The subject of management companies has been cropping up a lot lately. Hilary Bicken and I were at a NORML conference in Aspen last weekend, and a number of the attorneys there, especially those with roots in the California medical marijuana community, had questions about dealing with management company structures. On a side note, we really like that NORML is still chugging along. A lot of voices for industry are popping up as different states legalize, and it is nice that NORML continues to be a voice for legalization and consumer advocacy; it is a good check on the corporate side of the industry. But back to management companies — what are they and why are they risky?
Management companies developed in the early days of California’s medical industry. Because California does not have a fully regulated state system for medical marijuana, companies that operate there generally need to organize as various versions of nonprofits. These nonprofits face three big obstacles: banking, taxes, and how to pay their nonprofit directors and officers. Many in the industry have seen management companies as the solution. The nonprofit entity pays gobs of money to the management company, which is generally organized as an LLC or corporation. The money is often tied to the revenues of the nonprofit. The management company then opens a bank account by telling the bank that it is a “business management” or “consulting” company, without disclosing its marijuana ties. It also is free to distribute profits to its owners, and the business freely deducts its expenses because it is not subject to IRC 280e. It’s a perfect structure.
But not really.
The main problem with this structure is that it works by actively concealing the source of its funds from third parties. It is pure money laundering under federal law, which bars conducting financial transactions with the proceeds of unlawful activity when the perpetrator knows that the transactions are designed to disguise the underlying activity. As I often say when I give presentations on financial matters for marijuana businesses, just because a pot business is violating the federal Controlled Substances Act does not mean that it also has license to violate all other federal laws. And it is usually its violations of these other federal laws that lead to arrests. Using this sort of structure for a cannabis business opens that marijuana business not only to criminal liability, but also to massive civil liability from the companies with which it does business. Lastly state nonprofit regulators can (and do) come down hard on nonprofits that engage in concealing activities to distribute profits, a prohibited act.
Though this exact issue does not crop up as much in states with regulated systems and for-profit businesses in the marijuana space, a subtler version has been cropping up as a purported method for helping on tax payments. The general idea is to create a leasing company with common ownership with the marijuana company and then use that leasing company to purchase capital equipment and real estate that will then be leased to a marijuana cultivation company at above market rates. The marijuana company categorizes the lease payments as a cost of goods sold rather than business expenses, rendering IRC 280e moot. The leasing company, in turn, is able to fully deduct (or capitalize and depreciate) the cost of the equipment and real estate because it is not even subject to 280e. This can lead to big tax savings. As long as everything is run as an arms length transaction and at market rates, it is not even illegal.
However, the urge there is to overcharge on the lease payments, increasing the amount that the licensed marijuana company can deduct. This is a problem for the IRS, which can come in and see that the companies are not really being run as separate businesses and then can merge the returns on audit. Worst case scenario is that this can be seen as tax evasion, but even without the criminal side, civil penalties on the unpaid tax can be a killer.
Bottom Line: If a corporate structure produces results that are fantastic and make you feel like you are beating the system, there’s a good chance that the structure isn’t legal.