When it comes to tax planning for cannabis businesses, a superficial understanding of tax law is dangerous. Tax planning for cannabis business requires a deep understanding of federal tax law principles. Recent Tax Court decisions only confirm this fact. In this Advisory, we discuss one of those decisions and the erroneous assumptions on tax law that lead to it.
Under Federal income tax law, a reseller’s gross income equals gross receipts minus costs of goods sold. A reseller’s taxable income is its gross income minus allowed trade or business deductions. Section 280E of the Internal Revenue Code denies all trade or business deductions of a business trafficking in cannabis. As a consequence, a cannabis reseller’s gross income is also its taxable income.
Note that Section 280E applies to a trade or business, not a business entity. A single trade or business can be conducted by more than one business entity. So, breaking up your cannabis business elements into separate business entities may not mitigate the impact of Section 280E. Some business entity structures increase a cannabis business’s tax liability.
For various regulatory and financial reasons, cannabis businesses may have to be divided into separate business entities. For example, if a medical marijuana business must be conducted by a nonprofit corporation, the business will need other entities to manage or provide financing.
In many cases, folks used management companies. These management companies were formed as passthroughs (partnerships or S corporations) owned by the people organizing and financing the entities in the structure. The nonprofit paid the management company a fee for its services/capital. The management company used the fee income from the nonprofit to pay salaries and other expenses that were not deductible to the nonprofit because of Section 280E.
Unfortunately for the organizers/financiers of one of these structures, the Tax Court held that the management company was also subject to Section 280E. Since the management company was subject to Section 280E, none of the salaries paid to employees of the management company were deductible. Neither were other expenses. The S corporation’s taxable income was equal to the entire fee income. The taxes paid by S corporation shareholders on their S corporation income probably equaled or exceeded the net cash flow of the S corporation.
That case, Alternative Health Care Advocates, confirmed a belief we’ve held on business and tax planning for cannabis resellers and related companies. Simply dividing functions of a business into separate business entities does not necessarily mitigate the impact of Section 280E. If the entities are engaged in a common enterprise, they will likely be treated as engaged in a single trade or business.
Don’t despair, though. There are still options for legally mitigating the impact of Section 280E. It is essential, however, that every legal marijuana business be thinking critically about potential tax consequences and that decisions about entity formation, structure of the enterprise, scope of services, and capital raises, for example, be informed by a comprehensive understanding of the potential tax consequences.