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Jim has spent his career advising individuals, non-profit organizations, closely-held businesses, and Fortune 100 companies on tax law, including federal and multi-state tax controversies. A frequent blogger and speaker on local, state, and federal tax issues, Jim's current focus is on the ever-changing cannabis industry and the regulations governing it.

california marijuana tax
Returns are due next month. Time to hustle.

In California, the first Cannabis Tax Return is due on April 30, 2018 and many of our clients are now working through the issues related to the Cannabis Cultivation and Excise Tax. In addition, many marijuana businesses must file their first 2018 estimated federal tax payment by April 17, 2018. To estimate taxable income, every Cannabis business must understand how to treat the Cannabis Cultivation Tax and the Cannabis Excise Tax on their federal income tax return. Are California Cannabis Taxes an expense of a cannabis business? If so, are cannabis taxes deductible for federal income tax purposes?

We have discussed the mechanics of IRC §280E here and here. IRC §280E disallows deductions for cannabis cultivators, manufactures, distributors and retailers. However, expenses included in cost of goods sold (“COGS”) reduce taxable income and operates outside the reach of IRC §280E. Generally speaking, IRC §280E is less damaging to cultivators than retailers, because cultivators can attribute more business expenses to COGS.

Cultivation Tax
California imposes a cultivation tax on harvested cannabis that enters the commercial market. The tax is:

• $9.25 per dry-weight ounce of cannabis flower;
• $2.75 per dry-weight ounce of cannabis leaves; and
• $1.29 per dry-weight ounce of fresh plant.

The tax is imposed on the Cultivator alone; under state rules, cannabis cannot be sold unless the tax is paid.

IRS regulations (Treas. Reg. §1.471-11) provide Cultivators and Manufactures with a helpful roadmap regarding what costs are appropriate to include in COGS. Taxes can be included in COGS if they are otherwise allowed as a deduction under IRC §164. Under IRC §164, state taxes are deductible if they are “paid or accrued … carrying on a trade or business”. In addition, the state taxes may be included in COGS if they are “attributable to assets incident to and necessary for production or manufacturing operations or processes”. For example, property taxes are included in COGS. Finally, the regulations look to whether a tax is included in COGS in the business’s financial statements.

Cultivation taxes are paid or accrued in carrying on a trade or business. The cannabis plant is an asset of the business (i.e., raw material) that is the core ingredient in all cannabis products grown or processed. Clearly cannabis is the raw material incident and necessary to production; cannabis may not be sold under California law unless the Cultivation Tax is paid. Finally, the tax is imposed based on a characteristic of a business asset (i.e., weight of raw material), like a property tax.  Accordingly, there is a reasonable argument that IRS regulations require that the California Cultivation Tax be included in COGS of a Cultivator.

Excise Tax
California imposes a 15% Cannabis Excise Tax on the purchases of cannabis or cannabis product sold. Generally, the tax is imposed on the average market price. The average market price is the Distributor’s wholesale cost plus a mark-up determined by the CDTFA. Currently the mark-up is 60%. For example, a retailer’s cost of an ounce of cannabis is $75/ounce plus $5 of transportation cost. The mark-up is $48($80 *60%). The average market price is $128 ($80 +$48); the Cannabis Excise tax is $19.20 ($128*15%). The Retailer’s COGS includes the $80 cost. The Retailer will charge the consumer tax of $19.20. Note that for cannabis retailers, COGS is generally limited to the direct purchase cost of cannabis.

So, the big question here is: Should the $19.20 of Cannabis Excise tax be included in the Retailers COGS? By statute, the cannabis excise tax “shall be imposed upon purchases of cannabis”. The Retailer collects the tax from the consumer and pays the tax over to a California Distributor. As the tax is the ultimate liability of the cannabis purchaser, the statutes suggest that the cannabis tax collected is not a cost to the Retailer. Like state sales taxes, the Cannabis Excise Tax is a liability to the Distributor. As such the Cannabis Excise Tax is reflected on the Retailer’s balance sheet and not as an expense on the income statement. The Cannabis Excise Tax probably escapes the reach of IRC §280E.

Although California cannabis taxes do not conflict with IRC §280E, all cannabis businesses should consult with their tax advisors before taking a final approach. For Cultivators and Manufactures, there is a reasonable argument that the Cultivation Tax is included in COGS. For Retailers, there is a reasonable argument that the Cannabis Excise Tax is passed directly to the consumer and, therefore, outside the reach of IRC §280E. At the very least, that may be a good place to start the discussion.

audit marijuana cannabis
Can your cannabis business survive state scrutiny?

Like all business, cannabis businesses are subject to audit by state taxing authorities and other agencies. These audits tend to proceed differently with cannabis business, though, given the unique regulatory approach states take with marijuana. If a regulatory audit turns up issues, then fines and even loss of your business’s license could follow. This post outlines the top issues in preparing for, and managing, a regulatory audit of your cannabis business.

Plan Ahead

Every state with a regulated cannabis market has specific record keeping requirements.  Prepare for future audits by keeping meticulous records. Like other businesses, a marijuana business must keep detailed records regarding all aspects of the business including: sales, inventory management, purchases, taxes, employment, environmental compliance, legal and transportation. Unlike other businesses, a cannabis business is required to keep all source documentation. For example, purchases of goods and services must not only be supported by master goods and service contracts, but transaction level invoices; bank statements must include check and deposit slip detail.  When in doubt, keep as much detail as possible.

As stated HERE and HERE, it is wise to conduct periodic self-audits to identify any weakness in record keeping or any other compliance issues. Self-audits allow a cannabis business to address issues as early as possible. Self-audits also assist a business is constantly improving not only its regulatory compliance but improving customer service and profitability.

Each state differs in how long records must be maintained. Washington requires that records be archived for three years while California requires records be archived for seven years.  However long a state requires a cannabis business to archive records, it is a best practice to archive records in electronic format where possible, alongside retention of hard copy data.

Don’t Panic

Cannabis regulators will notify you by letter that your cannabis business is under audit. Included with that letter will be a list of records to provide. All states with regulated cannabis markets have wide latitude to inspect records and your physical business location. For example, Washington regulations require a cannabis business to archive a wide variety of documents and mandate that such records “must be made available for inspection if requested by an employee of the WSLCB.” In general, a cannabis business will have no standing to challenge a cannabis regulatory agency right to demand and to inspect records. Your time and money will be best spent gathering the records requested.

Typically, records must be produced in a very short time frame, so a cannabis business should immediately begin to gather the documents requested. Typically, information must be requested from CPA’s bookkeepers and attorneys, so give your business as much time as possible to get this information.

Disclosure and Truthfulness

Most states have strict sanctions for a cannabis business that fails to provide documents to the regulators. For example, a determination of a failure to provide documents in the State of Washington will result in the cancellation of a license. As expected, most states have strict sanctions for misrepresentations of fact to cannabis regulators. Again, a determination that a cannabis business has misrepresented facts will result in the cancellation of a license. A cannabis business must be aware that every document provided and statement made to the regulators is “on-the-record”. A cannabis business should never speculate or guess in responding to inquiries made by the regulators.

Understand the Appeal Process and Your Rights

Although your cannabis business has an affirmative duty to provide accurate information to the regulators, you do have legal rights and protections.

If the enforcement officer identifies a potential violation, the enforcement officer must follow a specific notice procedure. In Washington, the enforcement officer must issue an Administrative Violation Notice (AVN) and deliver the notice to the cannabis business, or the businesses agent or employee.

The AVN must include:

  • A narrative description of alleged violations;
  • The dates of violations;
  • A copy of the relevant statutes or regulations;
  • An outline of the licensee’s options;
  • Identify the recommended penalty; and
  • Identify any aggravating or mitigating circumstances adjusting the penalty.

Requesting a Stay

If the regulators suspend a license, the licensee must promptly initiate an adjudicative proceeding before an Administrative Law Judge assigned by the Washington office of Administrative Hearings. A hearing must be held within 90 days of the date of suspension.

In Washington, a cannabis business must petition for a stay of suspension within 15 days of service of the suspension order.  A hearing must be conducted within 14 days from receipt of the filing of the petition for stay.

Other Remedies

A Washington cannabis business has 20 days from receipt of the AVN to:

  • Accept the recommended penalty; or,
  • Request a settlement conference; or,
  • Request an administrative hearing;

Missing this key 20-day period will result in a range of sanctions from penalties to revocation of the cannabis business license.

One of the key tactical decisions is whether to request a settlement conference or to move directly to requesting an administrative hearing. Although a settlement conference offers an opportunity to resolve issues in a more informal manner, there may be instances where moving directly to an administrative hearing is wise. This tactical decision should be considered carefully in consultation with counsel, and is highly dependent on the facts and circumstances of each case.

Conclusion

Although a regulatory audit is intimidating, your cannabis business can best prepare for such an audit by aggressively implementing best practices, performing internal compliance audits, and keeping meticulous records. Remember, states that have legalized adult cannabis use, such as Washington, are under scrutiny by the federal government. Increased federal scrutiny puts pressure on states to enforce their local cannabis laws, and a key part of such enforcement is through regulatory audits. For all of these reasons, your cannabis business would be wise to plan for an audit by state regulators.

Just check the box!

The Tax Cuts and Jobs Act took effect January 1, 2018. This Act made dramatic changes to prior federal tax law. The most significant changes were: 1) the reduction of the corporate tax rate, and 2) a new 20% deduction for individuals and other non-corporate taxpayers operating a business. We outlined the income tax consequences of operating as C corporation versus operating as a partnership here and here. All cannabis businesses should review the tax consequences of being classified as a C corporation versus a partnership and consider changing how their cannabis business is taxed by making an “Entity Classification Election.” This post outlines some of the opportunities and pitfalls in making this election.

The New Landscape on Choice of Entity

The Act lowered the corporate tax rate to 21%. However, a corporation and its shareholders are still subject to double taxation.  Dividends paid are taxable and the highest marginal rate on dividend income is 23.8% (capital gain rate of 20% plus net investment income tax rate of 3.8%). Accordingly, the top rate for operating via a corporate form is 44.8%.

By contrast, the marginal tax rate for a partner in a cannabis-related business can be as high as 45.1%. Though the new law allows partners to deduct up to 20% of income from operations, it is unclear if a partner of a cannabis business is allowed this deduction, per I.R.C. 280E. Furthermore, the self-employment tax computation is capped each year.

The Need for Analysis

Merely comparing the highest marginal rates between a corporation and a partnership indicates it is slightly better to operate as a C corporation (a 44.8% rate versus a 45.1% rate). However, a raw comparison of rates is usually only the first chapter of the story. Under the new law, other factors can be important, such as the individual tax bracket of each owner and whether cash distributions are planned. A business may or may not qualify for the favourable 20% deduction and this further complicates the analysis. For these reasons, you should be sure to run all of the relevant numbers before choosing to file as a C corporation.

Electing to be a C Corporation

If, after running the appropriate analysis, you determine that being taxed as a C corporation is best, your next step should be to file Form 8832, an Entity Classification Election (“C Election”).  The following entities may elect to be taxed as a C corporation:

Filing a C election for tax purposes has no impact on how your entity operates under state law. Though it is recommended to amend your company’s operating agreement to reflect the C election, the governance, management and sale provisions of the company will not materially change.

When to Make the Election

A C Election may apply prospectively or retroactively. The easiest approach is to elect on a prospective basis. An LLC that has been taxed in prior years as a partnership can also make a C election for the current tax year. For example, an LLC that wants to be treated as a C corporation for 2018, should make that election by March 15, 2018.

If you miss the opportunity to file a prospective election, you still may make a retroactive election under very specific circumstances. A business that wants to be treated as a C corporation must file a request for late election relief no later than 3 years and 75 days from the effective date of the election. For example, an LLC that wants to be taxed as a C corporation beginning on January 1, 2016, must file a request for late election relief on or before March 15, 2019. The most common situation is to make a C election on or before the due date of your tax return.

For example, a business currently categorized as a partnership that wants to elect to be treated as a C corporation for 2018, can file an election on March 15, 2019. The election must meet all of the following criteria for late election relief:

  • The entity failed to file Form 8832;
  • The entity has not yet filed the tax return for the desired election year;
  • The entity has acted as a C Corporation;
  • The entity has reasonable cause for failing to file Form 8832.

Though the IRS is not required to grant late election relief to a taxpayer, the IRS has traditionally been very fair in granting relief and most taxpayers will meet this criterion. Once a business elects C corporation status, it must for the next five years continue to file as a C corporation. Finally, a business must examine how a C election will be treated for state income tax purposes. Some states may require an independent election to be treated as a C corporation, for example.

The new tax law presents opportunities for businesses to reduce their federal income tax liability. All marijuana business should examine their current tax filing profile and act as quickly as possible to take advantage of the lower tax rates imposed on C corporations.

california tax marijuana
Your standard CDTFA qualified cannabis tractor.

California cannabis businesses are now acquiring temporary permits to enter the new cannabis marketplace made possible under MAURSCA. As part of that process, all cannabis businesses have been introduced to the California Department of Fee and Tax Administration (“CDTFA”), the agency tasked with administering the new cannabis cultivation taxes and sales tax.

The CDTFA administers sales tax exemptions on purchases of certain farm equipment and agriculture products. These exemptions are available to cultivators, processors and manufacturers. California sales tax rates are high – ranging from 7.25% to 10.25% of the sales price. Sales tax savings go directly to the bottom-line and a business could save up to $1,025 on every $10,000 invested in eligible supplies and equipment.

This post provides a quick outline of California sales tax exemptions available to cultivators. A second post will cover licensed processors and manufactures.

Seeds and Plants

The sale of seeds and plants are exempt from sales tax so long as the purchaser uses those seeds and plants to create products sold in the regular course of business. Plants include “cuttings of every variety”. Consequently, a cultivator should be able to purchase clones and plants exempt from sales tax. To document the exemption, a cultivator must give a seller an exemption certificate.

Fertilizers

The sale of certain fertilizers is exempt from sales tax so long as the fertilizer is applied to land or in “foliar application” where the products of such plants (i.e., cannabis) are sold in the regular course of business. Only very specific types of fertilizers and nutrients qualify and the definitions are highly technical. For example, “commercial fertilizer”  and “agricultural minerals” qualify. These substances generally contain combinations of nitrogen, phosphoric acid and potash under 5%. On the other hand, “packaged soil amendments” (i.e., hay, straw, peat moss) do not qualify. To document the exemption, a cultivator must give a seller an exemption certificate.

Farm Equipment and Machinery

As a rule, the sale of farm equipment and machinery is taxable. However, the purchase of certain farm equipment and machinery is partially exempt from sales tax. The partial exemption is currently 5% of the sales price. For example, the sales tax rate on the purchase of eligible equipment in Arcata is 3.5% (8.5%-5.0%); resulting in a $500 savings on the purchase of $10,000 worth of equipment.

Three requirements must be met to take the credit. The first and most problematic requirement, is that the purchaser’s business must fall within specific federal SIC codes.  SIC codes are created by the federal government to track statistical information on U.S. businesses. Because cannabis is illegal under federal law, no specific SIC code is currently available for the sale of consumable cannabis. Nonetheless, a cultivator may argue that their business operation meets this requirement because it is included in the general farm category of SIC 0191.

The second requirement is that the equipment should be used at least 50% or more in harvesting agricultural product. The third, requirement is that the equipment should be farm equipment and machinery as defined under regulations. The regulations broadly define farm equipment and machinery. The CDTFA has identified the following equipment as qualifying for the exemption:

  • Planting equipment;
  • Trimming Tools;
  • Drying racks and trays;
  • Grow tents and lights;
  • Environmental controls;
  • Hydroponic equipment;
  • Irrigation equipment;
  • Hand tools;
  • Repair and replacement parts;
  • Wind machines.

Vehicles that are designed to be used exclusively on roads and highways, such as pick-up trucks, do not qualify. To document the exemption, a cultivator must give a seller an exemption certificate, Form CDTFA-230-D.

Buildings for Raising Plants

Certain buildings are considered farm equipment for purposes of the farm equipment and machinery exemption discussed above. Generally, they must be single purpose structures and do not include structures used for storage or administrative purposes.  The buildings must:

  • Be specifically designed for commercially raising plants;
  • Used exclusively for that purpose.

For example, a greenhouse would generally qualify. To document the exemption, a cultivator must give the seller an exemption certificate, Form CDTFA 230-D.

Solar Power Facilities

A business that otherwise qualifies for the farm equipment partial exemption, may purchase certain solar equipment at the reduced sales tax rate.

In general, solar power equipment used at least 50% in the production of cannabis would qualify for the farm equipment and machinery partial exemption. Solar power equipment may qualify even if the equipment is tied to the local power grid.

For example, a solar facility producing a total 1000 kw of electricity per year would qualify so long as at least 500 kw per year was used to power the cultivator’s farm equipment and machinery. Note that in this example, the cultivator could sell on the open market the excess 500kw of electricity. Potentially, the cultivator can deduct on its federal income tax return all expenses related to this separate power distribution business.

Diesel Fuel Used in Farming

The purchase of diesel fuel is generally subject to sales tax; however, a partial exemption from sales tax of 5.0% applies to the purchases of diesel fuel used in farming activity or in transporting product to a manufacturer or a distributor. The computation for this sales tax exemption is the same as for the exemption for farm machinery and equipment. To obtain the partial exemption, a cultivator must present to the seller an exemption certificate, Form CDTFA-230-G.

Furthermore, California imposes a $0.36 per gallon excise tax the sale of diesel fuel. However, a cultivator may purchase diesel fuel used to power farm equipment exempt from the diesel fuel excise tax. To obtain the exemption, a cultivator must present to the seller an exemption certificate, Form CDTFA-608 REV.

Liquid Propane Gas Used in Farming

Sales of liquid propane gas used to operate machinery used in farming or harvesting are fully exempt from sales tax. To obtain the full exemption, a cultivator must present to the seller an exemption certificate, Form CDTFA 230-N REV.

Conclusion

As cultivators make capital investments in their cannabis operations, they have an opportunity reduce the amount of sales tax they pay on their purchase of certain consumables and high-ticket items. These exemptions provide bottom-line savings; however, the CDTFA strictly enforces compliance in this area. Accordingly, cultivators should keep meticulous books and records and ensure that they issue completed exemption certificates on these purchases, and check in with a qualified CPA or tax lawyer with any questions.

Unfortunately, IRC 280E is not included.

On December 22, 2017, the Tax Cuts and Jobs Act (“The Act”) otherwise known as PL-115-97,
was signed into law. The Act is the most significant overhaul of the U.S. Tax Code since 1986 and is effective beginning in 2018. Accordingly, cannabis businesses need to understand now how the new tax law affects their business. Below are the most significant issues impacting a cannabis business, as well as, some ancillary cannabis business.

  1. The Act did not repeal IRC 280E.

The number one tax issue in the cannabis business is the impact of IRC 280E. We have discussed how IRC 280E impacts the industry many times, including here, here, here, and here. Prior to the enactment of the new tax law, GOP political advocates such as Grover Norquist called for the repeal of IRC 280E, much to the delight of the cannabis industry. However, IRC 280E was not repealed. One prevailing reason for this was that a repeal did not fit into Congress’ budget: repeal would have been budgeted as a tax cut, which would have forced Congress to replace that lost revenue. So, IRC 280E lives on (at least for now).

One bright spot is that cannabis business will pay less federal income tax beginning in 2018. The decrease in tax rates mitigates the impact of IRC 280E.

  1. The Act makes the C Corporation more attractive.

The centerpiece of GOP tax reform is the reduction of tax rates. As we have written before, in determining the legal structure for your cannabis business, one choice is the C Corporation.

C Corporations pay tax at the corporate level. Individual shareholders are then taxed on dividends at a rate as high as 20%. In the past, this “double taxation” has discouraged the use of C corporations. The Act mitigates the problem of double taxation by reducing the C Corporate tax rate to 21%. The tax rate on dividends does not change under the new law.

Besides this new reduction in tax rates, C corporations offer other benefits such as audit protection for shareholders and greater flexibility in offering employee benefits. Based on these significant changes, every cannabis businesses should review their current operating structure and consider operating as a C corporation.

  1. The Act makes some Limited Liability Company & “Pass-Through” entities less attractive.

The most common entity choice for those starting a business, cannabis or otherwise, is the limited liability company. We have outlined some of the advantages  and disadvantages of operating as a limited liability company in the taxation context.

A limited liability company may take on many forms for tax purposes but the common characteristic is that income “passes through” to the owners. Income that passes through to individual members or owners is taxed at the individual tax rate. Under the new law, some owners of pass-through entities will enjoy a deduction of 20% of business income.

  • For example, assume a single individual (in the 24% tax bracket) earns net income from an ancillary cannabis business that she operates as a sole member of a limited liability company. If the limited liability company’s business income is $100,000, her federal income tax from that business is $19,200 [($100,000 -$20,000) * 24%].

Now, the exceptions. First, Congress framed the pass-through benefit in the Internal Revenue Code as a deduction; IRC 280E will disallow this deduction for all cannabis cultivators, manufacturers, distributors and retailers. In the example above, a cannabis business would pay tax on $100,000 of income. As such, federal tax law continues to punish a cannabis business.

Second, while some ancillary cannabis businesses may benefit from the 20% deduction, other owners of pass-through entities will have their 20% deduction reduced or even disallowed under a maze of complex and interrelated exceptions.

Overall these exceptions operate to favor business that make substantial capital investments (including real estate) over businesses that provide services, or are labor intensive.  For example, most service businesses–including those in health care and consulting–expressly do not qualify for the deduction unless their overall taxable income (after several adjustments) is below $157,500 (or $315,000 for those filing a joint tax return). On the other hand, an ancillary cannabis business such as a lessor of real estate (without significant payroll costs) will likely benefit from continuing to operate as a limited liability company.

  1. The Act limits tax deductions for some debt financing.

Instead of making an equity investment in a cannabis business, investors often choose to be a lender. Under IRC Section 280E, it is difficult for a cannabis business to deduct interest expense.  Under the old law, ancillary businesses can deduct all business interest.

The Act has put significant limitations on deducting interest. Under the Act, the amount of interest expense allowed to be deducted cannot be greater than the sum of:

  • Interest income;
  • 30% of “Adjusted Taxable Income”; and,
  • Interest expense from certain “floor plan” financing.

Adjusted Taxable Income is generally taxable net income with adjustments for: interest income and expense; losses; and certain capital investments. Although included in the computation, floor plan financing should not be an issue with most ancillary cannabis businesses.

  • For example, an ancillary business receives a loan and pays $5,000 of interest per year.  A business with Adjusted Taxable Income of $18,000 can deduct all its interest expense ($18,000*30%=$5,400); a business with Adjusted Taxable Income of $15,000 may only deduct $4,500 ($15,000 * 30%) of interest expense.

There are two major exceptions. The first exception allows certain real estate business to elect to deduct interest expense in exchange for using a less favorable depreciation method. The second exceptions allow a business with annual gross receipts of less than $25 million (averaged over a three-year period) to deduct all its interest expense.

Finally, all taxpayers can apply any disallowed interest expense to future years.

Because the new tax law applies to the 2018 tax year, the IRS will be scrambling to provide additional guidance to businesses and their tax advisors. The IRS will almost certainly issue additional regulations, and other formal guidance throughout 2018. In addition, it is very likely that Congress will take up a Technical Corrections Bill in 2018 to fine-tune the Act.  We can only hope that such fine-tuning includes the repeal of IRC 280E.

California's Cannabis Excise Tax
California’s Cannabis Excise Tax

The California Department of Tax and Fee Administration (“CDTFA”) last week adopted Emergency Regulation 3701, Collection and Remittance of the Cannabis Excise Tax, clarifying that California’s Cannabis Excise Tax applies to sales of cannabis acquired before January 1, 2018, but sold to customers on or after January 1, 2018. These regulations are in addition to Emergency Regulation 3700, Cannabis Excise and Cultivation Taxes issued in late November.

Emergency Regulation 3701 was issued to close a perceived loophole in California’s Cannabis Excise Tax. Cannabis distributors and retailers have no room for error under Emergency Regulation 3701 and this blog post explains its requirements.

California’s Cannabis Excise Tax – The General Rules

Under MAUCRSA, cannabis retailers must collect the excise tax from their customers on every cannabis sale made on or after January 1, 2018. The excise tax is 15% of the Average Market Price. In turn, retailers must pay their distributors the excise taxes collected from their retail customers because distributors are ultimately responsible for remitting the excise taxes to the CDTFA.

Under MAUCRSA, no person is required to be a licensed distributor until January 1, 2018. The CDTFA recognized that on January 1, 2018, newly-licensed retailers will have cannabis inventory purchased before January 1, 2018, and such “pre-MAUCRSA Cannabis” not purchased from a licensed distributor. Emergency Regulation 3701 outlines the process for collecting and paying the excise tax on pre-MAUCRSA cannabis sales

So suppose Retailer A purchases pre-MAUCRSA Cannabis in 2017 and on January 2, 2018, purchases cannabis from Distributor Z for $100/ounce. The wholesale cost of cannabis to Distributor Z is $100 an ounce. The Average Market Price of an ounce is $160.00 ($100 x 1.6). The Cannabis Excise Tax due on the sale of the pre-MAUCRSA Cannabis is $24.00 ($160 x 15%) and Retailer A must collect this excise tax from its own customer.

Requirements of Emergency Regulation 3701 – Distributors

The distributor must, in turn, remit the excise tax to the CDTFA. The retailer must pay excise taxes collected from its customers to a distributor by the 15th of the month following the retail sale.  Distributors must report and remit the tax to the CDTFA on that transaction as part of its ordinary compliance process and provide the cannabis retailer a receipt that provides the following:

  • Payment date
  • Distributor name;
  • Retailer name
  • Amount of the Cannabis Excise Tax;
  • Retailer’s Seller Permit Number;
  • Distributor’s Seller Permit Number. A Distributor not required to hold a Seller’s Permit must identify its exempt status.

So suppose Retailer A sells pre-MAUCRSA Cannabis on January 25, 2018. The excise tax collected from the customer is $24.00. Retailer A must pay the cannabis tax collected to Distributor Z by February 15, 2018. Distributor Z must report this transaction on its first-quarter Cannabis Tax Return for 2018 and pay the tax to the CDTFA by April 30, 2018, the due date of its first-quarter tax return.

Emergency Regulation 3701 — Open Issues

Emergency Regulation 3701 raises a number of questions, including the following:

  • May a cannabis retailer choose one distributor to set the Average Market Price, but pay the excise tax to another distributor? In Example 2, Retailer A pays Distributor Z. Could Retailer A pay Distributor Q so long as it transacts business with Distributor Q?
  • Can a cannabis retailer sell pre-MAUCRSA Cannabis before purchasing cannabis from a newly-licensed Distributor? It appears not, as at least one transaction must be completed with a distributor to set the Average Market Price.
  • How are the emergency regulations implemented if the distributor is part of a Microbusiness?

These and other issues will presumably eventually be addressed in CDTFA’s Cannabis Tax GuideIn the meantime though, Retailers must be aware that every sale under MAUCRSA is subject to California’s Cannabis Excise tax regardless of the date the cannabis was placed into inventory. Retailers that fail to comply with Emergency Regulation 3701 are subject to penalties, including the possibility of losing their California Retailer license.

Speaking of MAUCRSA, four of my firm’s California cannabis lawyers will be putting on a FREE webinar on MAUCRSA tomorrow (December 18), entitled, What You Need to Know Now to Get Your California Cannabis License on January 1. This event will feature two of our Los Angeles-based cannabis attorneys, Hilary Bricken and Julie Hamill, and two of our San Francisco-based cannabis attorneys, Alison Malsbury and Habib Bentaleb. It will give an overview of the recently issued emergency MAUCRSA rules governing medicinal and adult use cannabis licensing and operations in California and cover the licensing process for each license type, operational standards for all license types (including renewable energy requirements for cultivators), the 6-month “transitional” period for product and operations, major changes between the MCRSA and MAUCRSA rules, and key unknowns posed by the rules. You can register for this free webinar by going here.

California cannabis taxes
The rules of the California cannabis taxation road

On November 30, 2018, The California Department of Tax and Fee Administration (“CDTFA”) adopted Emergency Regulation 3700, Cannabis Excise and Cultivation Taxes. Shortly before issuing these emergency regulations, the CDTFA released a Formal Issue Paper with an analysis critical to understanding the regulations. This post provides a high-level overview of these emergency tax regulations and what you need to know now about California’s cannabis tax regime.

Cannabis Cultivation Tax. The cannabis cultivation tax applies to all cannabis that enters California’s commercial market as follows:

  • $9.25 per dry-weight ounce of cannabis flower;
  • $2.75 per dry-weight ounce of cannabis leaves; and
  • $1.29 per ounce of fresh cannabis plant.

Fresh cannabis plant is defined as flowers, leaves, and whole plants, that have been weighed within two hours of harvest without further processing. The emergency regulations address measurement issues in computing the cultivation tax. The CDTFA rejected the current industry standard that an ounce equals to 28.00 grams and instead calculates an ounce at 28.35 grams.

Cannabis distributors are to collect the cultivation tax when the cannabis enters the commercial market, which is when all testing and quality assurance has been performed. Beginning on January 1, 2018, the California Bureau of Cannabis Control will allow the sale of untested cannabis or cannabis product for a limited time. During this transition, the emergency regulations clarify that the distributor collects the cultivation tax when the cultivator sells or transfers cannabis or cannabis product to the distributor. With but a few exceptions, cannabis removed from a cultivator’s site is presumed to have been sold and is taxable.

Plant waste is not subject to the cultivation tax. The emergency regulations define the term “Plant Waste” by referencing  Sections 40141 and 40191 of the California Public Resource Code. In general, plant waste is unusable cannabis mixed with other ground material such that the total mixture is at least fifty percent non-cannabis material by volume.Cannabis Excise Tax

The Cannabis Excise Tax is imposed on the retail purchase of all cannabis and cannabis products at 15% of the Average Market Price, which price is determined by first identifying whether the transaction was at arm’s length or not. An arm’s length transaction is a sale that reflects a fair market price between two informed and willing parties. For arm’s length transactions, the Average Market Price is the wholesale cost plus a markup determined by the CDTFA. The emergency regulations define wholesale cost as the amount paid by a retailer for cannabis and cannabis products including transportation costs. Discounts and trade allowances do not reduce the amount included in the wholesale cost.

Every six months, the CDTFA must determine the markup.  Recently, the CDFTA has determined that the markup from January 1, 2018, to June 30, 2018, is 60%. The computation of the cannabis excise tax is illustrated in the following example:

Assume a retailer purchases cannabis from a Distributor at $200.00 per ounce and incurs $20 of transportation costs. In this case, the Average Market Price of an ounce of cannabis is $352.00 ($220.00 x 1.60) and a consumer who purchases a 1/4 ounce of cannabis will pay $13.20 ($352.00 x 1.15 x 1/4) in cannabis excise tax. The Average Market Price is used to compute the cannabis excise tax and may not be the ultimate retail sales price.

California allows a single business to engage in multiple commercial cannabis activities and a business that engages two or more licensed cannabis activities (e.g., as a distributor and a retailer), will not be deemed to have transferred cannabis at an Average Market Price. Instead, these transfers will be considered not to have been at arm’s length and the Average Market Price will be the retail sales price at which the retailer sells the cannabis. For example, if the retail sales price of cannabis is $200 per ounce a consumer who purchases a quarter ounce of cannabis at  $200 will pay $7.50 in cannabis excise taxes ($200.00 x 15% x 1/4).

The emergency regulations clarify that a distributor must report and remit its tax payments to the CDTFA during the quarterly period in which the cannabis was sold or transferred to a retailer, not during the quarterly period when the retailer pays its taxes to the distributor. This may lead to accounting and cash flow issues since distributors must pay their taxes to the CDTFA before they receive cash reimbursement from their retailer buyers.

The emergency regulations also clarify that the penalty for nonpayment of tax is 50%. Take note that this 50% penalty takes effect if the tax payment is only one day late. The emergency regulations allow for a waiver of this penalty for “reasonable cause,” but never define what constitutes reasonable cause. According to CDTFA commentary, examples of reasonable cause include late payment of tax due to a lack of banking services, a limited number of facilities to accept cash payments, evolving industry regulations and the remoteness of some commercial cannabis operators.

California is clearly very serious about collecting tax revenues from cannabis businesses and the complexity of California’s new cannabis tax laws is going to make tax compliance a challenge for every participant in the California cannabis market.

 

 

Cannabis taxesOn September 27, 2017, the Trump Administration introduced its framework for tax reform, known officially as the “Unified Framework for Fixing our Broken Tax Code.” Not surprisingly, the proposal leaves the details to Congress. Though the current proposal is short on detail, cannabis businesses should be aware of the impact the overall rate may have on their choice of legal entity.

Up front caveat: there is no chance Congress will pass a tax bill that exactly matches the current proposal. The proposal doesn’t have enough detail, for one. But more important is that the Congressional meat grinder of wheeling and dealing and lobbying generally ends up yielding a product that differs greatly from initial proposals they receive from the White House. Regardless, it’s useful to get an idea of what direction the administration and Congress are likely to push taxes.

Tax Proposal Highlights. The centerpiece of the current tax proposal is to dramatically reduce tax rates, as per the below.

Business Form

2017 Tax Rate

Proposed Tax Rate

Sole Proprietor 10%-39.6% 25%
Partnership/LLC 10%-39.6% 25%
S Corporation 10%-39.6% 25%
C Corporation 15%-39.0% 20%

The current proposal will change how entities treat the costs of equipment and other capital assets under the tax code. Under current law, businesses cannot deduct the full cost of capital equipment — the cost is deducted over a period of years through scheduled depreciation. The new proposal would, at least for a limited time, treat capital expenses the same as operating expenses, allowing companies to deduct the full cost of capital equipment in a given year. This could be a significant benefit to cannabis growers and producers, who can categorize most of their capital equipment as costs of goods sold. Retailers, on the other hand, are unlikely to benefit because deductions for their capital equipment expenses are generally barred by IRC §280E.

In determining the legal structure for your cannabis business, you have two fundamental choices. Do you form a corporation, which is subject to federal income tax itself, or do you form a “pass-through-entity” (typically a limited liability company) where the entity pays no tax, but profits or losses are allocated to the company owners, and those owners must pay individual taxes?

C Corporations. C Corporations are liable for federal income tax at the entity level. Shareholders are not individually liable for those taxes, but they are liable for taxes paid on dividends they receive. This is the dreaded “double taxation” people refer to when criticizing the corporate tax system. But if the corporate tax rate for C Corporations is reduced to 20% across the board, C Corporations may become very attractive to cannabis businesses.

C Corporations can offer additional benefits. If the IRS audits a C corporation, additional taxes assessed are a liability of the corporation, not a personal liability of the shareholders. Compare to a partnership, where even if a partner were completely innocent of any blame in a situation where prior year profits were understated, that partner would be individually liable for any assessment of unpaid taxes. The IRS treats shareholders active in a C corporation as employees and thus not subject to the 15.3% self-employment tax. C Corporations also typically offer greater flexibility regarding employee benefits and incentive compensation.

Limited Liability Companies. Limited liability companies have become the most common entity choice for those starting a business, cannabis or otherwise. They protect their members from personal liability like a corporation, and they also provide considerable management flexibility, lacking the mandatory formal structures of corporations.

For income tax purposes, the LLC is a chameleon and may take on many forms. An LLC with a single individual member is treated as a disregarded entity — individual members report business operations directly on their personal tax returns. Under the current tax proposal, a sole proprietor’s (or single member of an LLC’s) income from his or her business activity would be taxed at 25%, however, it also indicates that a “wealthy individual” may not avoid “the top personal tax rate.” But the proposal does not have any details on how exactly that exception would be included in a final tax bill.

An LLC with more than two members is treated as a partnership and tax is imposed at the partner level, with the partners’ share of income or losses reported on their personal income tax returns. Again, under the proposal, each partner’s tax rate is capped at 25%.  Presumably, a partner that is a C Corporation will be taxed on 25% of its pass-through income.

Finally, an LLC may “check-the-box” and elect to be treated as C or S corporation. S Corporations are pass-through-entities and S Corporation shareholders are taxed at the shareholder level similar to partners in a partnership. The income of an LLC that elects to be treated as a C corporation would presumably be taxed at the 20% corporate tax rate.

One benefit of a pass-through-entity is that a partner is not subject to double taxation as cash distributions to a partner may be received tax-free. In addition, an LLC/partnership generally may be dissolved with a lower risk of triggering recognition of income on the liquidation. For example, let’s say that a C corporation buys a piece of real estate for $400,000, and two years later the real estate has appreciated in value to $600,000. The shareholders’ original investment in corporate stock is $300,000. If the corporation dissolves and the shareholders receive the real estate, they have to pay tax on the fair market value of the property ($600,000) less their original stock investment ($300,000). So, the shareholder must pay tax on a gain of $300,000. But in an LLC/partnership, the liquidation of the partnership would not be a taxable event, so the partners would not immediately pay tax on that value. 

There are a few drawbacks to partnerships in the cannabis space. As discussed earlier, partners have individual liability for tax that the partnership owes, so all partners must be diligent to ensure they are making sufficient tax payments. Additionally, because of some quirks in the partnership tax code, IRC 280E has the effect of making a partner that is selling its interest pay more tax on the sale of that partnership interest than a similarly situated shareholder in a C corporation would pay. Finally, members/partners must pay employment taxes at the 7.65% rate, whereas the C Corporation pays a shareholder employee’s share of such taxes. 

If you are making an entity selection decision soon, keep an eye on Congress. The tax code can be hard to understand, and the media doesn’t always concentrate on details that can have a dramatic effect on things like business entity selection. Any major tax reform will create a lot of confusion and will change some common assumptions, so stay vigilant.

Cannabis TaxesI regularly speak with clients regarding the tax issues that impact their buying, selling or operating a cannabis business. There are certain things I hear again and again regarding their taxes and their tax planning that are simply not true. The below are the five most common.

1. Calculating the Odds of Getting Audited Constitutes Tax Planning. It does not. This is a dangerous myth as it causes businesses to focus on the wrong question. This handicapping is called “audit lottery” and it will always lead you astray. The IRS only audits a small portion of small business and individual returns, but as Mark Twain once said, there are “lies, damn lies and statistics.”  Stating the obvious, a cannabis business is just not comparable to any other legal business and its odds of being audited by both the federal government and the state where it operates are much higher than for other types of businesses.

Other factors auger against playing the audit lottery. To increase efficiency, the IRS selects issues or industries it believes are rife with noncompliance or abuse. Based on a history of noncompliance by cannabis businesses, the IRS is active in auditing cannabis businesses. A recent law change has made it easier for the IRS to audit partnerships and LLC’s and beginning in 2018, the partnership/LLC is responsible for remitting tax due on any IRS adjustment on audit.

The energy spent guessing the odds of an audit are better spent understanding how to comply with federal tax law and how to document transactions in the most efficient manner.

2. Drafting Legal Documents Are Sufficient To Support My Tax Return.  We have written on the importance of corporate governance and compliance here, here and here.  The same concepts apply to taxes.  You should have legal documentation to support the fundamental financial events of your business. Is this transaction a loan from an owner or a contribution to equity? What are the management rights and responsibilities of a new partner? The answer to these and other questions should be supported by your legal documentation.

But having contracts in place is merely the starting point when it comes to your taxes. An important tax law maxim is that the “tax follows economics.” This means the proper tax treatment reflects what happens in your business, not what contracts are drafted and placed in a file.

In evaluating the tax consequences of a transaction, the IRS will always start with the documents, but it will then analyze how the business really operates (i.e., its economics) and compare that to the documents. Unsigned documents are ignored. Documentation that does not support the economics of the business are ignored. Contracts and legal documents not reflected in your books and records are ignored. Your contracts and corporate documentation must reflect how your business operates. Then, and only then, are they useful in determining the correct tax treatment.

3. Compliance with State Law is not Relevant for Federal Income Tax Purposes. Our cannabis clients often wrongly believe state law operates independently from federal law. In administering federal tax law, the IRS often restructures or ignores transactions with no business purpose or that were structured solely for tax avoidance purposes. Most often, the starting point in that evaluation is state law and a transaction that comports with state law has a greater chance of being viewed favorably by the IRS. Conversely, a transaction or structure that does not comport with state law, will most likely be rejected by the IRS on its face.

4. Having a Tax Professional Prepare My Return Limits My Responsibility.  Wrong. You the taxpayer have the ultimate responsibility for the information presented on your return. By signing your tax return, you are declaring, under penalty of perjury, that to the best of your knowledge, the information presented is, true, correct and complete. This includes information presented on schedules and statements. It is therefore crucial you have a clear understanding of the facts presented on the return and the reasons behind any tax treatment of a transaction.

5. Tax Law Applies to My Cannabis Business Differently Than Other Businesses. This is true to the extent that cannabis businesses are forced to reckon with IRC §280E. But generally, the principles of federal income tax law apply to a cannabis business the same as they do for a non-cannabis business. The tax law allows for a degree of flexibility in evaluating how a legal entity and its owners are subject to tax. A business may choose to operate as a limited liability corporation, and as such, be treated for tax purposes as a disregarded entity (i.e., the sole member is subject to tax) a partnership (i.e. each partner is subject to tax) or as a “C” corporation (i.e. the corporation is subject to tax). The tax law governing these options are no different for a cannabis business.

The cornerstone of the cannabis industry is strict state regulation, reporting, and compliance. Understanding and avoiding the tax myths discussed above will assist you in evaluating how to properly and effectively comply with both state cannabis law and federal income tax law.

E-commerce Taxes for cannabis businessesMore non-cannabis companies are getting into the business of manufacturing or selling their products to cannabis growers, retailers, and consumers. Some of these ancillary cannabis businesses sell their products online using third-party marketplaces like Amazon. Ancillary cannabis businesses using marketplace providers may be required to collect sales tax from their customers and pay income tax. This post discusses some of the sales tax issues these ancillary cannabis businesses face.

Sales Tax Compliance. A business that sells to an out-of-state customer is generally not required to collect sales tax on shipments to that customer unless it either owns property or employs people in the customer’s state. Less contact is required for a state to impose state income tax from an out-of-state seller. A business may be subject to a state’s income tax merely by selling products to customers located in that state. For example, a business that owns inventory located in California must collect sales tax from its California customers and pay income tax to California. A business with no physical connection to Oregon other than selling to Oregon customers is subject to the Oregon income tax. This is the bad news.

Sales through Marketplace Providers. Business that sells their products on-line often use marketplace providers like Amazon.  These marketplace providers typically list products on their website, processes the sales transactions, and ship the product from its own fulfillment center. Though the product is physically in the possession of the marketplace provider, the selling business still has legal title to the product. Because the selling business holds legal title to the inventory, the selling business is responsible for collecting sales tax from the customer. A state may collect past taxes at any time from a business that does not comply with state tax law. On audit, it is common for a state to ask for 10 years of back taxes. To encourage sales and income tax compliance, the Multistate Tax Commission, a quasi-governmental agency, is offering tax amnesty for past due taxes in 24 states. This is the good news.

State Tax Amnesty. Under the tax amnesty program, most participating states will automatically forgive all prior year income and sales tax liabilities (including penalties and interest) of businesses that sold through marketplace providers if the selling business agrees to collect sales tax and file income tax returns going forward.  A few participating states will consider tax amnesty on a case-by-case basis.

Medical marijuana is still illegal in many of the participating states. However, the following medical marijuana states are offering to forgive past income and sales tax, penalties, and interest: Arkansas; Connecticut; District of Columbia; Florida; Louisiana; Massachusetts; Minnesota; New Jersey; and Vermont. The State of Colorado, will forgive a business’s prior year’s sales/use tax liability; however, a business with more than $500,000 of sales to Colorado residents must pay Colorado income tax from 2013 onward.

To qualify for this tax amnesty, a business must meet the following requirements:

• Not be registered in the state;
• Sell through a marketplace provider such as Amazon;
• Have no other physical contact with the state;
• File an application no later than October 15, 2017.

Every ancillary cannabis business that has ever sold any of its products through an online marketplace provider should analyze — and soon — whether it might be able to benefit from this tax amnesty.  Furthermore, every ancillary cannabis business that has ever sold online and shipped directly to its customer, should examine its compliance with state sales and income tax law.