Tag Archives: 280e

The Cannabis Industry and Tax Implications of Entity Structure: Issues to Consider

By Calvin Shannon
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This piece is intended to provide some considerations that current and potential license holders should think about as they work with advisors to make entity selection decisions or consider potential tax elections. Please note that this article is a high-level overview and is not intended to declare the best type of entity structure for a license holding entity. Although there are numerous tax variables that should be contemplated, tax issues are not the only concerns relevant to determining entity type. In addition, some states may tax entities differently than how the entity is taxed for federal purposes.

First, let’s look at the legal entity types that may be set up to hold a license, operate a business and what that may mean for how an entity is taxed. Often, entities are set up as either limited liability companies or corporations.

If a limited liability company is organized and the entity is owned by only one owner, a single member LLC, the default tax treatment would be that the entity is disregarded for tax purposes. In other words, it would not file a separate federal income tax return, except in some states including CA, TX, TN and RI. All the tax consequences of the activities within the legal entity are reported on the tax return of the owner of the entity.

If a limited liability company is set up and the entity is owned by more than one owner, a multiple member LLC, the default tax treatment would be that the entity is taxed as a partnership. An entity taxed as a partnership reflects the tax consequences of the activities within the legal entity on a partnership return. The partnership generally does not pay tax on the activity, but rather the taxable income and loss are passed through to the owners of the LLC. The owners of the LLC reflect the taxable income or loss on their tax return and are responsible for paying any resulting tax. In the rare instance of an entity being audited, there is a possibility that the entity may have to pay tax on the partners behalf, depending on the ownership structure. Either a single member LLC or a multiple member LLC may elect to treat the LLC as a C-corporation or an S-corporation for tax purposes.

The Taxation of C-Corporations & S-Corporations

The default treatment for an entity set-up as a corporation is the entity will be taxed as a C-corporation. An entity taxed as a C-corporation, including an LLC electing to be taxed as a C-corporation, pays the tax on any taxable income generated by activities within the entity.  Additionally, any distributions of earnings from the C-corporation to the owners of the entity are generally considered dividends which are required to be reported as taxable income by the owners when received. In other words, the earnings of an entity taxed as a C-corporation are potentially taxed twice. Once, as they are earned within the entity, and then again upon distribution to the owners of the entity.

An entity set-up as a corporation, a single member LLC or a multiple member LLC may elect to be treated as an S-corporation. Like an entity taxed as a partnership, an S-corporation does not pay tax at the entity level, but rather passes the taxable income and loss through to the owner or owners. Additionally, like a partnership, distributions from an S-corporation are not taxable as dividends to the owner when received.

Since we covered how different entities are taxed based on how they are set-up, and what elections they may or may not make, we will explore some of the issues that should be considered when making an entity selection. We will also address potentially electing to treat an entity one way or another for tax purposes. 

S-Corporations 

Advantages: The advantages of an S-corporation are limited to the avoidance of double taxation associated with C-corporations, as well as some potential benefits of lower Social Security and Medicare taxes.

Disadvantages: The primary disadvantage of an S-corporation for a license holding company is any non-deductible expenses resulting from 280E are passed through to the owner(s), which then reduces the ownership’s tax basis in its investment in the entity. A reduction in tax basis is determinantal to owners of an entity because the basis is used to reduce taxable income when/if the owner liquidates ownership in the entity.

Other disadvantages of S-corporations include but are not limited to restrictions on ownership of the entity, a requirement for reasonable compensation paid to owners and a lack of flexibility in the allocations of earnings among owners.

Partnerships

Advantages: The advantages of a partnership include but are not limited to the avoidance of double taxation associated with C-corporations, flexibility in the allocation of earnings and losses among owners, and flexibility in the type of owners of the entity.

Disadvantages: Like S-corporations, the primary disadvantage of a partnership is any non-deductible expenses resulting from 280E are passed through to the owner(s).

Other disadvantages of partnerships include potential self-employment taxes on earnings allocated to active owners, potential complexity in the allocations of taxable income and losses among partners in entities with many owners or different classes of ownership.

C-Corporations

Advantages: In contrast to S-corporations and partnerships, the tax basis resulting from the ownership’s investment in the entity is not subject to reductions from non-deductible expenses being passed through to owners. This protection of tax basis is particularly important to owners of license holding entities.

An additional advantage of C-corporation tax treatment may be a lower tax rate applied to taxable income.

Disadvantages: The most significant disadvantage of C-corporation tax treatment is the potential double taxation of earnings that might be applicable if the entity does have earnings that are distributed.

In addition to the items address above, the advantages and disadvantages of the entity type and related tax elections, additional considerations include:

  1. How much of the 280E nondeductible expenses will the taxpayer be subject to?
  2. How much earnings will the entity be distributing to the owners?
  3. How complex is the entity’s ownership?
  4. The lack of certainty regarding whether or not the qualified business income deduction (QBID) enjoyed by pass-through entity owners is allowable as a deduction by owners receiving pass-through income from an entity subject to 280E.
  5. Are there plans for selling the entity and if so, what is the time horizon for doing so?

At Bridge West, we advise taxpayers to consult with cannabis advisors who have experience in the industry, can help navigate the complexities of tax compliance and Code Section 280E and are experienced with entity structures.

MORE Act Passes the House – Is Legalization Around the Corner?

By Steve Levine, Alyssa Samuel
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On Friday, December 4, 2020, the US House of Representatives passed the Marijuana Opportunity Reinvestment and Expungement Act of 2019 (the MORE Act), which would effectively legalize cannabis by removing it from the Controlled Substances Act. The bill (H.R. 3884) has several key components:

  • Most importantly, the bill would remove cannabis from the list of controlled substances in the Controlled Substances Act, as well as other federal legislation such as the National Forest System Drug Control Act of 1986. This would effectively end many of the obstacles created by the federal illegality of cannabis such as the lack of access to banking, tax consequences such as 280E, adverse immigration impacts and threats of federal criminal enforcement.

    Rep. Earl Blumenauer (D-OR) donning his cannabis mask as he presides over the Congress
  • Second, not only does the bill preclude future prosecution for cannabis-related crimes, the bill is designed to be retroactive and would provide for the expungement of past non-violent cannabis offenses.
  • The bill creates a prescribed excise tax on cannabis and cannabis products. The funds collected from the taxes would be channeled into opportunity and reinvestment programs.
  • A Community Reinvestment Grant Program would be established aimed at the provision of services for “individuals most adversely impacted by the War on Drugs,” such as job training, education, literacy programs, mentoring, and substance use treatment programs;
  • A Cannabis Opportunity Program would be established providing state funds for small business loans in the cannabis industry targeted at social equity candidates; and
  • An Equitable Licensing Grant Program providing funds for states to implement equitable cannabis licensing programs aimed at minimizing “barriers to cannabis licensing and employment for individuals most adversely impacted by the War on Drugs.”
  • The bill would require all cannabis producers to obtain a federal permit. Cannabis businesses would need to be licensed at the state, local, and federal levels to operate.

This MORE Act is a substantial step in cannabis legislation. Reactions to the proposed legislation have been mixed. While the bill does include some measures aimed at social equity, critics of the bill claim it does not go far enough. Similarly, while the bill includes a federal permitting provision, this would be the beginning of a nascent federal regulatory scheme.

What does this mean for your business? 

While this bill passed in the US House of Representatives, it would still need to pass in the U.S. Senate this term, which by most accounts does not seem likely. However, the passage of this bill signifies the progress that has been made and provides insight on what further legislation may look like.

2021 Trends: Nine Developments in California’s Cannabis Market

By Amy Steinfeld, Jack Ucciferri
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While we’re pleased to report that 2020 is almost over, 2021 will be a mixed bag. New jurisdictions will open their doors to cannabis and consumption will continue to rise, but competition from new operators and illicit supplies will increase. As California’s cannabis industry matures and turns the page on a bizarre year, market uncertainty will linger as the pandemic drags on and overtaxation and regulation strangle profits. But let’s remember, cannabis has been cultivated for over 6,000 years and has withstood far worse—this market isn’t going anywhere and will continue to grow and become more impactful.

Access to Traditional Finance Services

The U.S. Senate will likely pass legislation providing cannabis businesses access to traditional banking and financing services. This will be a game changer for the industry. Valuations will go up. Increased liquidity will smooth transactions. Companies will look to affordable debt to expand their footprints and capacity to compete on a new scale. Full federal legalization could be a game changer if 280E tax restrictions are lifted and interstate and international cannabis trade open up, but the timing of this is hard to predict.

Continued Quarantine-Induced Consumption

Cannabis consumption will continue to increase as Californians seek to ease pandemic-related stress, temper quarantine conditions, and sample an eye-popping array of new products. Sophisticated consumers will be open to spending more on unique and niche products. But hemp-derived cannabinoids may present a new source of competition, especially if CBD remains unregulated. By the end of 2021, cannabis beverages will begin to compete with mainstream alcohol categories. Pharmaceuticals will increasingly take notice of this industry and the increasing share of consumers turning to plant-based remedies.

Ever More Cultivation Opportunities 

In pursuit of revenue, agricultural counties will liberalize their policies on cannabis cultivation by permitting more acreage and streamlining permit processes. Neighborhood groups will push back, but policymaker concerns will be assuaged when they see cannabis farms operating innocuously (and sustainably) around the state. Advances in seed breeding, pest-and-disease control, outdoor growing techniques and odor abatement technology will help too.

New Retail

Cities and counties will revisit opening their borders to cannabis retail storefront and delivery as they attempt to fill budget gaps. Many cities will allow cannabis retail for the first time and/or expand the number of licenses available. These new dispensaries will provide a much-needed outlet for the influx of licensed flower and will continue to spur innovation and consumer education. But a “second wave” of retail speculators seems poised to let optimism override judgement, setting themselves up for failure or acquisition by incumbents.

Getting Social Equity Right

2021 will be a pivotal year for social equity, which will establish a foundation for a just cannabis economy. The industry will have to grapple with how to ensure that those most impacted by the criminalization of cannabis and most often excluded from traditional financing exposure are provided with equitable access to meaningful opportunities. As California’s regulated cannabis market grows, getting social equity right will be important if the industry is to firmly establish itself as an inclusive industry that addresses impacts on marginalized communities and responds to customer demands.

Formalizing Appellations  

California’s new CalCannabis Appellations Program will provide cultivators and brands a way to credibly market the value of their unique growing regions and cultivation methods. These distinctions only apply to cannabis planted in the ground, excluding greenhouse and warehouse grows. The expectation is that high-end consumers, trained to recognize place-based designations and quality certifications in other products, will reward products that boast these designations. How many consumers will be willing to pay the premium and how long full implementation of the program will take, remains to be seen.

Prices May Begin to Drop

2020 was a great year for the few fully licensed cultivators in California permitted to sell to the regulated market. 2021 may be different. Numerous licensed cultivation projects will complete the permitting processes and come online next year. While growing demand may outpace supply at first, by Q3 supplies could swamp the market. Premium flower is perhaps an exception. Adding to the pricing pain, as always, is California’s illicit market, which will continue to undercut prices, as legal growers toil to comply with a labyrinth of state and local regulations. Nonetheless, cannabis will remain the most profitable crop on a per acre basis for some time.

Business Turmoil

The drop in prices coupled with continued high taxes and regulatory burdens will result in turnover of assets and businesses. Less efficient and inexperienced cultivators will struggle, many unable to ultimately withstand pricing pressure. Others will be hit by enforcement actions for failing to comply with California’s myriad regulations. Retailers, already burdened by punitive tax structures, real estate finance commitments and onerous local regulations, will need to be disciplined and have a clear strategy to address new competition.

Consolidation

Driven by business failures and renewed investor interest, California’s regulated cannabis industry may consolidate rapidly in the second half of 2021. Institutional finance will enter the space with a much more disciplined approach than prior capital sources. Traditional agricultural interests will invest in cannabis cultivation projects. Well-run retail chains will begin to outcompete, and then acquire, mom-and-pop competitors. Big brands will continue to expand their shelf space, relegating smaller competitors to niche and novelty status.

In short, the cannabis industry will continue to be highly dynamic, exciting, enticing and risky.

How Cannabis Businesses Can Prepare for Tax Season

By Melissa Diaz
3 Comments

A Little About 280E

The 280E statute bans businesses from deducting business expenses for gross income associated with the trafficking of Schedule I or II substances. While other businesses can deduct any number of expenses when filing their taxes — employee salaries, rent, equipment, electricity, etc. — 280E limits cannabis companies to only expensing deductions directly related to earning a profit, or the cost of goods sold (COGs).

For example, a dispensary whose square footage is split between 60% sales floor and 40% lobby may only deduct 60% of rent expenses because that’s the portion dedicated to COGs. Transactions do not occur in the lobby, so that portion of the rent is not deductible.

Image: Flickr

So long as cannabis remains a Schedule I substance, companies that produce, sell and otherwise touch the plant in their operations must comply with 280E.

Tips for Tax Success

While taxes can be complex and stressful for cannabis businesses, it is possible to limit the headaches. With tax season right around the corner, here are a handful of tips to ensure a successful filing.

  • Close Out Your Books. Before tax preparation can even start, cannabis businesses want to make sure to close out their financials for the previous year. It may sound like a no-brainer, but with the extra scrutiny facing companies in the industry and the nuances of 280E, it’s extremely important to have fully reconciled and closed-out books to work from when preparing taxes. Incomplete books can cause delays and add unnecessary extra stressors to the process that could result in penalties or additional liabilities.
  • Consult a Cannabis Tax Professional. Once books are ready to go, it’s time to consult a tax professional who has experience in the cannabis industry. A cannabis-focused tax pro will be familiar with the intricacies of 280E and and will be able to identify relevant business expenses to ensure compliance and limit liabilities. In addition to 280E issues, a competent accountant will also be able to highlight any other tax code changes that may impact a business. Every business is different — even in the cannabis industry — and since the tax code is large, complex and prone to new rules and interpretations, it’s important to have a strong accountant guiding the way.
  • Justify Your Numbers. After consulting with a tax professional and identifying relevant business expenses, it’s time to back up the numbers. This is where strong record-keeping comes into play. Ongoing regulatory hurdles limit cannabis firms’ ability to participate in the financial system where, generally, record creation is inherent with each transaction. But in a cash-heavy industry like cannabis, record creation and retention fall on the businesses themselves. This is because cash transactions don’t come with any built-in records. That inherent lack of documentation is yet another potential pitfall for cannabis businesses and taxes since large amounts of cash often raise eyebrows at the IRS. It is up to businesses to provide adequate proof of their tax numbers. Since the IRS will put zero effort into investigating the accuracy of your numbers, it will likely assume the worst when reviewing your filing.

Preparation is King

Taxes can be stressful. But they don’t have to be. Navigating tax season as a cannabis business is all about preparation. By putting in the work and partnering with an experienced tax professional, cannabis operators will be able to avoid penalties, limit their audit risk and stay on track with their business goals.

2020 Financial Trends for the Cannabis Industry

By Melissa Diaz
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The past year has been another strong year in cannabis. Investors continued to pour money into the burgeoning industry — surpassing 2018 investment totals in just 40 weeks — and new markets opened up for recreational and medical cannabis. And following the passage of the 2018 Farm Bill, CBD has proliferated and become one of the hottest health supplements in the country.

But as the year winds down, the industry appears to be poised for a more challenging shift in the new year, as once-heady expectations for some big companies don’t pan out and some states clamp down, rather than loosen up, certain regulatory hurdles.

Here are some financial trends to keep an eye on in cannabis over the next year:

Finding New Capital Investment Will Be Tougher

After an initial investment boom in recent years, cannabis investors are realizing not everything colored green turns to gold. With public cannabis companies not performing as well as hoped and restrictive tax laws still plaguing the industry, investors are growing more cautious when it comes to cannabis. Add in other macroeconomic trends that are pointing to a global economic slowdown, and 2020 is shaping up to be a tough year to find cannabis capital.

Image: Flickr

That’s not to say funding will completely dry up, but operators and business owners must be aware that investment deals that perhaps closed in a matter of days in previous years, likely will take weeks or months while investors dig deeper into books and perform higher levels of due diligence before inking a deal. This means cannabis businesses must carefully plan and watch their cashflow and pursue fresh capital or investment earlier rather than later.

Expect More M&A and Consolidation

With the green rush reaching a crest of sorts, reality is setting in for some smaller cannabis operators. Expect to see more consolidation with smaller dispensaries and cultivators being bought up and absorbed by the big kids. More limited capital and investment options coupled with continued regulatory and legal uncertainties mean unsustainable operating costs for independent and smaller operators, which means the only way to survive may be to sell to a larger player.

New Markets & Regulations

The new year brings new states opening up to recreational or medical cannabis sales, as well as newer or altered regulations in existing markets. Cannabis firms must keep an eye on these new markets and regulations to best determine whether they plan to expand or not.

How stringent or lenient regulations are written and executed will determine the size and viability of the market. One state may severely limit the number of licenses it issues, while others may not put any limit. For example, Oklahoma issues unlimited licenses to grow hemp at $1,500 a piece. While that sounds promising for smaller hemp producers, it also could potentially lead to an oversaturation in the market. On the flip side, a more restrictive (and costly) licensure structure could lead to a far more limited market where only the industry’s largest players will be able to compete.

Image: Cafecredit, Flickr

Cannabis businesses also should keep an eye out for new regulatory hurdles in existing cannabis markets. For instance, California is raising its excise tax on cannabis beginning Jan. 1. That will result in higher costs for both consumers and cannabis companies. High state and local taxes have been a challenge industrywide because they make legal operators less competitive with the illicit market. Also, a proposed rule in Missouri could ban medical cannabis operators from paying taxes in cash. Such a rule would prove problematic for an industry that has had to rely on cash because of federal banking regulations. 

Credit Card Payments

While cannabis businesses may face several new and recurring hurdles in 2020 on the financial front, at least one looming change should make business easier: credit card payment processing. Because of cannabis’ continued banking woes, dispensaries and other plant-touching operations have not been able to accept credit cards. Though federal banking limitations remain in place, in 2020 we will see payment processors introduce new, creative and less expensive ways to navigate current banking limitations that will allow cannabis sellers to take credit cards. Opening up payments in this way will not only make transactions and record keeping easier for customers and businesses alike, it also will attract consumers who don’t use cash.

While some of these trends may prove challenging, in many ways they are signs that the cannabis industry is shifting and maturing as we enter a new decade. Many hurdles remain, but the size and momentum of the industry will only continue to grow in 2020 and beyond.

Four Payroll Best Practices for Cannabis Companies

By Michelle Lanter Smith
6 Comments

Among the myriad business challenges facing cannabis companies, processing payroll ranks right up there. On top of the industry’s overarching banking and regulatory hurdles—not to mention prohibitive tax liability—its varied, sometimes unconventional pay models can fall outside the scope of traditional payroll processing.

Obviously, despite the many business issues clamoring for attention, the cannabis industry is powered by people—and for a business to succeed, employees must be paid accurately, legally, and on time.

While the industry is still evolving in many respects, there are steps cannabis businesses can take right now to ensure payroll is processed correctly and compliantly—including these four best practices.

1. Implement Foolproof Tracking Processes for Each Pay Model

In addition to salaried and hourly employees—who can be difficult to time-track, depending how they’re distributed—some growers pay bud trimmers by the ounce or pound of trimmed, manicured product. While such productivity-based compensation may make absolute sense for your business, most conventional time and attendance and payroll software isn’t equipped to administer this pay model.

As a result, some companies may resort to manual tracking—but that can create regulatory recordkeeping challenges of their own. The answer: flexible time and attendance software that allows companies to track employees’ time and/or productivity using a variety of data collection methods for different elements of the workforce. It may mean using conventional biometric time clocks at processing facilities and retail dispensaries…mobile time-tracking apps for gardeners and growers in the field…and versatile apps that track employee output by work order or piece rate, however your business chooses to define it.

Furthermore, regardless of how it’s collected, all that data needs to flow seamlessly into your payroll processing system, ensuring pay is calculated correctly for every pay model. The HR payroll software is out there, but you may need to look for it.

2. Verify that Your Payroll Provider Is Cannabis-Friendly

Perhaps you’ve heard horror stories of cannabis companies getting abruptly dropped by their software providers with a mere 30-days’ notice. Some leading HR payroll software companies have made seemingly overnight decisions to withdraw from servicing the cannabis industry, leaving employers struggling to pay their people. Who can implement new HR payroll software in 30 days?

Make sure your payroll provider is committed to serving the cannabis industry for the long haul. If the commitment isn’t there, start looking elsewhere. Beyond avoiding potentially damaging business disruptions, partnering with a software provider that actively services the cannabis industry will offer unique capabilities you may not find elsewhere.

3. Become an Expert on IRS Code 280e (COGS)

Thanks to section 280e of Internal Revenue code, state-compliant cannabis business cannot deduct business expenses except for the cost of goods sold (COGS).

The saving grace here for growers and processors: labor costs that are inventorial in nature are considered cost of goods sold. That includes the cleaning, trimming and curing of product, as well as packaging and inventory labor.

Therefore, for tax purposes, it’s critical to assign each employee a specific title and role within your operation. This is particularly important for vertically-integrated companies whose employees wear more than one hat.

Say, an employee works part time in cultivation and part time in your retail dispensary. You need to be able to track their work time and compensation separately—i.e., you need a time and attendance system that can track split shifts—and keep detailed records of what labor costs are and aren’t deductible.

 4. Consider Integrated HR Payroll Software

Because of payroll challenges, many cannabis businesses are still piecing together disparate HR systems, such as applicant tracking, time and attendance, payroll and benefits. But when their integration isn’t flawless it can create the need for duplicate inputting and elaborate manual workarounds.

Furthermore, a patchwork software can stop businesses from accessing reports and analytics that inform decision-making and better position the company for growth—while also ensuring the company is in a position to provide whatever regulatory information may be required.

The answer: choose a payroll provider that offers complete, integrated HR payroll software—one that that can demonstrate its long-term commitment to serving the state-licensed cannabis industry.

Taxes & Cannabis: 280E, R&D Credits, 199A & Qualified Opportunity Funds: Part 2

By Zachary Gordon, Jason Hoffman
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Editor’s Note: This is the second piece in a two-part series delving into tax issues. Part one discussed tax code 280E as it pertains to cannabis businesses. Part two will go into research and development credits, 199A and a discussion of risk as it relates to Qualified Opportunity Zones. 


While 280E is the most influential code section for the cannabis industry, structuring never happens in a vacuum. There are many open questions that each business must answer for themselves without court adjudication. We believe that among the riskiest of questions is whether a cannabis business can claim research and development credits.

There is no clear legal authority that either allows these credits or disallows them but certainly utilizing such credits comes at great risk. At the beginning of this article we talked about Congress and the purpose of 280E. Congress’s intention was to make sure that only the minimum required tax deductions were available to Schedule 1 and 2 sellers. A cannabis business receiving a research and development credit would not be with the intension of Congress. While the credits would be computed based on COGS expenditures, at this time we do not believe that a cannabis business should take this credit. Disallowance of COGS would create a constitutional challenge which is why Congress allowed the COGS deduction. Disallowance of Research and Development Credits does not open up the same constitutional issue since the credit is not part of COGS although calculated based on COGS expenditures. 280E states very clearly that credits arising from other code sections are disallowed in the entirety.

More recently the Tax Cut and Jobs Act (TCJA) opened up new issues for cannabis companies that are still unfolding. Two of the most publicized are Qualified Opportunity Funds and Section 199A, the 20% deduction (Qualified Business Deduction).

The 199A deduction allows eligible pass-through entities to claim an additional deduction of 20% of the income (subject to certain limitations) at the individual level potentially lowering the tax rate from 37% to 29.6%. While the American Institute of Certified Public Accountants (AICPA) and others have asked the IRS to clarify if 280E would make a cannabis business ineligible, the final regulations on the subject did not address this issue. There are other significant limitations and hurdles in 199A regulations that any business would have to first pass to be considered for the rate deduction. If a cannabis business meets all other eligibility and limitation criteria, should the pass-through income to their investors be qualified income under 199A? The answer will depend on whether the courts will treat this “deduction” as falling under the general prohibition of 280E.

We believe that there is a reasonable chance that the courts will allow the 199A deduction for cannabis companies. That does not mean, however, that we advise cannabis companies to claim this on their pass-through returns as Qualified Business Income. Much like everything else, it depends on the particular business and the risk profile that management is willing to tolerate. This is one area of tax law that is sure to be challenged in court. The more risk-averse business should pass on claiming this deduction on their returns, but monitor development with an eye to amending at a later date if favorable precedent emerges. If the amounts are large enough, consideration should be given to applying for a Private Letter Ruling, but that also has its own tax risks.

Another new tax incentive that was in the TCJA was Section 1400Z or Qualified Opportunity Zones (QOZ). The incentive allows for the deferral of capital gains until December of 2026. The use of 1400Z also results in up to a 15% decrease in capital gains tax- and tax-free appreciation if all requirements are met. While the IRS has only released proposed regulations and we anticipate significant changes to them when they are released as final, there was nothing in the proposed regulations limiting cannabis businesses from using Qualified Opportunity Funds (QOF) in their structure. It is interesting to note that the TCJA and proposed regulations did list other types of businesses that could not make investments under 1400Z along with all its benefits. Liquor stores, golf courses and sun tan parlors were among those listed but cannabis growers and dispensaries were not.

As the industry continues to mature, new issues and precedents will require CPAs and attorneys to find new solutions to best serve the industry.Using Opportunity Zones to entice investors sounds like a great opportunity, but there are significant risks. The first risk is that the proposed regulations, while currently proposed, may not be final. There is always a chance that the IRS will take a different position when the final regulations are released and add cannabis to the type of businesses that do not qualify. Another risk, and one that was previously mentioned as part of 199A and other areas of structuring, is that the IRS and the courts can always disagree with the taxpayer’s position. This is a new area of tax law and will eventually be litigated. The loss of the Opportunity Zone benefits can significantly change the return to the investors and lead to other issues.

All of these issues come into play when structuring businesses in this industry. These issues must be evaluated as they pertain to the business needs. This can be very complex and requires a great deal of research for each business opportunity. We have found that professionals operating in this industry like to know about all of their options. The most important thing we can do for the industry is to continue to educate the professionals working in it.

Accountants should be available to assist their clients and their clients’ attorneys with structuring techniques aimed at asset protection and minimizing 280E disallowances. Accountants should also be ready to speak to the questions outlined above and be prepared to explain the risks associated with each choice. As the industry continues to mature, new issues and precedents will require CPAs and attorneys to find new solutions to best serve the industry.

Taxes & Cannabis: 280E, R&D Credits, 199A & Qualified Opportunity Funds: Part 1

By Zachary Gordon, Jason Hoffman
3 Comments

Editor’s Note: This is the first piece in a two-part series delving into tax issues. Part one discusses tax code 280E as it pertains to cannabis businesses. Part two will go into research and development credits, 199A and a discussion of risk as it relates to Qualified Opportunity Zones. Stay tuned for Part two coming next week!


When building a knowledge base in the cannabis industry as a CPA, one’s tax research typically starts with Internal Revenue Code (IRC) Section 280E. For those that are unfamiliar, 280E is only three lines long. With this in mind, we at Janover realized that we needed to understand the context for this highly influential tax section.

The genesis of 280E dates back to 1981 with a Tax Court case: Jeffrey Edmonson v. Commissioner. The decision in this case was that a seller of cocaine, amphetamines and cannabis could deduct most business expenses, cost of goods sold, packaging, home, phone and automobile expenses relating to the seller’s illegal business.

In 1982, 280E was enacted to reverse the Edmonson decision and deny sellers of Schedule 1 or 2 controlled substances the right to deduct business expenses. Under the Controlled Substances Act, the federal government defined Schedule 1 drugs as drugs that have no currently acceptable medical use and a high potential for abuse. Since cannabis is classified as a Schedule 1 drug, cannabis businesses were unable to deduct most business expenses.

To get a better understanding of what the legislators were trying to accomplish, House and Senate reports provided insight into what their goals might have been. Under the Explanation of Provision, the Senate Report reads:

All deductions and credits for amounts paid or incurred in the illegal trafficking in drugs listed in the Controlled Substances Act are disallowed. To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill.

As the Senate Report explanation provides, 280E specifically excluded cost of goods sold (COGS) from the disallowance of deductions. This treatment was affirmed by the Tax Court in 2012 in Olive v. Commissioner (139 T.C. 19 2012).

To date, there are not many cases that have dealt with the tax issues of 280E. In a 2007 decision involving Californians Helping to Alleviate Medical Problems (CHAMP), the Tax Court ruled that a taxpayer may deduct expenses allocable to an affiliated business that was separate from the entity “trafficking in a controlled substance.” In CHAMP, the legal caregiving business, which was a separate business, was able to deduct the allocated portion of shared expenses. This set a legal precedent that allowed a taxpayer engaged in the selling of a Schedule 1 or 2 controlled substance to distinguish expenses incurred on behalf of other non-prohibited business lines and deduct these expenses.

In addition to these court cases, tax professionals can rely on IRS Chief Counsel Memorandum CCA 201504011. The IRS Chief Counsel released this memorandum in January 2015 in order to respond to questions the IRS was receiving from practitioners.

Although Chief Counsel Memoranda, in general, may not be cited by taxpayers as precedent, this memorandum is the current and best authority outlining the IRS’s position with respect to the extent to which a cannabis business may deduct business expenses. The memorandum also refers to IRC Section 162, ordinary and necessary business expenses that would be disallowed, as well as separately identifying certain direct and indirect business expenses that would be allowed. Citing methods in Treas. Reg. 1.471, the memorandum states that a cannabis producer may allocate to inventory and COGS direct production costs, including direct material costs (Cannabis seeds or plants), direct labor costs (e.g., planting, cultivating, harvesting, sorting, etc.), and transportation or other costs to acquire of the cannabis. It also indicates certain indirect costs that may be taken as COGS.

As the industry continues to mature, more cases are finding their way to the Tax Court. On June 13, 2018, the Tax Court issued a ruling in Alterman v. Commissioner that specifically disallowed the use of 263A under 280E and applied only Section 471 to determine COGS. While we need to follow the facts and circumstances of each case, the broad language used might very well disallow capitalizing of inventoriable costs for companies subject to 280E.

IRC Section 471 is the general rule for inventory accounting for tax. IRC Section 263A is the uniform capitalization rules for tax. Most businesses need to utilize both 471 and 263A when accounting for inventory and to properly capitalize costs into COGS.This opinion may have lasting effects on the part of the industry trying to create brands associated with their cannabis products.

Many resellers and retailers of cannabis thought they could use 263A to capitalize more costs into inventory decreasing their tax burden. The Chief Counsel Memorandum disagreed and more recently the Tax Court in Patients Mutual Assistance Collective Corp v Commissioner sided with the IRS and upheld some of the precedents set in Alterman v. Commissioner. In siding with the IRS, the judge concluded that a taxpayer who is subject to 280E can only deduct costs of goods sold under 471 as the IRC existed when 280E was enacted (in 1982). The taxpayer in the case used two arguments that were not new to the cannabis industry, but to no avail. The first argument was that the business was not trafficking in a controlled substance because the government had abandoned a civil forfeiture action. The second argument that was rejected was that a portion of the business involved branding, marketing and the sales of other non-illegal products. The claimant tried to convince the court that deductions related to these operations should not be subject to the same disallowance of deduction as outlined in 280E.

This second argument is very important for structuring purposes. The court used a significant portion of its opinion to address why the entire business is integrated and completely subjected to 280E. This opinion may have lasting effects on the part of the industry trying to create brands associated with their cannabis products.

This case has even more implications given part of the ruling in which the courts stated that being state licensed in no way effected the Schedule 1 determination at the federal level and, therefore, subjected them to 280E. The judge went so far as to separate the Department of Justice, which enforces the Schedule 1 status of cannabis, and the Department of the Treasury, which has full authority and enforcement rights to treat cannabis as a Schedule 1 drug subject to 280E for income tax purposes. This ruling made it clear that even if the Department of Justice is not pursing criminal charges against state-licensed cannabis businesses the IRS is not precluded from fully enforcing the Internal Revenue Code.

NCIA Federal Policy Update: Q&A with Aaron Smith

By Aaron G. Biros
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The Justice Department rescinding the Cole Memo, the Omnibus bill including Leahy Amendment protections, a host of potential bills for federal cannabis policy change: a lot has been happening in Washington D.C. recently with respect to cannabis business. With the National Cannabis Industry Association’s (NCIA) Cannabis Business Summit in San Jose fast approaching, as well as the 8th Annual Cannabis Industry Lobby Days, we thought it would be a good time to hear what NCIA has been up to recently.

We sat down with Aaron Smith, co-founder and executive director of NCIA, to learn what the organization is working on right now and how we might be able to make some real federal policy changes for cannabis.

Aaron Smith, executive director of NCIA

CannabisIndustryJournal: With the Department of Justice rescinding the Cole Memo, working as a group to tackle federal policy reform is now more important than ever. Can you give us a 30,000-foot view of what NCIA is doing right now to help us work together as a group and affect policy change?

Aaron Smith: So our team in D.C. consists of three full-time staff members as well as lobbying consultants, who have been really focused on the appropriations process, which is the way we’ve been able to affect change in such a dysfunctional congress by affecting the budget and restricting law enforcement activities. The medical marijuana protections, formerly known as the Rohrabacher–Farr amendment, [and now known as the Leahy Amendment] prevent the Department of Justice from using funds to prosecute state-legal medical marijuana businesses and patients. Going into the fiscal year, thankfully after a lot of hard work, we were able to include protections for medical marijuana, which just happened last week. Now we are really focused on the next year’s fiscal budget, working to hopefully expand those protections to cover all state-legal marijuana activity so the Department of Justice cannot go after all state-legal cannabis businesses, including those businesses in the recreational cannabis industry, which is certainly one of our priorities right now. As Congress starts to transition into fiscal year 2019 appropriations, the D.C. team is working with Capitol Hill staff and other cannabis groups in D.C. to ensure an organized, uniformed strategy through the appropriations process.

CIJ: What are some other priorities for NCIA in the House and Senate right now? What is NCIA focusing its resources on?

Smith: Another big issue for us is the 280E section of tax code, which prevents legal cannabis businesses from deducting normal business expenses. A lot of these businesses face upwards of a 70 percent effective tax rate. Working with our champions in Congress, we are working on reforms to 280E so we can make normal deductions and be treated fairly, just like any other legal business. The Small Business Tax Equity Act of 2017 addresses this issue and has bipartisan support in the House and the Senate right now, and we are working to build more support for that. This bill currently has 43 cosponsors in the House.

The other big issue for us right now is banking reform, which is a very high priority for NCIA as it affects most of our members. The Secure and Fair Enforcement (SAFE) Banking Act of 2017 provides a “safe harbor” and additional protections for depository institutions who provide “financial product or service” to a covered business. This bill currently has 89 cosponsors in the House. NCIA’s D.C. team and lobbying consultants continue to push for cosponsors and support on these important bills.

CIJ: I saw that the Omnibus spending package includes Leahy Amendment protections for cannabis businesses through September. Would you consider that a win in your book? How are you working to maybe extend those protections?

Smith: It was a big win for us. It doesn’t always seem like it because it is really just maintaining the status quo, but we are up against an Attorney General lobbying congress to strip those protections and the house didn’t allow us to vote on it. But by including the Leahy Amendment in the budget we are not only protecting medical marijuana patients and businesses, but we sent a clear signal to Congress that the intention is not to go backwards. We have been playing some defense recently given the current administration’s policies. But we are working with our allies in congress to negotiate those protections for recreational businesses as well. Negotiations for that are just getting started now.

The fiscal year ends September 30th so the protections are in place for now, but Congress needs to pass another budget for the next fiscal year with those protections included. It’s hard to say when the vote will be, because they haven’t been passing budgets in a timely manner, but usually it’s in May or June, right around our Lobby Days. This is what we are focused on now, getting as many of these cannabis businesses and NCIA members out there to really show Congress what the legal industry looks like.

CIJ: NCIA is hosting the 8th Annual Cannabis Industry Lobby Days a little more than a month from now; do you have any goals for that event? Is there anything in particular you hope to accomplish there? How can cannabis businesses get involved?

Smith: The primary purpose of Lobby Days is to show members of Congress and their staff (many of whom have never had exposure to cannabis businesses) what a responsible industry really looks like. And it lets business owners come tell Congress how current policies and laws are affecting their business. It is great for the cause and helps change minds in DC.

Last year, we came out of Lobby Days with several new co-sponsors of cannabis legislation and we hope to get that again this year. It is a great opportunity to connect and network as well; some of the top people in the industry will be there.

Laura Bianchi
Soapbox

Jeff Sessions’ Latest Moves Should be a Wake-Up Call for the Cannabis Industry

By Laura A. Bianchi
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Laura Bianchi

The legal cannabis industry was recently rocked to its core by the announcement that Attorney General Jeff Sessions would be rescinding the so-called “Cole memo” and several other Obama-era legal directives suggesting the federal government would leave state-by-state cannabis reforms more or less alone. Suddenly, it seemed the entire cannabis movement was in jeopardy. Laws legalizing medical and recreational cannabis could be at risk. A booming industry predicted to be worth $50 billion annually by 2026 could instead be going down in flames.

Here’s the good news: As a business transactions attorney who’s been working in the cannabis industry for eight years, I don’t see any cause for panic. The Cole memo and the other directives the Justice Department are rescinding were not laws, orders or even legal precedents – they were simply legal guidance, and murky at that. The memos provided guidance to federal prosecutors regarding cannabis enforcement under federal law, suggesting that federal prosecutors not focus resources on state-legal cannabis operations that weren’t interfering with other federal priorities, such as preventing the distribution of cannabis to minors and preventing revenue from the sales from going to criminal enterprises, gangs and cartels. Yes, federal prosecutors could take Sessions’ recent moves to mean it’s open season on medical and recreational cannabis businesses. But with medical cannabis programs of one form or another up and running in 29 states and Washington D.C., and recreational cannabis now legal in eight states and Washington D.C., dismantling the entire legal cannabis industry would require a Herculean federal effort that would come at the expense of a cornerstone of the Republican Party now in power: The vital importance of states’ rights.The best way to stay on top of those rules? Form relationships with your state program regulators

In other words, I don’t see the termination of the Cole memos as the end of the nascent cannabis industry. But I do think the development should be a wake-up call for all those people in the cannabis industry who have been playing fast and loose with their business operations. After all, if federal prosecutors do decide to make examples of certain cannabis operations, they’re going start with those who are not operating within the confines of the applicable state rules and regulations.  Any business that smells even slightly of tax evasion, interstate trafficking or the allocation of cannabis-derived revenue to benefit a criminal enterprise will end up at the top of that target list.

So how should well-meaning cannabis operators stay off the feds’ radar? Simple: Follow all the rules.

Unless you want orange to be your new black, you can’t afford to be sloppy with your business structure and financial records.For starters, you need a CPA who’s not just at the top of their game, but who also understands the very specific – and potentially debilitating – nuances of cannabis-specific tax liabilities. That’s because thanks to a quirk in the tax code called IRS section 280E, cannabis companies are utterly unique in that they are not allowed to deduct expenses from their business income, save for the costs of goods sold. You want an accountant who thoroughly grasps this issue, so they can help you plan for and (to the extent possible) minimize your tax liability. And you want to address such matters before you start to realize positive revenue, so you’re ready to handle an effective tax rate that can be upwards of 70 percent. Last I checked, the IRS doesn’t consider “But I can’t afford to pay my taxes!” a valid excuse.

Along the same lines, you need a business corporate attorney who’s well-versed in the world of cannabis. That’s because while it might seem exciting to jump headlong into the cannabis green rush, you’re not going to get very far if you don’t deal with the boring stuff first. I’m talking about start-up financing strategies, business contracts and agreements, profit and loss forecasts, cash-flow analysis, and long-term financial plans. Properly structuring your business from the get-go isn’t just important if you ever plan to seek capital or sell your business. It’s also necessary if you want to keep the feds happy. In other industries, regulators might cut first-time business owners some slack. Not so in cannabis. Unless you want orange to be your new black, you can’t afford to be sloppy with your business structure and financial records.

Jeff Sessions and Eric Holder
AG Jeff Sessions (left), the man responsible for the recent uptick in worries

Finally, make sure you’re playing by all the cannabis rules, regulations and requirements of your state and jurisdiction. While this suggestion might seem like a no-brainer, far too often cannabis brands hire hotshots from Fortune 500 companies who don’t know anything about cannabis regulations and how they apply to their business.

The best way to stay on top of those rules? Form relationships with your state program regulators. Here in Arizona, I am in constant contact with our regulators discussing nuances and new business concepts for which the rules are unclear, convoluted or simply silent. Working with the enforcers might not come naturally to many folks in the cannabis business, but we’re dealing with a new and evolving industry where there’s little or no business, regulatory or judicial precedent. We’re all in this together.

It’s exciting to be at the bleeding edge of a bold and booming new industry like cannabis, but to do so safely and legally, cannabis industry pioneers need to make sure they’re striking the right balance between daring innovation and sensible business security.

We shouldn’t expect Jeff Sessions to launch a new army of prohibition agents around the country to kick down doors of cannabis businesses. But it wouldn’t be a bad idea for cannabis entrepreneurs to start acting like he might.