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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.

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.

Cannabis taxesThe United States Court of Appeals for the Ninth Circuit recently ruled on its second tax case regarding IRC §280E.  Decisions from the Ninth Circuit are significant as they apply to the cannabis-friendly states of Alaska, California, Nevada, Oregon; and Washington. In Canna Care vs. the Commissioner, the Court of Appeals upheld the United States Tax Court’s ruling denying a California dispensary’s operating expense deductions under IRC §280E.

Background

Canna Care Inc. was a medical marijuana dispensary prohibited under California law from earning a profit on the sale of cannabis.  On audit, the IRS applied IRC §280E to deny the deduction of all operating expenses, including substantial officer’s salaries and automobile expenses. Canna Care appealed the tax assessment to the U.S. Tax Court. Canna Care made the following three arguments before the U.S. Tax Court:

  • That medical marijuana is not a Schedule I controlled substance;
  • That Canna Care was not “trafficking” for purposes of IRC §280E because its activities were not illegal under the California Compassionate Use Act of 1996;
  • That the Tax Court decision in CHAMP was incorrect.

The Tax Court denied all three arguments and upheld the tax assessment against Canna Care. First the Tax Court reiterated that medical marijuana is a Schedule I controlled substance. Second, the Tax Court held that the sale of medical marijuana is always considered trafficking under IRC §280E, even when permitted by state law. Thus, operating expenses associated with the sale, manufacturing or production of cannabis are always disallowed under IRC §280E.

Third, the Tax Court held that the CHAMP had been correctly decided. Canna Care’s argument that its sole business was providing charitable work like the taxpayer in CHAMP was without merit. The Tax Court held that because Canna Care’s only business was selling cannabis, none of its operating expenses could be deducted under IRC §280E. The Tax Court noted that Canna Care arguably had a second trade or business selling clothing and could have argued these expenses should be deducted. As that fact was not stipulated in its petition, the Tax Court could not consider that issue on the merits.

Appeal to the Ninth Circuit Court of Appeals 

Canna Care appealed to the Ninth Circuit Court of Appeals. None of the arguments before the Tax Court were made on appeal.  Instead, Canna Care raised three new arguments, two of which were unique to Canna Care’s facts and likely not applicable to most other cannabis businesses.

Canna Care’s primary argument was that IRC §280E violates the Excessive Fine Clause of the 8th Amendment of the United States Constitution. In oral argument before the Ninth Circuit Court of Appeals, Canna Care argued that IRC §280E was enacted by Congress to punish drug dealers, and as such, it imposes a fine on cannabis dispensaries. Canna Care noted that its income tax liability was 1000% of its net income and a 1000% tax rate for engaging in an activity allowed under California law constituted a grossly disproportionate fine on such activity. The tax rate impact under IRC §280E is especially disproportionate when compared to the tax rate of other business – both legal and illegal. Accordingly, Canna Care’s income tax liability imposed under IRC §280E constitutes an excessive fine in violation of the 8th Amendment.

In oral argument, the three-judge panel offered several observations:

  • A tax deduction is granted by the legislative grace of Congress. Congress has clear constitutional authority to deny a tax deduction. Why is IRC §280E outside Congress’ legislative authority?
  • IRC §280E was enacted in 1982, well before enactment of the California Compassionate Use Act of 1996. This means that anyone getting into the cannabis industry was and is on notice of its the burdensome tax liabilities cannabis companies face.  Given such notice, why does application of IRC §280E constitute an excessive fine under the 8th Amendment?
  • Why isn’t Congress the appropriate branch of government to address IRC §280E?

The Ninth Circuit Court of Appeals dismissed Canna Care’s appeal and upheld the Tax Court’s holding. Because the arguments presented were not raised in the lower court, The Court did not address the merits of each argument.

Assess Risk & Preserve Refund Claims

When filing their tax return, a cannabis businesses must understand the impact IRC §280E has on its tax liability. Equally important, cannabis businesses must understand the risk of not applying IRC §280E when filing their tax return. The immediate tax savings must be weighed against the risks and the costs of later having to defend the position in court.

Though it is difficult to challenge federal statutes on constitutional grounds, the constitutional arguments do have some merit. A cannabis business that challenges an IRS assessment under IRC §280E should raise all arguments early in the process to prevent a court from later dismissing arguments on procedural grounds.

Because the Ninth Circuit Court of Appeals did not rule on the merits of the 8th Amendment claim. it is possible a federal court could some day rule that IRC §280E is unconstitutional. To preserve a potential refund claim, all cannabis businesses should consider filing protective refund claims. A protective refund claim keeps the refund statute of limitation open beyond the standard three-year period. After October 15, 2017, a cannabis business cannot recover tax paid for tax year 2013. However, if a court were to hold after October 15, 2017 that IRC §280E is unconstitutional, a cannabis business that filed a 2013 protective refund claim can recover its taxes paid for that year.

It is likely more cases will be filed challenging IRC §280E.  A cannabis business should take stock of its current tax return filings applying IRC §280E and craft a strategy to defend its position.

Oregon cannabis lawAs the marijuana industry grows and consolidates, marijuana businesses are forced to consider more complex business structures to meet their business needs. Such business structures must reduce costs, increase operating efficiency, and most importantly, strictly comply with federal and state law.

One strategy for cannabis retailers, especially those with multiple outlets, is to establish an employee leasing company. If the retailer has three stores, for example, each organized as an LLC, its owners may organize a fourth LLC to lease employees to the stores. This leasing company will then contract with, and act as paymaster for, each store LLC. In this arrangement, the employees who work at each store LLC are not store employees; rather, they are leased employees who receive their W2s from the leasing company. Accordingly, the employee leasing company is solely liable for employment tax.

Employee leasing companies offer two key benefits: consolidation of costs and employee retention. Without the leasing company, each retailer in the example above is required to manage the compliance costs of accounting, employment taxes, workman’s compensation, and medical benefits. By consolidating these functions, the employee leasing company should be able to reduce these compliance costs.

Employee leasing companies also benefit employees by making the marijuana retailer a more attractive employer. As leasing company employees, they receive their W2s from a non-cannabis company, it may be easier for them to sign leases, acquire mortgages and take on other formal obligations. In addition, the consolidated purchasing power of the employee leasing company should provide more robust employee benefits at a lower price.

State law on employee leasing companies varies considerably. Some states scarcely address the concept; others regulate extensively. A good example of the latter is Oregon. In Oregon, employee leasing companies must be licensed by the state’s Workers Compensation Division. The completed application is detailed, takes a few months to process, and entails a $2,050 licensing fee (paid every two years). Once licensed, the leasing company is jointly responsible for the hiring company’s entire workforce—including non-leased employees—which requires special procedures and insurance.

In a payroll leasing arrangement, the leasing LLC will have service agreements with each store LLC. Such agreements must reflect an arm’s-length market rate. Many methods are used to determine an arm’s length market rate but all are based on the facts and circumstances of your business. One common methodology is “Cost-Plus.” In a Cost-Plus arrangement, the employee leasing company compiles its costs and adds an arm’s-length market profit. The IRS carefully examines on audit, arm’s-length charges between affiliated entities.

Finally, employee leasing companies cannot be used as a device to avoid taxes, circumvent the correct application of Code §280E, or to launder money.

The use and benefits of an employee leasing company are not limited to retailers; producers, processors, and manufactures may also benefit from using an employee leasing company. But before you establish an employee leasing company for your cannabis business(es), it is critical you have an operational strategy in place and reasonable projections of the costs. It is even more critical that you understand 280E and structure your entities to comply fully with that. Only after having done all this will you be in a good position to evaluate whether an employee leasing company is best for your cannabis business.

California Cannabis Taxes
California Cannabis Taxes: taxes on taxes

California’s Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA) will make dramatic changes to cannabis taxation in California in the following ways.

Marijuana Excise Tax (Effective January 1, 2018). MAUCRSA changes the structure of California’s Marijuana Excise Tax. Under prior law, a 15% excise tax was imposed on the gross receipts of any retail sale by a dispensary or other person required to be licensed to sell marijuana and marijuana products directly.

In contrast, MAUCRSA imposes a 15% excise tax on “the average market price” of any retail sale by a cannabis retailer. Potentially, there are two average market prices. The first is based on good faith negotiation in the open market, in which case the average-market-price is wholesale cost plus a mark-up determined every six months by the  California State Board of Equalization. The second is based on a “non-arm’s length transaction,” in which case, the average market price is the gross receipt from the sale.  Ignoring the irony that the good faith arms-length negotiation includes a mark-up determined by the Equalization Board, this distinction is crucial in determining how the tax is collected and remitted. Though the cannabis consumer is ultimately subject to the Marijuana Excise Tax, it is the Distributor that must collect the Tax from the Retailer and, in turn, remit the funds to the Equalization Board.

For “arms-length” transactions, the Distributor must collect the tax from the retailer “on or before 90 days after … the sale [from the distributor] to the retailer.” For non arm’s length transactions, the Distributor must collect the tax from the retailer when the retailer sells cannabis product to the consumer, but in no event more than 90 days after the Distributor’s sale to the Retailer.

The Marijuana Excise Tax is in addition to sales and use taxes imposed by California’s state and local governments and it is included in gross receipts for purposes of computing sales/use tax. This essentially creates a tax on a tax.

Cultivation Excise Tax (Effective January 1, 2018).  Under MAUCRSA, California’s Cultivation Excise Tax will be imposed on the cultivator after the cannabis is harvested and enters the commercial market. For cannabis flower, the tax is $9.25 per ounce. For Cannabis leaves, the tax is $2.75 per ounce. The Equalization Board has the authority to create a tax stamp/tax container system whereby proof of tax payment is evidenced by either a stamp or a pre-approved container.

The Cultivation Excise Tax is collected on the “first sale or transfer” of cannabis by the cultivator to the manufacture. What constitutes a first sale is not defined in the statutes. For a transfer of cannabis product to a distributor, this tax is collected when the cannabis “enters the commercial market.” When Cannabis “enters the commercial market” is defined as the time when the cannabis or cannabis product has completed all required inspection and testing. The cultivator is subject to the Cultivation Excise Tax, but is relieved of that burden so long as a manufacture or distributor provides detailed documentation. Under MAUCRSA, the Equalization Board has the authority to prescribe a substitute method and manner for collecting and paying the Cultivation Excise Tax and it is likely the collection and payment process will be fine-tuned.

Finally, a county may impose a tax on the privilege of engaging in a wide variety of cannabis activities, including cultivating, manufacturing and sales. Under MAUCRSA, counties have some latitude to structure their tax including: the tax rate, method of apportionment, and manner of collection. The county tax may be imposed in addition to the various other local ordinances taxing cannabis.

Anyone who knows California knows it is serious about tax collection in general and MAUCRSA’s treatment of cannabis excise taxes is no exception. Strict record-keeping and compliance is going to be essential for all participants in California’s cannabis market.

Cannabis tax lawyer
Sweat equity: it’s complicated

When our lawyers set up legal structures for cannabis companies, the choice of legal entity is one of the most important things we must consider. Many cannabis businesses use limited liability companies. For tax purposes, an LLC is typically treated as a partnership or as a disregarded entity. In both of these cases, the tax liabilities pass through to the partner/members. However, an LLC may check-the-box to be taxed as a corporation. In that instance, the LLC is subject to tax, whereas its partner/members do not pay tax. Once an LLC is formed, the next important decision is how to fund the LLC.

In this two-part series, we will outline some of the tax traps and opportunities in the initial funding of your LLC. Part I will discuss opportunities in capitalizing your businesses with equity and creating an ownership relationship with the business. Part II will discuss opportunities and risks in funding a cannabis business using debt and creating a debtor/creditor relationship with the business.

The Benefits of Contributing Property. Generally, the contribution of “property” in exchange for a membership interest is tax-free. Members often contribute cash, land, and equipment to a cannabis business in exchange for an interest in a partnership/LLC. This is a classic tax-free contribution. What is often overlooked is that intellectual property may be property for purposes of a contribution. Industrial processes, formulae, designs and “know-how” in the right circumstances are considered property and can be contributed to a partnership tax free. However, this approach should only be taken with careful consideration, analysis and documentation.

The most straight-forward contribution is a contribution of cash in exchange for a member interest in a Partnership/LLC. A member may contribute cash in exchange for a membership interest in an LLC. Such a contribution is typically tax free under federal partnership tax law. If an LLC elects to be taxed as a C corporation, a member may contribute cash in exchange for a deemed “stock interest”. Again, such contribution is typically tax-free. Many companies start with extremely small cash contributions, like $1.00 for each member. However, there is some risk there to equity holders, since some courts have pierced the corporate veil against undercapitalized entities. Nonetheless, there is no minimum amount of cash required to form a valid partnership or corporation for tax purposes. In determining the appropriate dollar amount of contribution, a cannabis business’s founders should use common sense and good business judgement.

Sweat Equity may be Painful but is not Prohibited. Investors often can bring valuable experience and “know-how” to a cannabis business and want to contribute such “know-how” in exchange for an ownership interest in the LLC. In general, a mere promise to contribute services in exchange for a membership interest is subject to tax. This is generally considered a “capital interest” in the partnership. Capital interests are defined by the IRS as ownership interests where the member has a right immediately following the contribution, to its share of the liquidation value of the partnership/LLC. To illustrate, imagine one member contributed $1,000,000 in cash to a new company, and the other member agrees to do all the work for the company, and they split the LLC up 50/50. Even if the business doesn’t generate any revenue, the member contributing sweat equity is going to be on the hook for $500,000 on that year’s tax returns. This is because if the LLC liquidated the next day, that member would be entitled to receive the $500,000 as a liquidating distribution. Although the guidance in this area can be complex, it is based on a simple, maxim – “You can’t get something for nothing (in tax)”

One way to get around this is for a member to receive a “profit interest” instead of a a standard equity interest. A profit interest is defined as an interest where the new member would not receive any value if the partnership were to be immediately liquidated after the contribution. Note however, that this treatment has some strict limitations and requires careful drafting of an operating agreement.

In capitalizing a cannabis business, founders all bring different skills and resources to the new venture. All founders should carefully consider the mechanics of offering equity interests to each new member. As we will discuss in Part II, the use of debt financing brings additional, flexibility, risks and opportunities to funding a new cannabis venture.

Cannabis tax lawyer
New tax law will impact cannabis businesses

Our cannabis business lawyers are often called on to help clients choose the most effective legal entity for operating their cannabis business. In making this choice, we consider many factors, including the tax impact to investors. See Cannabis Companies and Phantom Income and How To Open A Cannabis Business: For-Profit vs. Not-for-Profit, that is the Question.

Our  cannabis clients usually choose to operate as a limited liability corporation (“LLC”). For federal tax purposes, a LLC with more than one member is treated as a partnership unless the LLC elects to be taxed as a corporation.  Accordingly, any change to partnership tax law applies to LLCs as well.

One important consideration for LLC Partners/Members is identifying who is authorized to represent the partnership in the event of an IRS audit. Under current law, Partners/Members appoint a Tax-Matters-Partner or “TMP.” Though the TMP is the contact point for dealing with the IRS, the TMP function is ministerial.

For tax years beginning in 2018, Congress significantly changed the way the IRS audits partnerships and LLCs taxed as a partnership. Under current law, the IRS must collect tax directly from each Partner/Member. In general, each Partner/Member may defend the audit adjustment as he or she sees fit. The new law requires the IRS collect tax directly from the partnership. In essence, the IRS now has “one-stop-shopping” to collect tax. But there is more. To collect tax from the Partnership/LLC, the new law requires each Partnership/LLC have a “partnership representative.”

There are two significant issues regarding appointment of a partnership representative (“PR”). The first is that the partnership representative (PR) has more power than the TMP. The PR has the sole authority to deal with the IRS and to bind each Partner/Member to the consequences of the PR’s decisions. In other words, the PR ultimately will decide how much tax each Partner/Member will pay as the result of an audit. An odd quirk of the law is that the PR does not even have to be a partner/member of the LLC.

It is important for Partners/Members to choose their PR carefully and in choosing a PR, Partners/Members should consider the following:

  • Who should be the PR?
  • Should election of the PR require a unanimous vote or something less?
  • Should the PR have unlimited authority or should such authority be limited under the partnership agreement or the operating agreement?
  • If the authority of the PR is going to be limited, what will be the scope of the PR’s authority?
  • What will the mechanism be to resolve deadlocks?

These above considerations can and should be addressed when drafting new partnership/operating agreements. Current partnership/operating agreements should be amended, however, the timing on when to do so is dependent on each Partnership/LLC’s specific situation. Because the new law will start applying beginning in 2018, Partnerships/LLC’s have a bit of time to address this issue, however, if you are mending your partnership agreement or operating agreement for other reasons, now is the time to make your PR decisions.

And here is the second issue: the IRS can select your partnership representative if you fail to do so yourself. This portion of the new law is controversial and raises many legal issues, many of which remain unclear. But what is clear is that you can avoid this harsh result by having your partnership/LLC choose its PR in a timely manner. Choosing a PR is one of many tax issues that must be considered when drafting a partnership agreement or operating agreement and as 2018 approaches, this is just one more issue cannabis businesses will need to address.

Another day, another (tax) dollar.

The U.S. Tax Court again addressed IRC §280E in the recent case Canna Care, Inc. v. Commissionerdisallowing all of the California’s dispensary’s “operating deductions” under IRC §280E. Unlike prior cases, the Tax Court in Canna Care does not address the computation of COGS, but rather the deduction of regular business expenses, such as salaries.

Cannabis taxation is not fair.
Cannabis taxation is not fair.

Overall, this case does not change the holdings in CHAMP or Olive. [For those of you that need a quick refresher, CHAMP held that where CHAMP was essentially engaged in two separate businesses, one legal (caregiving) and one illicit (dispensing MMJ), it was entitled to deduct COGs for the caregiving portion of its business; Olive applied CHAMP to less favorable facts, holding that where Olive’s primary business was selling marijuana, and its other services amounted to mere “amenities,” Olive was unable to claim any deduction.] What’s notable about Canna Care is the taxpayer’s direct attack on the application of IRC §280E.

Like the taxpayers under scrutiny in both Olive and CHAMPS, Canna Care was a medical marijuana dispensary. Canna Care was organized as a California mutual benefit corporation, and as such, was considered a non-profit entity under California law. Canna Care took care in emphasizing that it operated at a deficit. However, the Tax Court noted that the officers and directors were paid salaries that “far exceeded the salaries paid to any other employee,” an indicator that Canna Care was perhaps not so altruistically motivated. In addition, the Tax Court noted that corporate funds were used to pay for officer’s automobiles. Importantly, Canna Care highlighted to the Tax Court its involvement with the community including: involvement in cancer and diabetes walks; the hosting of regular meetings for Americans for Safe Access, a medical marijuana advocacy group; and, the offering of prayer and counseling services. Even that community emphasis was not enough to save Canna Care.

Taxpayer advanced three arguments, all of which were rejected by the Tax Court.

First, that medical marijuana is not a Schedule I controlled substance.  The Tax Court indicated that Taxpayer “advanced numerous arguments” as to why medical marijuana should not be considered a Schedule I controlled substance.  The Tax Court did not elucidate any of these arguments and summarily rejected them.

Second, that Canna Care was not “trafficking” for purposes of IRC §280E because its activities were not illegal under the California Compassionate Use Act of 1996.  Taxpayer cited the Cole Memo as well as the 2014 FinCEN Memo as support.  The Tax Court, citing both Olive and CHAMP rejected this argument.  In summary, the Tax Court held that the sale of cannabis is always considered trafficking for purposes of IRC Sec. 280E, even when permitted by state law.

Finally, that CHAMP was incorrectly decided.  Canna Care argued that CHAMP really was not involved in two trades or businesses but one.  Canna Care argued that the taxpayer in CHAMP was not allowed to perform “caregiving services” under California Law; therefore, the taxpayer in CHAMP was merely a single entity doing charitable work.  Canna Care argued it was a charitable entity similar to the taxpayer in CHAMP, and therefore was entitled to a full deduction of operating expenses.

The Tax Court disagreed, stating that “CHAMP did not involve a determination as to whether the taxpayer qualified as a caregiver for purposes of California law.”  The Tax Court noted that the critical determination in CHAMP was that taxpayer was engaged in two separate trades or businesses. The Tax Court noted that Canna Care stipulated that it was in the business of distributing medical marijuana. The Tax Court noted that Canna Care received income from the sale of books and T-shirts. However, the evidence presented did not allow the Tax Court to determine what percentage of income was derived from sale of books versus the sale of cannabis. As such, the Tax Court held that Canna Care was engaged only in the sale of medical marijuana.  Therefore all operating expenses were disallowed under IRC § 280E.

The Tax Court did not outline the taxpayer’s numerous arguments in any detail, so it is difficult to dismiss those arguments out of hand. We can safely say, however, that this case clarifies several points.

  • First, the argument that the sale of cannabis is not trafficking for purposes of IRC 280E will be difficult to sustain.
  • Second, CHAMPS and Olive are the current templates in determining whether an expense is deductible under IRC §280E. Good works or community involvement are not sufficient, by themselves, to support a tax deduction outside the application of IRC §280E.  In order to be deductible, such activity must be considered a separate trade or business entered into with a profit motive.
  • Third, the case once again highlights that the essence of a successful IRC §280E argument is the substantiation and development of facts. Because the taxpayer had, in the court’s view, insufficient evidence to carve out two separate trades or businesses, the taxpayer was unable deduct any operating expenses.
  • Finally, so long as IRC § 280E is on the books, the cannabis industry will suffer. The industry would be well-served to support aggressively the passage of the Small Business Tax Equity Act of 2015 or other legislation repealing IRC §280E.  I believe it can, and must, be done.

Until today, the cannabis industry had little to look forward to when discussing IRC §280E and its draconian application. See Marijuana Taxation: 280E Ain’t Getting Better Anytime Soon and Marijuana Taxes: The IRS on Section 280E. Now Washington State producers, processors and retailers have some good news to consider regarding their 2014 tax return: IRC §280E does not apply to the three-tier Washington Marijuana Excise Tax (“MET”) as in effect through June 30, 2015.

Marijuana Tax LawsThis is because on July 31, 2015, the IRS Office of Chief Counsel issued an internal memorandum (“July Memo”) outlining how taxpayer’s should account for the State of Washington MET. The July Memo is not precedential but it does reveal how the IRS views the MET. Though in the July Memo, the IRS is taking an approach that seemingly sidesteps its own analysis offered earlier this year, their conclusion is favorable to Washington producers, processors and retailers and may offer an outline on how other states’ marijuana excise taxes could be treated for federal tax purposes.

It has been a long time since I have been able to put “IRS,” “favorable” and “marijuana” in the same sentence.

IRC §280E prevents a cannabis producer, processor or retailer from deducting costs incurred in conducting a trade or business unless those costs are considered a Cost of Goods Sold (COGS). As a consequence, marijuana businesses are required to determine what expenses are included in COGS. Until this July Memo, the IRS has offered no guidance regarding how any specific state’s marijuana excise tax would be treated for purposes of COGS or IRC §280E.

In the July Memo, the IRS interpreted IRC §164 addressing the deductibility of taxes. Specifically, IRC §164(a) identifies the following six types of federal, state and foreign taxes allowed as a deduction:

  • Real Property Taxes
  • Personal Property Taxes
  • Income and Profit Taxes
  • GST Taxes
  • Environmental Taxes
  • Motor Vehicle Taxes

IRC § 164(a) states that any taxes not described above, are deductible if paid or accrued …”in carrying on a trade or business” and further provides that “[n]otwithstanding the preceding sentence, any tax (not described in the first section) …paid or accrued … in connection with an acquisition or disposition of property, shall be treated … in the case of a disposition, as a reduction in the amount realized on the disposition”

The July Memo states that the MET is imposed “in connection with the disposition of property” and so for federal tax purposes, the amount of gross receipts is reduced by the amount of MET with the same economic consequences as if a deduction were allowed. Significantly, the Memo concludes that the MET is neither a cost to be considered included in COGS nor a deductible expense. Accordingly, IRC §280E and the regulations and guidance regarding COGS do not apply.

Beginning July 1, 2015, HB 2136 reconfigured the MET into a trust-fund tax imposed on the retail purchaser so that taxpayers no longer need to consider the deductibility of the MET for federal tax purposes.

In light of the July Memo, each state’s excise tax should be reviewed to determine the federal tax treatment under IRC §164. Such analysis may prove to be difficult. To encourage the development of the cannabis industry in their state, policymakers should consider restructuring the state’s excise tax in the form of a trust-fund tax to reduce uncertainty regarding the federal tax implications of their marijuana excise tax.