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.

  • Dean Homayouni

    It is generally agreed that an LLC or Partnership structure is not the best structure for a cannabis related business as a result of audit and tax assessment exposure. Further, C Corporations in California are allowed to deduct additional operating expenses for cannabis business as compared to LLC and partnerships. California is attempting to address this issue with AB 420. The last amended date is June 13, 2017. The structure to be chosen is state specific. As an, example Pennsylvania has a tax structure opposite of California where it is better to be structured as an LLC versus a corporation for the allowed expense deductions. However, with large tax exposure and audit uncertainty exposing limited partners or LLC members to such liabilities is not recommended. I thoroughly enjoy your articles. You should write a summary of IRC Section 471 and the required full absorption method. I spoke with The IRS Chief Counsel about small taxpayers being able to use the cash method (See Revenue Procedures 2001-10 and 2002-28) versus full absorption as required by IRC 471.. The recommendation was to follow settled case law and stick to Treasury Reg 1.471 and full absorption. Another nice discussion can also be the Beck case. See IRC Interpretation 201504011, T.C. Memo. 2015-149. There is also the issue of the deductibility of excise taxes. This is addressed an allowed in Office of Chief Counsel IRS Memorandum 201531016 dated June 9, 2015. One of the lawyers in this blog write about paying a penalty for not doing an electronic deposit of federal tax and payments. The 10% penalty can be waived if certain procedures are followed. See Department of the Treasury, Internal Revenue Service, Control # SBSE-04-0615-0045 dated June 9, 2016.Another informative heads up is the exposure if a business fails to file Form 8300 on a timely basis and when they have to be filed. The IRS has a Form 8300 Reference Guide.