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Tax Considerations for Cannabis Business and Investment

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The growing cannabis industry has piqued the interest of many business owners and investors who predict it could become a multi-billion dollar industry. Legal developments bolster this enthusiasm, as more than 30 states and the District of Columbia have thus far legalized marijuana for medical and/or recreational purposes.

Varying state laws, however, are slowing overall growth, and the biggest speed bump remains federal classification of cannabis as an illegal controlled substance.

Typically a company has the ability to deduct ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. However, Internal Revenue Code (IRC) Section 280E limits tax deductible expenses to only permitted cost of goods sold using the full absorption inventory method – applicable to producers/growers and/or inventory costing for distributors that are involved in the trafficking of illegal substances. Marijuana production and distribution therefore carry steep tax and business costs, as well as obvious legal risks. Yet bullish investors and entrepreneurs anticipate an eventual payoff, as all of 50 states are projected to legalize marijuana over the next decade and federal legalization is expected to follow. If this happens, it could lead to explosive market growth.

Despite this bullish forecast, proper planning must address the current federal prohibition to minimize immediate legal and tax exposure. Here are some areas to look out for.

Twice the Exposure

Under Section 280E, items that are not considered cost of goods sold related to operating a cannabis business remain non-deductible, including business insurance, advertising and marketing, executive, back office and sales salaries and related fringe benefits associated with these employees, certain rent and real estate taxes, professional fees, etc.

As an example, a marijuana businesses annual sales revenue is $100 and its costs of goods sold are $50, representing $50 of gross profit. In addition, the Company incurs $100 of other expenses in carrying on its operations. Economically the Company has a $50 net loss during the year.

However, due to IRC Section 280E the Company has $50 of taxable income, inasmuch as the $100 of other expenses remain non-deductible. Assuming an effective tax rate of 30%, the Company would have a tax obligation of $15 on an economical loss of $50, further reducing the Company’s assets available for continuing operations.

Separate Operations

If a company has two distinct businesses, and one is not subject to the disallowance under 280E, it is essential to treat each entity separately and business owners should consider having separate entities for each business line for legal and tax purposes. – This applies, for example, to a cannabis business that also wants to operate in the hemp-derived Cannabidiol (CBD) business which is legal under federal law.

In these cases, it is important for the companies to maintain separate books and records, and maintain strong internal controls so that each business operates on its own. Strong documentation is key to withstand federal scrutiny.

In instances where business lines could share common employees, paperwork must detail separate time and costs spent on each operation. The business lines should also not be co-located, or they may be deemed non-distinguishable from each other.

On the investor side, it’s important to understand the full scope of investment. This means reviewing all of the company’s revenue-generating products.

The investor should also assess whether strong management is in place, and if business leadership has significant industry experience. This is particularly important in the early stages of a business.

Bankruptcy Considerations

Contingency planning should include possible bankruptcy.

Because marijuana remains illegal under federal law, the government could seize company assets any time. This risk should be weighed before starting or investing in a cannabis venture.

Minimizing risk also can be expensive.

Insurance companies either are not interested in providing policies to marijuana entities, or coverage comes with premiums disproportionately high compared with other industries. An expensive policy could put a significant strain on the company’s cash flow needs.

Lack of Traditional Finance

Like insurance companies, major banking institutions shy away from businesses associated with the marijuana industry. Banks not only risk their reputation, but can lose their license for lending to a business selling federally illegal substances.

Business owners may approach local banks and credit unions. The New York State Department of Financial Services recently issued guidance to encourage lending to medical cannabis businesses.

However, lenders often limit the number of monthly transactions and amount of weekly deposits. As a result, marijuana businesses typically have significant cash on hand. This raises the risk of theft by external and internal parties.

It is therefore imperative that business owners and investors assess whether management has instituted robust internal controls to safeguard company cash.

The business should also have a strong security system, and ensure a designated employee counts the cash daily, reconciling it with receivables and expenditures. Suffice to say, the business should also conduct thorough employee background checks.

No One-Size-Fits-All

Business owners and investors should also review various business structures.

If a business plans eventually to go public, C-corporation status may be the best option. Investors should be aware that C-corporation investment will trigger a taxable event upon stock sale or dividend distribution, while pass-through entities will pay tax on their share of the partnership income, whether distributed or not.

States have different excise, sales, and use taxes, of course. These could all be significant determinants of corporate structure as well.

The right tax professional is an essential part of long-term planning. They can allocate the expenses appropriately to ensure proper application to Section 280E. They can also facilitate engagement with attorneys at the forefront of federal and state laws, and coordinate introductions with risk-tolerant investors looking to partner with business owners.

While the cannabis industry remains high risk, proper planning can help ensure long-term success if, and when, legalization occurs nationwide, and the market then booms.

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