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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 cannabis tax

On July 20, 2018, the CDTFA released its discussion paper on proposed rulemaking regarding the administration of the cannabis cultivation and excise taxes. This blog post highlights the issues addressed in the proposed regulation.

By way of background, on August of 2017 the CDTFA promulgated two emergency regulations. The first, Regulation 3700, Cannabis Excise and Cultivation Taxes, was promulgated to ensure that essential guidance was available when California’s regulated cannabis market became operational on January 1, 2018. The second, Regulation 3701, Collection and Remittance of the Cannabis Excise Tax, was promulgated to clarify the imposition, collection, and reporting of the Cannabis Excise Tax. We previously discussed these regulations here, and we a discussed the Cultivation and Excise Tax here and here.

The CDTFA will not take action on Regulation 3701. However, the CDTFA has proposed many revisions to Regulation 3700. We summarize them below, and provide some commentary throughout.

  • Expands the definition of cannabis flower to include trimmed or untrimmed flower but excludes leaves and stems removed before sale. The consequence of this proposed change is to assure that even trimmed flower will be taxed at the highest tax rate of $9.25 per dry weight ounce.
  • Clarifies that “fresh cannabis plant” must be identified as fresh cannabis plant and recorded in the upcoming track-and-trace system. Until the track-and-trace system come online, a paper invoice or manifest must indicate that “fresh cannabis plant” is being transferred. This documentation is important. Fresh cannabis plant is taxed at the lowest rate of $1.29 per ounce; the proposed change clarifies what information is required to support paying tax at the lowest cultivation tax rate.
  • Prohibits separately stating the cannabis excise tax on the receipt provided to a retail cannabis customer. Instead, the regulations require the invoice to state “The cannabis excise taxes are included in the total amount of this invoice”. Retailers purchasing from third-party distributors must compute the excise tax based on their wholesale cost plus 60% mark-up as determined by the CDTFA. Separately stating the excise tax allows a consumer to determine the wholesale cost of a cannabis retailer. The proposed prohibition does not provide retailers the flexibility to disclose the computation of the tax to its customers.
  • Clarifies that transactions between two distributors must document that no cannabis excise tax was collected or remitted on the transaction. That is, the distributor that sells cannabis to the cannabis retailer is the one responsible for collecting and remitting the cannabis excise tax to the CDTFA.
  • Clarifies that invoices documenting the cultivation tax must disclose the weight and category of the cannabis that entered the commercial market. This change is to assure that the receipt a manufacture provides to a cultivator includes the weight and category (i.e., cannabis flower, cannabis leaves, or fresh cannabis plant) of cannabis transferred. The weight and category must match the information in the track-and-trace system.
  • Requires a manufacture to provide a distributor (or next party in the transaction) an invoice or manifest that documents the weight and category of cannabis used to produce the cannabis product. This change is to assure that a distributor has the necessary information to properly collect and remit the cultivation tax to CDTFA.
  • Clarifies that a cannabis accessory is not subject to the 15% excise tax. When a cannabis product is sold with a cannabis accessory, the cannabis retailer must segregate the wholesale cost of cannabis from the wholesale cost of the cannabis accessory on the customer receipt. If a cannabis retailer is unable to segregate the wholesale cost, the cannabis excise tax will include the wholesale cost of the cannabis accessory in the computation. The proposed regulation places the burden on the retailer to segregate its wholesale costs to avoid including the cost of a cannabis accessory from the excise tax paid by a cannabis consumer.
  • Clarifies that a 50% penalty is imposed for unpaid taxes. The 50% penalty is added to the cultivation or excise tax not paid by the due date.  For example, the tax payment for the third quarter of 2018 is due October 31, 2018.  A payment on November 1, 2018 would subject the distributor to the 50% penalty. Although the penalty can be waived for reasonable cause, a best practice is to always file and pay your cultivation and excise taxes on time.
  • Introduces proposed Regulation 3702 which requires the following information to be entered into the California track- and-trace system including: name of originating seller of cannabis; name of retailer purchasing cannabis; unique identifying number of cannabis supplied to the retailer; and the retailers wholesale cost. The CDTFA intends to use the track-and-trace system to collect real data to assist in their determination of the appropriate mark-up used in determining the average market price the computation of the excise tax.

The regulations discussed above are only proposed and may change as CDTFA considers comments and another stakeholder input.  Nonetheless, many of the recommendations contained in the proposed regulations are already on the CDTFA website. For example, the CDTFA website provides that “the flower category includes all dried flowers of the cannabis plant, whether trimmed or untrimmed”. So some of these provisions seem very likely to stick.

California cannabis businesses should continue to monitor these regulations as the CDTFA considers stakeholder comments and likely revises some portion of the proposed regulation. As the regulations develop, business owners should also revisit their tax strategies and operational protocols for tax efficiency.

For more on California’s cannabis tax regime, check out the following:

cannabis tax lawyerIn Alpenglow Botanicals LLC v the United States of America the United States Court of Appeals for the Tenth Circuit just ruled that the IRS has the authority to determine that a cannabis business is trafficking in a controlled substance for purposes of applying IRC §280E. This decision is going to shift how cannabis businesses pay their taxes and how cannabis tax lawyers view cannabis tax obligations. And not in a good way.

Alpenglow Botanicals LLC is a medical marijuana business. The IRS audited Alpenglow’s tax returns and determined Alpenglow was trafficking in a controlled substance and so it denied the company’s business deductions under IRC §280E. Alpenglow paid the tax assessment and filed for a refund, which was subsequently denied by the IRS. Alpenglow then went to federal court to recover its refund claim. In court, Alpenglow made the following three arguments:

  • The IRS does not have authority to disallow deductions under IRC §280E unless the taxpayer has a criminal conviction for trafficking;
  • IRC§280E violates the 16th Amendment of the U.S. Constitution; and
  • IRC §280E violates the 8th Amendment of the U.S. Constitution.

The Court rejected all of these arguments.

The Court determined that a criminal conviction is not a prerequisite for the IRS to apply IRC 280E and that the IRS has the authority to determine on audit that a taxpayer is trafficking in a controlled substance. The Court relied on its earlier decision  in Green Solutions Retail Inc. where it stated that “the IRS’s obligation to determine whether and when to deny deductions under IRC §280E, falls squarely within its authority under the tax code.” The Court in Alpenglow went further than Green Solutions in ruling that there’s no evidence Congress intended to limit the IRS’s investigatory power here.

Alpenglow cited a line of U.S. Supreme Court cases for the proposition that courts have invalidated regulations involving the taxation of illegal conduct — these cases strike down the imposition of a tax as a violating a taxpayer’s 5th Amendment right against self-incrimination. The Tenth Circuit Court distinguished those cases, noting that Alpenglow is challenging the IRS’s very authority to tax and investigate illegal activity at all  and held that this prior line of cases don’t apply to the denial of a tax deduction as opposed to the imposition of a tax.

The Court also determined that IRC §280E does not violate the 16th Amendment, which grants Congress the power to tax “income,” or the 8th Amendment, which prohibits the federal government from imposing “excessive fines.” The Court ruled that IRC §280E is not an unlawful penalty and disallowing a deduction is not a “punishment.”

Most importantly, this court’s decision on IRC §280E is going to have real life implications for many cannabis businesses. Every cannabis business that has filed a tax return challenging the application of IRC §280E should immediately review its tax returns and reevaluate their options.

cannabis 280E marijuana taxOn June 13, the U.S. Tax Court issued an opinion regarding the application of IRC §280E. In Alterman v Commissioner of Internal Revenue (“Alterman“) the Court held, yet again, that IRC §280E operates to disallow a cannabis businesses’ tax deductions. A few days later, the Court also issued Loughman vs. Commissioner of Internal Revenue (“Loughman“). In that case, the Court held that IRC §280E disallowed the deduction of wages paid to S Corporation shareholders. The disappointing but predictable outcomes in these cases highlight the need for Congress to repeal or modify IRC §280E.

By now, the destructive force of IRC §280E is well known. IRC §280E disallows deductions and credits to a business trafficking in a controlled substance. One exception is cost of goods sold (“COGS”). Other than a 2015 IRS General Counsel memorandum, the IRS has not offered much guidance regarding the application of IRC §280E. With this gap in IRS guidance, it is the courts that have outlined the (fairly narrow) parameters of IRC §280E.

Reading the IRS guidance and court rulings together, it is clear that selling or growing cannabis is always considered trafficking and expenses related to such activity are disallowed. A cannabis business can deduct all expenses related to a separate trade or business. A court is more likely to accept a separate business activity if that business can operate independently of a cannabis business.

Alterman

Alterman does not offer broad guidance regarding IRC §280E. In part, this is because the Court issued a Memoranda opinion.  A Memoranda opinion does not set a precedent for taxpayers; however, they are useful to illustrate how the Court may analyze the law.

Laurel Alterman and William Gibson operated a Colorado medical marijuana grow and dispensary. These taxpayers also sold cannabis paraphernalia, hats and shirts. The Court held that the sale of paraphernalia, hats and shirts was not a separate trade or business primarily due to the lack of records. Accordingly, costs associated with these activities were not deductible under IRC §280E.

In addition, the Court determined that certain costs were not allowable as COGS because of insufficient records, which should be a lesson to any cannabis business owner: It’s not enough to have potentially deductible costs, if you don’t keep records! Interestingly, the opinion uncharacteristically discusses, in detail, the records available, only to hold that those records were insufficient. (Court cases that disallow deductions because of poor recordkeeping typically do not discuss in detail, the records examined.)

Because of the fact-specific nature of this case, Alterman offers little guidance to cannabis businesses other than recordkeeping must be sufficient to support deductions.

Loughman

In Loughman, the Court did not address the issue of record keeping or substantiation. Instead, the Court addressed the issue of double taxation of income because of IRC §280E. And the Court concluded that double taxation is allowed.

Jesse and Desa Loughman were licensed in Colorado to grow and sell cannabis through a Colorado corporation, Colorado Alternative Health Care (“CAHC”). The Loughmans were the sole shareholders of CAHC and elected to be treated as an S Corporation for federal tax purposes.

An S corporation is not subject to tax; instead shareholders are taxed on S Corporation income at the individual level. Special rules treat S Corporation shareholder/officers as employees and require the S Corporation to pay them a reasonable wage. Under ordinary circumstances, an S Corporation deducts shareholder/officer wages; the shareholder/officer then pays income tax on the wages. The S Corporation’s deduction of wages prevents double taxation.

In this case, the IRS applied IRC §280E and disallowed CAHC’s deduction for wages paid to the Loughmans. Consequently, the amount of S Corporation income passed through to the Loughmans increased. The result is that the Loughmans wages are taxed twice — first as an employee and then as S Corporation shareholders.

The Court rejected the argument that IRC§280E discriminates against S Corporation shareholders operating a cannabis business. The Court reasoned that wage payments to a third-party performing the same services as the Loughmans would not be deductible under IRC §280E. Accordingly, the amount of pass through income to the Loughmans would not change: IRC §280E applies equally to increase S Corporation income, regardless of who receives wages. Furthermore, the Court noted that the taxpayer did not have to, but chose to, elect S Corporation status for their cannabis business.

As in Alterman, the Court issued a memorandum opinion. Accordingly, the Court’s determination only applies to the Loughmans and does not set precedent. Nonetheless, the Court highlighted a serious disadvantage to operating a cannabis business through an S Corporation– namely, double taxation.

The STATES Act

So where does that leave us? These cases highlight the dire need for a legislative fix of IRC §280E. On June 7, 2018, Senators Gardner and Warren introduced the Strengthening the Tenth Amendment Through Entrusting States Act (The “STATES Act”). The STATES Act exempts persons from the Controlled Substances Act, so long as they are acting in compliance with a state’s cannabis law. Specifically, under the STATES Act, the production or sale of cannabis in a cannabis legal state “shall not constitute trafficking”. Because IRC §280E applies to a trade or business that consists of trafficking, the STATES Act would effectively eliminate the impact of IRC §280E.

As more cannabis businesses are audited, expect more cases like Loughman and Alterman to move through the system. In addition, expect similar results on similar facts, unless Congress finally takes action. The STATES Act would do a lot of good for the industry, and eliminating the oppressive impact of IRC §280E is high on the list.

Your cannabis business should have a team of professionals and advisors on which you can rely. Our cannabis business lawyers are often asked to recommend accountants who work with cannabis businesses. Like choosing a good attorney, choosing a good accountant is essential to the success of your cannabis business. The right accountant can be a huge asset to your business.

Many cannabis investors own other businesses and may already have an accountant they trust. But because the laws governing the accounting profession do not offer much protection to Certified Public Accountants’ (“CPA”) working in the cannabis industry,  some skilled CPAs choose not to work with cannabis businesses, while others simply do not want to spend the time required to develop the expertise related to cannabis business accounting.

Therefore, when evaluating whether an accountant is a good fit you should ensure the accountant has a strong grasp of IRC 280E and cannabis accounting, all while keeping in mind the following three things.

cannabis marijuana accountant CPA

Understand the Types of Accounting Professionals

It is helpful to understand the core skills of the CPA, the bookkeeper and the Enrolled Agent.

A CPA is a Certified Public Accountant. To qualify as a CPA one must take a certain number of accounting related courses, pass a rigorous examination and be licensed in at least one state. Only a CPA may audit, review and give an opinion on a business’s financial statements. The CPA gives assurances (i.e., “certifies”) that financial statements may be relied upon by third parties such as a bank or a potential investor.

The role of the bookkeeper is to review all of a business’s transactions and assemble this information into useful financial information. Bookkeepers also sometimes prepare state tax returns and other government filings.

Another category of accounting professional is the Enrolled Agent (“EA”). The EA may prepare tax returns and otherwise represent clients before the Internal Revenue Service. To qualify as an EA, a person must pass a comprehensive IRS exam or have experience working for the IRS.

Look for Honesty and Diligence and More

This is the baseline for evaluating all professionals. Though it seems obvious, some accountants in the cannabis industry fall short and the below are some red flags:

  • Your accountant does not respond to you. Skilled accountants are busy and need to balance their work so all their clients are treated fairly. It may take a skilled accountant longer to complete a project than you wish. However, an accountant that does not call you back or keep you informed simply cannot help your business.
  • Your accountant takes shortcuts. This is often marketed as “creativity.” The cannabis industry is fast-paced, takes guts and is highly regulated. It is understandable that you would want to move your cannabis business forward as quickly as possible. Though you may find yourself tempted to “fudge” representations to get things done faster, making misleading statements on tax returns or bank applications or even on your own books and records or otherwise omitting key information will only hurt your business and its owners. A skilled accountant protects its clients from these temptations.
  • Your accountant does not understand legal entities. The fundamentals of accounting require reporting financial operations by legal entity, not merely by business group. For example, the same group of investors may own several cannabis dispensaries. If each dispensary operates as a separate legal entity, separate books and records must be kept for each of the legal entities. This is required both for tax reporting purposes and for recording the information necessary to comply with a state’s licensing requirements.

Transactions between commonly owned legal entities should reflect actual business practices and legal agreements and they should be documented with legitimate contracts. It is the legal agreements and business practices that dictate how a transaction is recorded on the books, not the other way around. Recording a transaction as a loan between two legal entities is proper only if supported by a valid loan agreement. Payments between two legal entities for management services must be supported with a management services agreement.

Restructuring legal entities is a function of state law not accounting entries. For example, the merger of two corporations must be reflected in corporate governance documents such as board of director resolutions and filings with the Secretary of State and if such corporate formalities are not followed the merger will not be recognized by state law. Only after the merger is recognized under state law should an accountant record this transaction. Beware of an accountant who records transactions unsupported by legal documentation.

Choose an Accountant with a Strong Professional Network

Skilled professionals know other skilled professionals. A good accountant will look out for your interests and refer you to another professional when appropriate. Accountants can help you with budgeting, minimizing costs, evaluating financial opportunities and complying with tax and financial reporting. However, your accountant should not prepare legal documents or create legal entities. Your accountant also should generally avoid taking a financial interest in your company, underwriting insurance policies, and/or acting as your broker.

A good accountant can help you meet your financial goals. There are many skilled accountants working in the cannabis industry and it is important you find one right for your cannabis business.

industrial hemp tax 280E
Not always taxed like marijuana, in theory.

Short answer: It depends.

As we discussed last week, the US Court of Appeals for the 9th Circuit in Hemp Industries Assn. et.al., vs. U.S. Drug Enforcement Admin., upheld the Drug Enforcement Administration’s (DEA) broad rule creating a separate classification for “Marijuana Extracts.”  Marijuana Extracts are broadly defined as “any extract containing one or more cannabinoids that has been derived from any plant of the genus Cannabis”. The ruling received an extraordinary amount of press, but lost in all of this breathless reportage was a very important point for a certain class of hemp businesses: The Court explicitly stated that the 2014 Farm Bill (“Farm Bill”) preempts the federal Controlled Substances Act (CSA). Accordingly, expenses incurred through an activity conducted strictly within the parameters of the Farm Bill arguably are not subject to IRC §280E.

Businesses that are operating outside the narrow parameters of Section 7606 of the Farm Bill, however, whether trading in hemp or any derivative product, will have to deal with IRC §280E. As a refresher, the Farm Bill allows a state to grow “Industrial Hemp” if it has implemented an official agricultural pilot program. These pilot programs, generally administered through state Departments of Agriculture, issue licenses or permits to businesses and individuals, allowing the cultivation of “Industrial Hemp.” That cultivar is defined as any part of the cannabis sativa plant with less than 0.3% THC on a dry weight basis. If a plant contains 0.3% or more THC on a dry weight basis, or is not cultivated by a pilot program licensee, the cultivator is operating outside of federal law and hence subject to IRC §280E.

So why is this such a big deal? As we explained previously, IRC §280E prohibits a deduction for any amount paid or incurred in carrying on any trade or business that consists of trafficking in a Schedule I or II controlled substance under the CSA. Accordingly, any industrial hemp business conducting the following activities is possibly subject to the horror of IRC §280E including:

  • Food and Body Care;
  • Textiles;
  • Building Material; and
  • Cannabinoids.

If IRC § 280E applies to a hemp business, that business will lose deductions otherwise available to almost every other US business. Clearly, IRC §280E puts these businesses at a competitive disadvantage. The disadvantage can be so severe as to be fatal in certain cases.

It’s important to note that although IRC 280E disallows expenses and credits paid for trade or businesses engaged in trafficking of marijuana listed as a Schedule I drug, this onerous code section does not apply to cost of goods sold. As such, a grower, farmer, cultivator, processor, or a manufacturer of hemp products may deduct any costs that are properly included in cost of goods sold. This rule is noncontroversial: In 2015, the IRS Chief Counsel issued a memorandum that clarified that a cannabis business may deduct these costs under IRC §471 and related regulations. Specifically, under IRC §471, costs included in cost of goods sold are those costs incident and necessary to production including:

  • Direct material costs;
  • Direct labor costs;
  • Utilities;
  • Maintenance;
  • Rent (real estate and equipment); and
  • Quality control.

Depending on your treatment for financial statement purposes, the following indirect costs may be included in cost of goods sold including:

  • Taxes necessary for production;
  • Depreciation;
  • Employee Benefits;
  • Factory administrative costs; and
  • Insurance.

On the other hand, a non-Farm Bill compliant hemp producer will lose under IRC §280E deductions related to sales, marketing and non-production related management costs.

In addition to creating headaches for non-Farm Bill compliant growers, the application of IRC §280E will have a detrimental impact on wholesalers and retailers of CBD products who also are not operating in full compliance with the Farm Bill. For these businesses, IRC §280E would operate to disallow a deduction for most overhead costs. This could have an especially severe impact on mixed retail businesses that sell CBD products in conjunction with other products.

Example: A pharmacy that sells products containing non-Farm Bill CBD as well as more traditional health products (e.g., shaving cream) may now be subject to IRC §280E. Unless the sale of non-CBD products can be considered a separate trade or business, it is possible that IRC §280E would operate to disallow the deduction of all operating expenses.

Finally, it is unclear if the IRS will apply IRC §280E retroactively to non-Farm Bill hemp businesses. The IRS could apply IRC §280E retroactively on audit or to years otherwise open. For example, the IRS could go back to tax year 2014 and adjust the income tax returns of certain taxpayers engaged in hemp manufacturing and sales of hemp products.

Under the new tax law effective January 1, 2018, Congress gave U.S. business several targeted tax benefits. For many businesses in the developing industrial hemp sector, the impact of IRC §280E reverses many of the benefits of the new tax law. Perhaps Congress can address some of these issues by passing the expansive Hemp Farming Act of 2018 which, as currently written, would explicitly remove Industrial Hemp and derivatives of that cannabis cultivar from the Controlled Substances Act. Better yet: repeal IRC §280E.

The tax outlook for California canna manufacturers isn’t all bad.

We previously identified a number of sales tax exemptions available to California cannabis cultivators. Fortunately, the state legislature is looking out for other businesses up and down the supply chain, such that cultivators are not the only class of licensee eligible for sales tax exemptions. This post will focus on a partial tax exemption available to manufacturers and other cannabis businesses engaged in certain research and development. It’s an important exemption to understand.

First, the tax exemption is not so much an exemption as a reduction of the state sales tax rate.  For example, an Oakland manufacture’s purchase of $100,000 of qualified equipment ordinarily pays state and district sales tax at a rate of 9.25%. The 9.25% rate includes a state rate of 7.25% and a district rate of 2.0%. In this example, the sales tax due is $9,250. With the partial exemption, the state sales tax rate is reduced from 7.25% to 3.3125%. Accordingly, the sales tax due is $5,312 [$100,000*(3.3125%+2.00%)] resulting in a total tax savings of almost $4,000.

A manufacturer must satisfy three key requirements to qualify for the credit:

  • The manufacturer must be a “qualified person”;
  • The manufacturer must purchase “qualified equipment”; and
  • The equipment must be used in a “qualified manner”.

Note that the partial exemption applies to qualified equipment that is leased as well as purchased. The requirements are very specific and somewhat technical. What follows are the key points to consider when purchasing equipment.

Qualified Person

A qualified person is a business that engages more than 50% of the time in a business activity described in the North American Industry Classification System (NSICS) under manufacturing codes 3111-3399 or codes related to research and development, revised codes 541713 or 541715. The NSICS code is a standard used by the federal government to classify businesses.  It is no surprise that NSICS codes have not been created for the cannabis industry. However, it appears that all cannabis manufactures should qualify for Miscellaneous Manufacturing, Code 339999. Accordingly, all cannabis manufactures and processors should be considered qualified persons for purposes of the credit.

Determining what research and development businesses qualify is more difficult. The research and development class is narrowly defined.  However, the CDTFA website suggests (without providing much detail) that certain product development and process improvement activities may qualify for the partial exemption. It is fair to say that any cannabis company operating a testing or genetics lab should look at this credit closely.

Qualified Equipment

A wide variety of tangible property (i.e., equipment) qualifies for the partial exemption. First, the manufacturing process is broadly defined and includes tangible personal property involved in:

“manufacturing, processing, refining, fabricating, or recycling of tangible personal property, beginning at the point any raw materials are received by the qualified person and introduced into the process and ending at the point at which the manufacturing, processing, refining, fabricating, or recycling has altered tangible personal property to its completed form, including packaging, if required.”

Qualified Equipment includes:

  • Packaging equipment “necessary to prepare goods so that they are suitable for delivery to and placement in finished goods inventory, including repackaging to meet the needs of a specific customer.” This definition is expansive and should include equipment that trims, packs, and seals cannabis products for sale in compliance with MAUCRSA:
  • Pollution control equipment;
  • Quality control equipment;
  • Component parts such as belts, shafts and moving parts;
  • Equipment used to operate, control, regulate or maintain the machinery including:
    • Computers;
    • Software;
    • Repair and replacement parts (with a useful life of more than one year);
  • Special purpose buildings used in manufacturing or that constitute a research facility;

The following equipment generally does not qualify for the partial exemption:

  • Consumables with a useful life of less than one year;
  • Furniture;
  • Equipment used to store finished products (e.g., shelving); and
  • Equipment and property used in administration, management, or marketing.

Qualified Use

To meet this requirement, the tangible property must be used more than 50% of the time in:

  • Any stage of the manufacturing process;
  • Research and Development;
  • Maintenance, repair, or quality control activity related to qualified equipment.

Compliance

Generally, a seller of manufacturing and research and development equipment is required to collect sales tax from the buyer at the time of sale. However, a seller is not required to collect the full amount of sales tax if they receive from the buyer a partial exemption certificate, Form CDTFA 230-M.

The exemption certificate is proof that the seller properly collected a reduced amount of sales tax and protects the seller. The CDTFA can not collect the full amount of sales tax from the seller on audit provided that the seller accepts the exemption certificate in good faith. The good faith standard is reasonable easy to satisfy. However, the seller should look out for buyers tendering certificates for purchases of products that obviously do not qualify, such as consumables or office equipment.

If California sales tax is not collected by the seller, a California purchaser of manufacturing equipment is required to pay use tax. For example, the Arizona manufacturer of a dryer may not be required to collect California sales tax if the equipment is shipped from Arizona to a California cannabis business. In this situation, the California cannabis business is required to self-assess use tax on its purchases. Provided that the equipment meets the qualifications discussed above, the purchaser may claim an exemption on their use tax return filed with CDTFA.

California cannabis businesses operate in a very challenging tax environment. All marijuana businesses should be aware of the type of tax exemption available; aggressively pursue all that they qualify for; and, properly document all exemptions they claim. For large capital expenditures, a cannabis business should consider requesting from the CDTFA written confirmation that the planned expenditure qualifies for exemption. A cannabis business that discloses its name and accurately describes the facts of the transaction, may rely on the CDTFA’s determination.

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.