires a fund to squeeze into a business model that may not align with what is needed.

In that context, we think the humble PIF deserves another look. The PIF fits within the charitable exemption from the 1940 Act because of the charitable remainder component. But even so, it can do what no other type of investment fund can do: It allows any number of investors of any level of wealth to pool their resources into a community-scale fund that can make equity investments in local businesses (along with any other kind of investments), with profits from those investments shared among the investors. No regulatory review is required, because of the securities law exemptions, which makes it efficient to set up. It’s like a local mutual fund without the regulatory burden.

There is, of course, the downside that the investors can’t get their money back because of the charitable remainder element. But that charitable remainder also brings a tax deduction, along with the knowledge that contributions will eventually go to a charitable cause. And depending on how the fund is invested, the years or even decades of income from a PIF may be far more valuable than the remainder interest. If the need arises, that life income stream can be transferred to another beneficiary.

Some may also argue that the assets of a PIF, being in a sense charitable assets, must be invested in a conservative way that does not accommodate the kind of small business equity investments that we are contemplating here. However, this argument is rooted in a false myth that fiduciary standards require charitable assets to be invested for capital preservation or for maximum financial return. While state laws vary, the general rule, as spelled out in the Uniform Prudent Management of Institutional Funds Act, is that charitable funds should be invested in a manner appropriate to the organization’s purpose – which could mean investing in local businesses, even if there is a higher risk of loss. The IRS recently underscored this point in a 2015 release on mission-related investing.

So a PIF can be much more than just a planned giving device that will eventually benefit the charitable sponsors. It can truly be an engine for local economic development that offers the benefits of investment to anyone in the community in an equitable and inclusive way. To date we are not aware of any PIF that is actually being used as a vehicle for community capital – that is, as a way for anyone to invest in the success of local businesses. However, in recent conversations that we’ve had, this idea has sparked significant interest, and we expect to see such a reimagined pooled income fund in action soon. So stay tuned.

Of course, nothing written here should be taken as legal, investment, or tax advice. If you would like to schedule a consultation with one of our principals at Cutting Edge Capital, click here.