Just check the box!

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

The New Landscape on Choice of Entity

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

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

The Need for Analysis

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

Electing to be a C Corporation

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

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

When to Make the Election

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

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

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

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

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

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

california tax marijuana
Your standard CDTFA qualified cannabis tractor.

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

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

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

Seeds and Plants

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

Fertilizers

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

Farm Equipment and Machinery

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

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

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

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

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

Buildings for Raising Plants

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

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

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

Solar Power Facilities

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

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

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

Diesel Fuel Used in Farming

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

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

Liquid Propane Gas Used in Farming

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

Conclusion

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

cannabis marijuana employment tax
Look out for a change in tax deductions for employer provided benefits — at least for some businesses.

President Trump signed the Tax Cuts and Jobs Act (the “Act”) into law on December 22, 2017.  The Act contains several sections that will impact companies that work with cannabis businesses and provide important indications of where states might be going with taxes in the coming year. As for the Act itself, its sweeping provisions went into effect on January 1, 2018.

Note that much of the Tax Act’s deductions and credits won’t apply to cannabis businesses due to IRC 280E, but these deductions and credits are still important to many ancillary businesses that serve the industry, and which may not be subject to 280E (we recommend that anyone with questions as to where they fall seek advice from their CPA or cannabis tax attorney). If these credits and deductions prove to be popular we may see states enact similar changes that will directly affect cannabis business themselves.

On the employment front, many cannabis businesses obtain employees through staffing agencies. Those agencies should will be subject to these new tax deductions and credits. We may see an influx of agency recruits, or a decrease, depending on how the recruitment companies take advantage of these deductions and how the new laws remove deductions for benefits provided to employees.

Sexual Harassment Settlements

Prior to 2017, we didn’t hear much about sexual harassment in the workplace. One reason for this is because a majority of sexual harassment settlements contain nondisclosure agreements. A nondisclosure agreement typically prohibits the employee from discussing the sexual harassment suit, its result or even the fact that harassment was ever alleged. Currently, employers are allowed to take a tax deduction for settlements paid out for sexual harassment and sexual abuse, regardless of the terms of the settlement agreement. That’s finally changing.

Going forward, employers cannot deduct settlement payments related to sexual harassment if the settlement agreement contains a nondisclosure agreement. Employers can receive a tax deductions on sexual harassment settlements that do not contain nondisclosure agreements. Payments in sexual harassment suits can be huge–meaning the tax deduction can also be huge. (Bill O’Reilly paid $32 million to one female accuser.) This will force employers to carefully consider how sexual harassment suits are settled, which is a welcome change. States might follow suit. Plan now how to handle sexual assault cases so you don’t have to make this decision.

Paid Leave Credit

Paid family and medical leave is a significant benefit for cannabis employees. Providing paid family and medical leave can attract highly qualified employees and help retain those employees. In what has been described as the first step towards a “nationwide paid family leave policy”, the Act provides employers incentives to provide paid family and medical leave—admittedly in a very complicated fashion.

Employers can qualify for up to a 25 percent tax credit for providing paid leave for qualifying employees under the Family Medical and Leave Act (FMLA). Employers qualify for the credit by providing at least two weeks paid leave equal to at least 50 percent of the employee’s regular wages. At a minimum, employers will receive a 12.5 percent tax credit for providing paid leave. The credit incrementally increases based on the percentage of regular wages the employee receives. The paid leave credit is only applicable to employees who earn less than $72,000 and have been employed at least one year. Paid leave must be provided separately from vacation leave, personal leave, or other medical or sick leave.

The Paid Leave credit expires in 2019 unless extended by Congress. Some congressional members have suggested Congress is considering enacting separate legislation that requires paid leave. Paid sick leave requirements are already in effect in several states, including those with cannabis laws.

Pay attention to expenses related to paid leave, and consider whether this a feasible option for your cannabis business. Several states already have paid leave and more are likely to follow. If your state does not already have paid leave that applies to your cannabis business, you should assume they will enact similar tax incentives soon.

ACA Individual Mandate

The Act removes the Affordable Care Act individual mandate to purchase health insurance. At first glance, this does not seem like it would affect your cannabis business, but staffing agencies employing more than 50 full time employees. are required to purchase healthcare for their employees. Employees that are recruited to your cannabis business are considered employees of the staffing agency. The ACA’s individual mandate was designed to work with the employer mandate to provide health insurance. The employer mandate is still in place. Employers with 50 or more full-time employees are still required to provide health insurance.  Without the individual mandate, it is likely insurance premiums will continue to rise unless Congress acts to reform health care.

Further, given the mandates were designed to work together, there is a strong suggestion that Congress will start to undo the employer mandate. It will likely come in the form of fewer reporting requirements or a complete removal of reporting requirements. This means that staffing agencies may reduce the number of recruits they have out at a time to avoid the employer mandate of the ACA, meaning you will have less of a pool to pull from.

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 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.

 

 

Oregon cannabis taxes
Oregon cannabis taxes

The Oregon Department of Revenue (“DOR”) imposes a point-of-sale tax called the Recreational Marijuana Tax on all Oregon recreational cannabis retailers. The DOR collects 17% of the value of all cannabis sold at each retailer location.

In theory, this tax burden is shared across the entire cannabis production line (producer, processor, distributor, and retailer) by depressing prices. Oregon law also allows cities and counties to impose up to an additional 3% point-of-sale tax, but this additional tax can only be implemented after a vote of approval from local residents. Local jurisdictions can opt to enter into an agreement with the DOR that allows the DOR to collect the tax their behalf, and most jurisdictions that have passed a 3% tax have elected to do so. In these jurisdictions, the DOR will collect a full 20%, and distribute the 3% to the local governments.

The DOR maintains a record of local jurisdictions that have implemented the 3% tax, as well the list of jurisdictions that have entered into a collection agreement with the DOR. In most cases, any local tax issues will be handled on your state tax filings (discussed below), but if you are located in one of the following jurisdictions you will need to contact the local government directly to arrange for payment:

  • Brookings
  • Columbia County
  • Coos County
  • Cornelius
  • Dundee
  • Dunes City
  • Gilliam County
  • Gold Hill
  • Gresham
  • Hines
  • Jackson County
  • Josephine County
  • La Pine
  • Lafayette
  • Rainer
  • Rockaway Beach
  • Sheridan
  • Tillamook (the city)
  • Tualatin
  • Veneta
  • Westfir
  • Wheeler
  • Yachats

At the state level, each month every retail location must submit an Oregon Marijuana Tax Monthly Payment Voucher along with payment for the prior month’s tax. The tax can be paid online through the DOR’s Revenue Online website or can be paid by check, money order, or by cash in Salem — with all of the various problems that arise from transporting large quantities of cash. Remember that you will need to submit a separate voucher and payment for each location, so if you have multiple retail cannabis locations you need to track sales separately for each location. In addition to the monthly vouchers, you also need to submit a quarterly return.

What does the State of Oregon do with your hard earned taxes? By law, the DOR distributes the state marijuana tax as follows (taken from the DOR’s Marijuana Fact Sheet):

  • 40 percent for education.
  • 20 percent for purposes for which money in the Mental Health Alcoholism and Drug Services Account may be used.
  • 15 percent for state law enforcement.
  • 10 percent to cities, based on population and number of licensees.
  • 10 percent to counties, based on total available grow canopy size and number of licensees.
  • 5 percent for alcohol and drug abuse prevention, early intervention, and treatment services.

Remember that cannabis businesses are still subject to any other general business taxes imposed by the state or local jurisdiction, and of course federal taxes as well (which you can read more about here, here, here, and here). Oregon’s Recreational Marijuana Tax should, therefore, be only one small part of your tax planning.

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.

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.