Cannabis Business Entities – Choose Carefully
To address all of the factors that go into selecting an entity, we would need a book that references books; however, here are some things to consider when setting up your cannabis entity, or for example, switching your mutual benefit non-profit corporation to another entity (as is regularly occurring in CA at present). You will need a knowledgeable cannabis attorney. We repeat, you will need a knowledgeable cannabis attorney working together with your CPA to get this right in terms of your legal and financial needs as an individual and as a business. Here, more than in any other circumstance, the advice you would normally receive from a tax or legal professional is counterintuitive when applied to the cannabis industry. Never mind the usual concerns that legal and accounting professionals must consider when deciding on the choice of entity, aside from the new tax laws, § 280E is the other 800-pound gorilla in the room. Due to the punitive nature of § 280E, tax liabilities can eliminate what would otherwise be a decent profit.
Imagine a cannabis startup where things don’t go well. The business ends up with a tax liability of $300,000 despite breaking even from a profit and loss perspective. This is not possible with a “normal” business, but this is a cannabis touching business that creates what we call “phantom income.” Sounds scary, right? You didn’t make any money, but you were disallowed so many deductions under § 280E that by the IRS’s calculations you had plenty of taxable income. So, they tax it. Say the owners decide to close its doors due to the excessive disallowance of deductions by § 280E that put them in the hole. The potential for these circumstances in the start-up phase of a cannabis business tends to lead tax advisors to suggest a C Corporation. The reason is, the properly implemented C Corporation may shield the owners of this money-losing business from personal liability for that $300,000 tax bill, as a C Corporation is treated as taxpayer separate from the individual shareholders. Pass-through entities (simple LLC, S Corp, partnership, sole proprietorship) may leave you holding the bag. While we offer no legal advice (we are not lawyers), it is important that those who advise you on entity selection take § 280E into account due to these unique circumstances.
Entity selection and the way assets are inserted into the entity to get it up and running may also have unintended consequences for spouses. A sole proprietor wife simply using an LLC to house her cannabis grow operation and funding her canna-business bank account (if she was lucky enough to get one) from her joint account with her husband could drag him into her potential § 280E tax liability mess and potential banking issues if they file a joint tax return. If you are thinking of getting married or are married filing separately and starting a cannabis business, you may want to evaluate the situation with your tax advisor and lawyer before you switch to married filing jointly.
Once again, no two instances are the same. As we mentioned earlier, if you are a Corporation in California, you are not subject to § 280E on your state tax return (you still are on your federal return); however, if you are a pass-through entity (LLC, S Corp, Sole proprietor, Partnership), § 280E applies. The opposite is true in various other states.
Let’s look at the characteristics of various entities:
First, understand that there is a difference between a legal C Corporation and forming an LLC that elects to be taxed as a C Corporation. The former provides specified legal protection in the state you are incorporated in and the latter gets you the tax treatment that we discuss here. We would need a lawyer to address the difference between an LLC taxed as a C and a straight up C Corp in each state, so we’re not going to go there. A C Corporation is a separate tax entity, meaning that the C Corporation first pays taxes at a flat rate of 21% (2018), and then dividends are distributed and are taxed at the owner level (this is called “double taxation”), generally as qualified dividends, at 0%, then 15%, then 20% tax rates as your income level rises. There is also the possibility of an additional 3.8% net investment income tax on top of the 20% if you are doing well. You can also be an employee of your C Corporation and pay yourself a reasonable salary subject to payroll taxes at the corporate and individual level, then pay ordinary income tax on your wages. You don’t need to have a firm grasp on these concepts, but your cannabis attorneys and CPAs should.
If you are looking to shield yourself from personal liability or grow into a massive corporation with investors, a C Corp may be the right choice. A highly profitable and expanding business that would put an individual in a high tax bracket, say making $700,000 and in a 35% tax bracket, may be better off as a C Corp, as it may be acquiring capital (by selling stock) to expand. A C Corp can also sell stock to an unlimited number of investors and have multiple classes of stock (an S Corp is limited to 100 investors and one class of stock). Also, note that C Corps can elect to be taxed as a passthrough S Corp. C Corps file IRS Form 1120 at the end of the year and must maintain many formalities to remain in corporate solution, such as meeting minutes. Normal C Corps can take Net Operating Loss deductions (NOLs) in bad years, but cannabis companies cannot due to § 280E. Remember, this is a broad overview; there are stacks of three-inch thick books on how C Corps operate, and most haven’t been updated for the new Tax Cuts and Jobs Act (TJCA).
Internal Revenue Code § 1202 – Partial Exclusion of Gain from Certain Small Business Stock.
Speaking of the TCJA and corporations, the 21% corporate tax rate rejuvenates IRC § 1202 which gives a potentially huge tax break to people (not corporations) who hold onto their C Corporation stock. If you plan to have a valuable business, there may be an advantage to be had by issuing your stock from a C Corporation. § 1202 has the potential to exclude 50% of your gain on the sale of the stock from capital gains tax if you hold your shares for 5 years and meet applicable criteria, such as it being a small business (assets less than $50,000,000) and not being on a laundry list of specified business types that need not apply (like accounting firms ☹).
If a start-up business is operated as an S corporation, the founders will not be able to convert the business to a C corporation in order to take advantage of Qualified Small Business Stock (QSBS) treatment for their previously issued stock. A corporation must be a C corporation when the stock is issued. Note also that stock acquired after the conversion of an S corporation may qualify as QSBS.
Sole proprietorships are risky if you are in the cannabis business. You have no limit to your liability and profits or losses and tax liabilities pass through to the first page of your individual 1040 return by way of Schedule C. If business loss exceeds other income, individual can carry forward NOLs indefinitely in a normal business, but we are talking cannabis, so once again § 280E bites you.
This is another pass-through entity which files IRS Form 1065 for information only – the partner’s distributive share of partnership income/ loss passes through to the individual’s return via Form K-1. The Operating Agreement dictates the terms of the partnership. There is unlimited personal liability for acts of the partnership or partner acting on behalf of partnership (joint and several liability). Partnerships dissolve upon death, bankruptcy, or incapacity of a partner, so it is a structure that is probably not a good choice for a cannabis company.
…you will need a knowledgeable cannabis attorney working together with your CPA to get this right in terms of your legal and financial needs as an individual and as a business.
S Corporations are pass-through entities that file Form 1120S. They must meet specific criteria to remain an S Corporation. Only individuals, estates, and certain trusts may be shareholders, so if you’re looking to get investors, you won’t be able to have a C Corp or partnership fund you. There are some formalities in having an S Corp, and you must run payroll and pay the owners a reasonable salary before paying any dividends (distributions). S Corps are traditionally used to reduce self-employment taxes that might otherwise be paid by a partnership or sole proprietorship turning at least a modest profit.
Loughman v. Commissioner – S Corporation Double Taxation – Oops!
In a 2018 Tax Court Memorandum Opinion (not precedent setting) regarding the case of Loughman v. Commissioner, an S Corporation felt the full burn of § 280E. The Loughman duo, owners and sole shareholders of a Colorado dispensary, paid themselves a salary for working in their business. Normally, an S Corporation deducts W-2 wages paid to employees and/ or owners performing services for the business. The Loughman’s were the only employees of their S Corp, and the IRS determined that § 280E disallowed deductions for a majority of their activities (trafficking) as employees/ managers of the dispensary. This caused the Loughman’s to be double-taxed. As the owners of the S Corp, the disallowed salary deductions created phantom income that passed through to their individual tax returns. Then, as employees, their W-2 wages were taxed and subject to Self-Employment taxes. They tried to argue before the Tax Court that they were discriminated against for being an S Corp; however, the court reminded them that they chose to make the election. Note that in a cultivation operation, the impact would not be as significant.
LLC (Limited Liability Company)
An LLC is statutory, meaning that it is not a tax entity as all the above are, but it is a status granted by the state that limits the liability of a sole proprietor, partnership, S Corporation, or an entity electing to be taxed as a corporation. An LLC with one member is typically a disregarded entity in the eyes of the IRS (a sole proprietor) and one with two or more partners is generally classified as a partnership.
Just remember that § 280E alters reality for any attorney or tax practitioner who is not well versed in the nuances of a state legal/ federally illegal cannabis business. They may be an expert in 99.9% of their field, but cannabis is often counter-intuitive and the devil is in the details.
Note: Choosing multiple entities is beyond the scope of this article.