I 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.