3 Tax Traps Cannabis Startups Can Avoid
Intro
Starting a cannabis business can be an exciting and lucrative venture, but it's not without its challenges. One of the biggest hurdles for entrepreneurs in this industry is navigating the complex world of taxes. With constantly changing regulations and a lack of clarity from the government, many cannabis startups can easily fall into tax traps that could cost them significant amounts of money. In this blog post, we'll explore the three most common tax traps that cannabis startups face, and how proper cost accounting can help you avoid them and set your business up for success.
Misunderstanding 280E
It has been said that legal cannabis is the most heavily taxed industry in the United States, and for good reason. Under IRC 280E a business that sells marijuana cannot take any deductions or credits. Not some deductions or some credits. No deductions or credits. This generally means that cannabis businesses pay about 3 times the amount of income tax than normal businesses.
The only way to reduce taxable income is to claim cost of goods sold (COGS), since this is considered a “return of capital”, and not a deduction. And since COGS is recognized when inventory is sold, CEOs often seek ways to put expenses into inventory, maximizing COGS with each sale.
Unfortunately, it’s not as simple as putting all the expenses as inventory. The IRS has specific rules that must be followed for cannabis accounting. These rules are outlined in IRC 471, which states that a cannabis business must use GAAP Cost Accounting on their financial statements. This means keeping books and records that meet the accounting standards of the Financial Accounting Standards Board – the authoritative body of accounting standards in the USA.
In Harborside v. Commissioner Cir. 2012, we saw the behemoth retailer of medical marijuana attempt to claim business expenses as cost of goods sold. In tax court, the IRS won the position that the tax reductions were illegal, and Harborside owed back taxes and penalties of about $10 Million (not to mention the legal fees).
The general rule of the IRS is this: “if you can’t prove a tax position, you cannot take it.” So if you don’t have good books and records, you may end up not being able to reduce your taxable income at all. This is exactly what happened in Alterman vs. Commissioner Cir. 2018, where a mom-and-pop dispensary tried to take cost of goods sold without adequate books and records. The IRS said they couldn’t possibly prove any deductions in this way, and not only disallowed the tax reductions, but penalized them for underpayment of tax.
Since the IRS is winning court cases left and right against cannabis companies, recovering an average of $4 dollars for every $1 spent auditing these companies, it’s no surprise that a cannabis company is 5 times more likely to receive an IRS audit than any other business in the country. The desperation caused by this heavy tax burden has inspired many accountants and lawyers to attempt crazy entity structures and aggressive strategies to reduce 280E taxes. Not only are these strategies expensive to implement, but they invite IRS audits, which may disallow them entirely.
Operationally speaking, most CEOs don’t expect to immediately make a ton of profit in the current market. What a lot of them miss is that, after considering 280E, they will usually operate at a loss – and sometimes a big loss. This means that taxes cannot be paid with profits, but must be paid from invested capital. This alone reduces equity, and demands that more money is invested into the business in order for it to survive. This may make a cannabis business seem like a poor investment, but it’s not.
In my experience, the way entrepreneurs make money in this industry is by taking losses for 3-5 years (sometimes more), using invested capital to increase sales, winning audits by having rock solid accounting, and exiting the company at a bigger gain than they spent in tax.
For example, I had a client who operated in cannabis retail for 4 years at a loss before selling his business for a $600,000 gain. And since his entity structuring was optimized for taxation, he was able to take the entire capital gain tax free.
What follows is not only how to make sure your cannabis business is appealing to investors and compliant with governments, but how to avoid the common tax traps that otherwise great cannabis businesses fall into.
Erroneous Entity Selection
Every business is considered a separate legal entity from its owners. There are many different types of entities, all with different short and long-term implications. As a cannabis entrepreneur, you will hear about different strategies for setting up entities – some better than others. And there’s no one size fits all formula that works for everybody. A great strategy for one business can be fatal to another, so getting this right is a critical step in your startup’s journey.
The most common entity types for canna startups are generally multi member LLCs. These can be treated as C-Corp, S-Corp, or Partnerships for tax purposes. Each of these has their own pros and cons. The most popular selection for cannabis companies is the C-Corp. This is because they shield owners from tax debts and personal liability. However, C-Corps also incur double taxation on dividends paid out to owners. S-Corps and Partnerships avoid double taxation, but the taxable income passes through to the owners. And while S-Corps are less flexible than partnerships in terms of taxation, they offer the owners protection on their personal assets. Depending on how a partnership is structured, it may not offer that same protection to the owners’ assets. And while there are certainly many choices in type of entity, you also must consider how many entities are needed to structure your business for optimal results.
Here are some considerations when selecting an entity type and structure:
What are the company’s short and long-term goals?
What are the owner’s needs?
Are there multiple verticals or lines of business?
And while there may be incentive for you to want to reduce the heavy tax burden of 280E, legal cannabis remains a highly regulated industry. It’s not a matter of if you will get audited, but when. Therefore, to minimize exposure to audit risk, it’s generally best to err on the side of caution when selecting entity types and structures. That said, you will see and hear about unique entity structures used by various cannabis companies.
Here are a few of the most common ones I see:
Forming separate lines of business - cannabis and non-cannabis divisions
Utilizing separate entities for each deduction class
Using management companies for real estate and labor
The IRS has gone out to say that a cannabis business cannot form another entity simply to reduce income taxes. If an auditor walks into your dispensary, they usually don’t care if you made one entity for cannabis sales, another for clothes/merch, and another for your employees. They can say, “it all looks like a dispensary to me”, and subject each entity to 280E.
The exception to this rule is when there is a genuine reason for having separate entities. For example, if you grow weed in your basement, you may have a separate LLC to protect your home from legal and regulatory risk. That said, the LLC you made for your home has a bona fide business purpose, and so it may make sense to deduct certain expenses within the scope of that activity.
Another exception can be when your cannabis business has a material separate line of business. For example, Cookies has a large retail clothing brand, and treating that as a separate line of business is totally fair in the eyes of the IRS. However, if you run a dispensary that sells 100K of pot per month and only sell $1000 per month of merch in the reception area, the IRS will probably not allow you to treat that space as a separate business, and may penalize you for trying.
What the IRS has not allowed is the pervasive “management company” approach. This is where a cannabis business, often a retailer, will uses a separate LLC to pay its employees. The cannabusiness funds the management company, and the management company deducts wages paid. Despite the high legal and accounting fees to set this up and maintain it, this can seem like a nice way to get around 280E… but it’s a trap.
In Alternative v. Commissioner Cir 2018, the IRS stated that a management company used for a cannabis company is “incidental to the trafficking of marijuana”, and therefore subject to IRC 280E. In effect, the management company cannot deduct wages, and the management company must recognize the funds it received from the cannabis company as taxable income.
This results in not just 280E taxes, but double 280E taxes! If 280E has an average effective tax rate of 70%, this would mean that the management company can result in a tax rate of 140% or more! This is one of many examples of how aggressive entity structuring can go wrong, so be smart when considering your structure.
There is a risk when trying to reduce 280E, so consult with a cannabis tax professional to ensure you make the best decision and avoid any tax traps. And when in doubt, play it safe. The lowest amount of tax you can pay is the right amount of tax.
Not Being Audit-Ready
It used to surprise me when I heard a startup CEO say something like “hey, I saw you were a cannabis accountant! We are still pre-revenue but can we call you when we are operational and need a CPA?” Despite the fact that there are many transactions pre ops and that many contractors are utilized in the embryonic stages of a cannabis business, I gave them the benefit of the doubt. Afterall, accounting is often misunderstood to be a luxury service, exclusive for big businesses. And despite this being incorrect for virtually every business, it is especially dangerous thinking for a cannabis CEO.
When accurate financial records are not kept, the company must operate with financial blinders. This inspires uneducated decision making. But even worse is the fact that financial data becomes harder to track and record the longer it goes unchecked. And when the auditors ask about what happened during the early phases of business, and about substantiation for startup tax exclusions, rock solid financial records are necessary to defend the tax position. Naturally, companies must use accountants and bookkeepers to get them caught up, all while dealing with auditors demanding back taxes.
Therefore, the longer financial data goes unrecorded, the more work is needed to catch up, and the worse it gets. I call this accrued financial mess “invisible audit debt”, because you won’t see how bad it is until the auditors come knocking, and the cost of poor accounting will become very apparent.
Mature markets made this mistake early on, and some of them are still struggling to get financially current. I write this so that cannabis startups in emerging markets don’t fall behind in this way. Startup CEOs in mature markets are generally aware of this, but even so, I still hear about cannabis companies needing years’ worth of financial cleanup.
And even this assumes that a company would keep accurate financial records if it was keeping them at all. In reality, cost accounting for 280E is complex, and many accountant do not understand the ins and outs of it. Cannabis accounting is not the same accounting used by other legal industries. Seemingly simple tasks, like recording COGS, can often be a blurred line, making it easy for startups to make mistakes and consequently raise red flags with the IRS. It's crucial to maintain detailed and accurate records to substantiate your deductions by using GAAP Cost Accounting.
But the specter of IRS audits shouldn't cast a shadow over your cannabis startup. Rather than viewing these audits as formidable adversaries, perceive them as a chance to validate your startup’s tax compliance, reinforce financial practices, and bolster investor confidence. An audit can be a daunting experience, but it doesn't necessarily spell doom for your startup.
The IRS will scrutinize every document, every transaction, every deduction. Therefore, it's crucial to maintain impeccable records of your financial transactions. Any ambiguous or missing information can create an opening for the IRS to question your financial practices. Adopting meticulous bookkeeping procedures will not only simplify the audit process but will also provide valuable insights to help manage your startup's financial health.
Consider involving a tax professional well-versed in cannabis industry regulations and IRS code 471. Their expertise can help steer your startup away from potential audit pitfalls and ensure compliance with complex tax regulations. With their guidance, you can focus on what you do best - growing your cannabis business.
Banks and credit unions are often hesitant to deal with cannabis businesses due to the federal-state legal disconnect, making it even more critical to maintain accurate, organized, and compliant financial records. If a banking relationship is established, ensure all cash transactions are thoroughly documented. Avoiding large, suspicious cash deposits can help keep your startup off the IRS's radar.
Adopting transparent business practices, such as fully disclosing all income, can make your startup less of a target for audits. Don't attempt to cut corners or conceal income to save on taxes. The repercussions of such actions can be devastating, leading to heavy penalties and tarnishing your startup's reputation.
Remember, when it comes to IRS audits, prevention is better than cure. A proactive, organized approach to your startup's financial management can help ward off IRS audits and fortify your startup's financial foundation. Stay knowledgeable, stay compliant, and let your cannabis startup flourish, unhindered by the fear of IRS audits.
Conclusion
Understanding the common tax traps of cannabis startups and how to avoid them is critical in the legal cannabis industry. This will help you navigate the maze of 280E, set up your entities for success, and stay audit ready at all times. And now that you know how to avoid the common tax traps for cannabis startups, you are ready to learn about tax savings opportunities that please investors and auditors. In my next article I touch on just that, so stay tuned for more tax tips!
And if you’re seeking accounting solutions for your cannabis startup, reach out today and see how we can help you.
