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.

Cannabis tax lawyer
New tax law will impact cannabis businesses

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

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

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

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

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

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

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

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

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

Cannabis tax lawyer 280EWhen folks in the medical and adult use marijuana industries hear “280E,” they tent to shudder since they know it means a large protion of their revenues will be going to the IRS without the usual deductions. However, just this week, Grover Norquist, a GOP political advocate and the well-known president of Americans for Tax Reform (which favors repealing 280E), opined that our GOP-led Congress may enact sweeping tax reform this year that would reduce the stress of 280E on state-legal marijuana businesses by lowering corporate income tax rates.

In case you missed it, 280E is the provision of the Internal Revenue Code creates such an onerous tax burden for cannabis businesses because it provides as follows:

“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”

Congress passed 280E in 1982 in response to a Tax Court ruling that a taxpayer could deduct expenses relating to his sales of cocaine, amphetamine, and marijuana. Deductible expenses included the costs of packaging, travel, and even scales used to weigh the illegal substances. This is no longer possible in the world of 280E.

Since cannabis is a Schedule I controlled substance, the IRS uses 280E to disallow marijuana businesses from deducting their ordinary and necessary business expenses. The result is that marijuana companies — regardless of their legality under state law –face higher federal tax rates than similar companies in other industries. There are differing opinions on the level of tax rates imposed on marijuana companies – from 40% to 70% to as high as 90% – all of which are higher than the 35% corporate tax rate paid by most other businesses in the United States.

But if Norquist’s predictions are accurate, there may be a bit of light at the end of the 280E tunnel for cannabis businesses. though if Norquist’s predictions are accurate. In an interview with MJ Business Daily, Norquist stated:

There’s a big tax bill this year – the tax reform package that takes corporate rates to 20% – which solves some of the problem for marijuana producers because now you’re paying 20% on all your sales instead of 35%. But we still need to get normal and reasonable and legal deductions made legal and normal for the marijuana industry, as well as for all other industries. Marijuana could get into that package if some of the libertarian Republicans made that a condition of voting for the whole package.

*  *  *  *

So, as we build support for a fix, we need to build support state by state, where we say, “Look, you don’t want federal tax law used to gut the effectiveness of federalism. Because you could say something can be legal at the state level, but if the federal government is going to tax it into oblivion, you really haven’t allowed federalism at all.

Norquist then went on to predict these tax law changes will occur within the “next few years.” Though our cannabis tax lawyers do see cannabis tax changes coming, they are less confident than Norquist on timing. There has been no successful standalone 280E fix bill in Congress and the current presidential administration’s back and forth policies on marijuana legalization make predicting such federal action difficult. But with legalization in California and marijuana reform in 28 other states and more coming soon, the odds of Congress rectifying this tax situation are increasing. We cannot and should not expect favorable 280E changes from either the Tax Court or the IRS unless and until Congress mandates such changes. It is therefore good to know that such changes are at least on the table.

Oregon cannabis lawyersOur Oregon office forms three or four cannabis companies per week. Our Washington office has formed hundreds of these businesses in the past four or five years, and our California office has seen a major uptick in company formation work since AUMA passed last fall. Though every state brings unique considerations for entity choice and structuring, most of these businesses (outside California) end up registering as either LLCs or C-corps. And most of them involve owners who bring different things to the table.

The most common example of differing contributions comes when one person brings skill and labor to the table, while another brings cash. The “sweat equity” partner may have expertise and relationships related to production or processing of cannabis, for example, while the traditional equity partner has the ability to immediately fund the marijuana business. In a classic scenario, these two individuals come to one of our cannabis business lawyers and say they would like to own the business “50/50”, or thereabouts. This raises some serious tax implications for the sweat equity partner.

The Internal Revenue Code values capital over labor, especially when that labor constitutes future services a person will contribute to a business in exchange for ownership. From the IRS’ perspective, if Party A contributes $100,000 in cash to an LLC or corporation, and gives a 50% interest to Party B (for a sweat equity contribution), the IRS will also value Party B’s interest at $100,000. Unfortunately, Party B will have to pay tax on that income, which is sometimes referred to as “phantom income.”

The following are a few of the more common ways to deal with phantom income in a situation where one member of a cannabis business provides the capital, and the other provides services:

Vesting. It is possible to have the sweat equity partner’s interest vest over time, through options allocated to that partner under a shareholder or operating agreement. The sweat equity partner will purchase and pay for his or her equity through distributions or dividends earned as an owner of the company. The vesting schedule here is very important. If the schedule is too long, the value of the membership (and the amount payable) may increase. If the schedule is too short, repayment may not be viable.

Company Loan. Often, the partner without cash at the onset will issue a promissory note to the company. Here, the sweat equity partner is acknowledging having received a valuable interest in the company, for which he or she owes a debt. The promissory note can be made with a commercially reasonable repayment period and interest rate, and the member can pay down the note with income received from the company. It is important to remember, though, that the note payments will be made from taxable income. This is simply a way to extend the tax hit over time.

Owner Loan. Sometimes, neither partner will contribute a sizable amount of cash up front. Instead, both partners will contribute a nominal amount, like $1,000, and the partner with cash will make a loan to the LLC. This option should be considered carefully, for a couple of reasons. First, from a tax liability perspective, the IRS may consider a company with a debt to equity ratio over 3:1 or 4:1 to be “thinly capitalized” and subject to scrutiny. From a legal liability perspective, an undercapitalized company may leave its owners open to vicarious liability on a “piercing the corporate veil” theory.

The above are simplified, high-level summaries of common methods lawyers and CPAs use to deal with phantom income in cannabis start-ups. It is important to note that each situation is unique and depends on a variety of factors. It is also important to note that sweat equity is not the only way phantom income is created in cannabis companies. Almost all pot companies have some amount of phantom income due to IRC 280, for example. That rule alone is a crucial business planning consideration for every marijuana entrepreneur.

Legal and tax structuring are critical decisions that can determine whether a marijuana venture succeeds or fails. Learning to look out for phantom income is key part of this analysis. That’s true for both sweat equity and cash investors — especially in this unique and highly dynamic industry.

California CannabisOn January 18, 2017, California state regulators attended a cannabis event in Sacramento to discuss cannabis policy and what lies ahead for California. Though previous reports indicated that California cannabis licensing could be delayed for an additional year, state regulators at the event promised a licensing program would be operational by January 1, 2018.

Lori Ajax, the Chief of the California Bureau of Medical Cannabis Regulation (soon to be renamed again to the Bureau of Marijuana Control under Proposition 64), told the audience:

We will not fail. We will make this happen by Jan. 1, 2018, because we have to […] It may not be pretty. But we will get there.”

Since Prop 64 passed last November, California regulators are now in charge of crafting comprehensive regulations and issuing state licenses to not only medical marijuana businesses but to recreational cannabis businesses as well. This includes 17 license types for medical businesses and 19 licenses types for recreational businesses, covering cultivation, manufacturing, retail dispensaries, distribution, testing, and transportation. The authority to regulate and license these cannabis businesses is divided among ten California state agencies.

The California Department of Food and Agricultural will oversee cannabis cultivation activities, and it created a new division, the CalCannabis Cultivation Licensing program, to issue permits and develop regulations for cultivators, including setting up a track and trace system for all cannabis plants that enter the California market. Amber Morris, a branch chief for CalCannabis Cultivation Licensing, was also in attendance at the event in Sacramento and she said that California state departments are working with economists to create a tiered permit fee program that will assign fees to cannabis cultivators based on the size and scale of their businesses.

A big challenge faced by state regulators is the lack of banking available to cannabis businesses and affiliated companies. Ajax expressed her hope that there would be some clarity on the matter by the time state licenses are issued, stating that banking is “a challenge for us, too. As we set up our online permitting system, we would like to accept credit cards. We don’t want to have to accept wads of cash.”

The banking issue has been high on the mind of California lawmakers, as we get closer to statewide regulation. In December, California Treasurer John Chiang wrote a letter to President Donald Trump seeking guidance ahead of California’s licensing program. In his letter, Chiang wrote that the new program could “exacerbate” the banking problem because California’s cannabis economy will be so large.

Due to federal prohibition on marijuana and anti-money laundering regulations issued by the Financial Crimes Enforcement Network (FinCEN), banks are reluctant to work with cannabis businesses. The banking challenge is not unique to California and it affects businesses in legal marijuana states across the United States. Several U.S. senators sent a letter to FinCEN in December asking for more guidance and explaining how the dearth of cannabis banking promotes tax fraud and creates a public safety issue because cannabis businesses are forced to deal in large amounts of cash.

Under the new California cannabis licensing program, state agencies will need to collect fees from licensed cannabis businesses. Yet most of these agencies have only one office — in Sacramento — which means anyone paying their fees in cash will need to carry that cash with them all the way to the capitol. To address this issue, California legislators recently introduced new legislation to increase the number of government offices that can accept payments from cannabis businesses for state fees and taxes. The legislation, known as the Cannabis Safe Payment Act, is sponsored by the Board of Equalization (BOE), which has been collecting sales tax from California medical marijuana businesses since 1996.

The BOE currently accepts payments in cash from cannabis businesses at its 22 offices across the state. However, to reach these offices, many California cannabis cultivators have to travel great distances with “bags of cash” in their cars, which BOE Chairwoman Fiona Ma agrees “is not the safest method of paying your taxes.” Thus, Ma states that the BOE’s “priority has to be increasing safety—for the business owner, the public, law enforcement, and state employees by enabling cannabis businesses to pay their taxes and fees in as many a safe and secure locations as possible.” Under the Cannabis Safe Payment Act, California counties that receive approval by board of supervisors and tax collectors will be able to accept cash payments from local cannabis businesses on behalf of the BOE and other state agencies.

With promises from the Marijuana Bureau to begin issuing state licenses by January 1, 2018, collaboration from state agencies to develop regulations and set permit fees, and efforts from state lawmakers to alleviate banking challenge, California legislators are showing they are hard at work creating a viable state licensing program for cannabis businesses. For cannabis businesses planning to take advantage of California’s new cannabis program, a lot of work lies ahead and you should start preparing now.

California cannabis attorneyCalifornia officially legalized recreational cannabis on November 8, 2016 through Proposition 64, and the next day several provisions under the initiative went into effect. Cannabis users in California over the age of 21 now have new freedoms to possess, use and even cultivate cannabis for their personal use. In contrast, marijuana businesses will have to wait until January 1, 2018 to receive their state licenses to cultivate, manufacture, and sell recreational cannabis in California. Prop 64 also applies new state level marijuana taxes to licensed businesses. A cultivation tax will be assessed on all harvested marijuana that enters the commercial market and collected from commercial cultivators. In addition, a 15% marijuana excise tax will be assessed on any retail sales of cannabis and collected by dispensaries. However, for qualified patients or caregivers who provide dispensaries with a Medical Marijuana Identification Card, Prop 64 exempts them from having to pay additional sales and use tax on top of the 15% excise tax.

The provisions of Prop 64 for both the cultivation tax and excise tax specifically state that they are “[e]ffective January 1, 2018,” but this language is not included in the subsection regarding the sales and use tax exemption for medical marijuana patients. While the authors of Prop 64 state that this was an unintentional error in drafting, the California Board of Equalization (BOE) has ruled that under the language of Prop 64, medical marijuana patients are immediately exempt from any sales tax. The BOE even went so far as to send letters to dispensaries across the state advising them to stop collecting sales and use tax as of November 9th.

What all this means is as of now through the end of 2017, the small percentage of medical marijuana patients in California who have or obtain a state-issued ID card can take advantage of this unintended tax break. California reportedly brings in around $50 million in annual tax revenue from sales of medical marijuana and some are worried that the state could miss out on millions in tax revenue through 2017. However, others claim that the effects will not be so great as currently only about 6,000 patients in California have the state-issued ID cards necessary to claim the exemption. The impact of the error may depend on how many California patients actually take the time (and the $100) it takes to register with the state as well as whether dispensaries will check for ID cards or simply offer their customers an unlawful discount. Considering most dispensaries do not bother to collect and pay sales tax at all, it’s hard to tell what effect this could have on California’s tax revenue next year.

The supporters of Prop 64 are also looking for a way to correct the problem if the BOE does not change its interpretation. One solution would be for two-thirds of the state legislature to amend the language, as is required under Prop 64, but this would not occur until the next legislative session begins in January. Alternatively, if California’s newly elected Attorney General Kamala Harris decides to weigh in with a more definitive ruling, we could see a swift end to this unintentional tax break. For now, cannabis consumers in California can enjoy a marijuana tax holiday, just in time for the holiday season.