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

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

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

The Court rejected all of these arguments.

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

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

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

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

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

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

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

Alterman

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

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

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

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

Loughman

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

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

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

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

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

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

The STATES Act

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

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

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

Short answer: It depends.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Qualified Person

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

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

Qualified Equipment

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

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

Qualified Equipment includes:

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

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

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

Qualified Use

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

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

Compliance

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

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

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

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

california marijuana tax
Returns are due next month. Time to hustle.

In California, the first Cannabis Tax Return is due on April 30, 2018 and many of our clients are now working through the issues related to the Cannabis Cultivation and Excise Tax. In addition, many marijuana businesses must file their first 2018 estimated federal tax payment by April 17, 2018. To estimate taxable income, every Cannabis business must understand how to treat the Cannabis Cultivation Tax and the Cannabis Excise Tax on their federal income tax return. Are California Cannabis Taxes an expense of a cannabis business? If so, are cannabis taxes deductible for federal income tax purposes?

We have discussed the mechanics of IRC §280E here and here. IRC §280E disallows deductions for cannabis cultivators, manufactures, distributors and retailers. However, expenses included in cost of goods sold (“COGS”) reduce taxable income and operates outside the reach of IRC §280E. Generally speaking, IRC §280E is less damaging to cultivators than retailers, because cultivators can attribute more business expenses to COGS.

Cultivation Tax
California imposes a cultivation tax on harvested cannabis that enters the commercial market. The tax is:

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

The tax is imposed on the Cultivator alone; under state rules, cannabis cannot be sold unless the tax is paid.

IRS regulations (Treas. Reg. §1.471-11) provide Cultivators and Manufactures with a helpful roadmap regarding what costs are appropriate to include in COGS. Taxes can be included in COGS if they are otherwise allowed as a deduction under IRC §164. Under IRC §164, state taxes are deductible if they are “paid or accrued … carrying on a trade or business”. In addition, the state taxes may be included in COGS if they are “attributable to assets incident to and necessary for production or manufacturing operations or processes”. For example, property taxes are included in COGS. Finally, the regulations look to whether a tax is included in COGS in the business’s financial statements.

Cultivation taxes are paid or accrued in carrying on a trade or business. The cannabis plant is an asset of the business (i.e., raw material) that is the core ingredient in all cannabis products grown or processed. Clearly cannabis is the raw material incident and necessary to production; cannabis may not be sold under California law unless the Cultivation Tax is paid. Finally, the tax is imposed based on a characteristic of a business asset (i.e., weight of raw material), like a property tax.  Accordingly, there is a reasonable argument that IRS regulations require that the California Cultivation Tax be included in COGS of a Cultivator.

Excise Tax
California imposes a 15% Cannabis Excise Tax on the purchases of cannabis or cannabis product sold. Generally, the tax is imposed on the average market price. The average market price is the Distributor’s wholesale cost plus a mark-up determined by the CDTFA. Currently the mark-up is 60%. For example, a retailer’s cost of an ounce of cannabis is $75/ounce plus $5 of transportation cost. The mark-up is $48($80 *60%). The average market price is $128 ($80 +$48); the Cannabis Excise tax is $19.20 ($128*15%). The Retailer’s COGS includes the $80 cost. The Retailer will charge the consumer tax of $19.20. Note that for cannabis retailers, COGS is generally limited to the direct purchase cost of cannabis.

So, the big question here is: Should the $19.20 of Cannabis Excise tax be included in the Retailers COGS? By statute, the cannabis excise tax “shall be imposed upon purchases of cannabis”. The Retailer collects the tax from the consumer and pays the tax over to a California Distributor. As the tax is the ultimate liability of the cannabis purchaser, the statutes suggest that the cannabis tax collected is not a cost to the Retailer. Like state sales taxes, the Cannabis Excise Tax is a liability to the Distributor. As such the Cannabis Excise Tax is reflected on the Retailer’s balance sheet and not as an expense on the income statement. The Cannabis Excise Tax probably escapes the reach of IRC §280E.

Although California cannabis taxes do not conflict with IRC §280E, all cannabis businesses should consult with their tax advisors before taking a final approach. For Cultivators and Manufactures, there is a reasonable argument that the Cultivation Tax is included in COGS. For Retailers, there is a reasonable argument that the Cannabis Excise Tax is passed directly to the consumer and, therefore, outside the reach of IRC §280E. At the very least, that may be a good place to start the discussion.

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.