Photo of Jim Hunt

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 tax marijuana
Your standard CDTFA qualified cannabis tractor.

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

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

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

Seeds and Plants

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

Fertilizers

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

Farm Equipment and Machinery

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

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

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

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

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

Buildings for Raising Plants

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

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

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

Solar Power Facilities

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

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

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

Diesel Fuel Used in Farming

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

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

Liquid Propane Gas Used in Farming

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

Conclusion

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

Unfortunately, IRC 280E is not included.

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

  1. The Act did not repeal IRC 280E.

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

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

  1. The Act makes the C Corporation more attractive.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

California’s Cannabis Excise Tax – The General Rules

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

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

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

Requirements of Emergency Regulation 3701 – Distributors

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

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

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

Emergency Regulation 3701 — Open Issues

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

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

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

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

California cannabis taxes
The rules of the California cannabis taxation road

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

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

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

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

Business Form

2017 Tax Rate

Proposed Tax Rate

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.