Leveraging Legal Cannabis Tax Breaks: A CEO’s Financial Edge
Introduction
The blooming legal cannabis industry presents unique opportunities and obstacles. Innovating in this rapidly expanding market can be highly lucrative, but threats come from competitors and the federal government. In an industry defined by volatile prices and heavy tax burdens, capital dependent companies must compete for limited outside investments. CEOs that want to stand out to investors must present realistic expectations and efficient cash flow strategies, and one of the surest ways to safely improve financial performance is leveraging tax breaks.
My goal in this post is to reveal the best tax breaks for cannabis companies that CEOs can use today. These are all audit safe strategies that can make a massive difference in your bottom line. For operators seeking tax relief, this can help get you above water. For those getting ahead, this can increase your advantage. So if you’re ready to grow, buckle-in and let’s get tactical!
Understanding Cannabis Tax Laws – IRC 280E Made Simple
For those who don’t know, cannabis businesses must follow unique tax rules. This is because of the rule that governs the accounting and taxation of cannabis: Section 280E of the Internal Revenue Code – AKA. “280E”.
280E disallows cannabis businesses from deducting ordinary business expenses or claiming any credits on their returns. This tax provision is almost always levied on the federal level. However, some states don’t fully conform to 280E, offering potential relief for cannabis businesses in those states. Those states are referred to as “280E non-conformant states” – and there are about 20 of them as of this writing.
Please note, although the state income tax deductions allowed by 280E nonconformant states can help cannabis businesses reduce taxes on the state level, this generally offers no relief on the federal income tax level. So although our goal is reducing taxes entirely, state taxes are just one place we can look, and this area is often neglected. How to reduce federal income tax for cannabis companies is the questions everyone is trying to answer.
To illustrate the real impact of 280E, let's delve into the numbers…
An ordinary businesses makes $1,000,000 in gross profit and incurs $800,000 in operating expenses. Their profit before taxes is $200,000 ($1,000,000 - $800,000). This is also their taxable income. Assuming a corporate tax rate of 21%, that would result in an income tax of $42,000 ($200,000*21%). Profit after taxes would be $158,000 ($200,000 - $42,000). Not too shabby.
Here's why we work on the cannabis businesses’ terrible tax situation…
Let’s say the exact same business from the previous example was now subject to 280E. Here’s how that would look.
With a gross profit of $1,000,000 and operating expenses of $800,000, that business would have profit before taxes of $200,000, but their taxable income would be $1,000,000. Why $1,000,000? Because the deductions of $800,000 would be entirely disallowed under 280E. Assuming a corporate tax rate of 21%, their income tax would be $210,000 ($1,000,000*21%). Therefore, the profit after taxes would be -$10,000 ($200,000 – $210,000). A $10,000 loss.
So the normal business paid tax of $42,000.
The company subject to 280E paid $210,000. That’s a 5x increase.
The reality of 280E has lead many companies to try risky strategies to reduce cannabis taxes. The IRS has cracked down on these attempts, and has been winning court cases left and right against companies desperately trying to get around this terrible tax code. However, there are some strategies that the courts have agreed to, and that can help companies minimize the tax burden of 280E.
So although not every company can utilize every strategy I discuss here, I will outline who can. Some companies that try variations of these tactics will not win an IRS audit, so be sure to consult with your tax advisor before implementing any of these tactics.
That said, it is important for cannabis operators to take advantage of the tax breaks available to them, because by doing so, a cannabis company can save on tax where the competition isn’t. Having that extra money to reinvest in operations affords cannabis companies a competitive advantage over other CEOs in the space who don’t take action to reduce the 280E tax burden. Top of Form
So what are the tax breaks we can possibly take?
Identifying the Key Tax Breaks for Cannabis Companies
Before we get into the tax breaks for cannabis companies, we must define what a tax break is. And the answer is simple: something that lowers taxes.
Tax breaks generally do one or more of 3 things:
1) Reduce Taxable Income
2) Reduce Tax Payable
3) Reduce the Tax Rate
I will start by showing how most companies are dealing with 280E, then I will show some unique opportunities that most CEOs are not taking advantage of.
Let’s start with the most basic strategy, how to maximize cost of goods sold for cannabis companies.
The CEO’s General Method: Maximizing Cost of Goods Sold with Cost Accounting
We’ve discussed 280E, the reason why cannabis companies can’t take deductions at the federal level. But even though we can’t use deductions, there are ways to reduce taxable and get similar benefits to normal companies not dealing with 280E.
Cannabis companies don’t get deductions, but here’s the one tax reduction cannabis companies can take: Cost of Goods Sold (COGS). Since COGS reduces taxable income, finding how to increase cost of goods sold is the most common strategy employed by cannabis CEOs.
As we saw earlier, operating expenses are non-deductible. However, we can take those same expenses as COGS if our accounting is set up right.
For example, a cultivation’s farmer’s wages are considered a cost of goods sold. That’s because cannabis needs work done on it from seed to sale. That labor cost is “absorbed” into inventory. This is the cost absorption accounting method for cannabis companies. And when inventory is sold, we realize COGS in the amount that it cost us to make it. Therefore, when weed is sold, plant-touching wages are reported in COGS. So if the year’s direct labor wages were put into inventory/COGS, we may be able to write off those payroll expenses.
So from a tax perspective, COGS is better than operating expenses for a cannabis company. This is why many operators seek ways to put everything possible into COGS. And while this is a good intention, the IRS defines the limits of what cannabis companies can take as COGS. The rule is that the accounting methods must be consistent with GAAP Basis Cost Accounting. This is a fancy way of saying “don’t do anything crazy”.
This becomes fairly complex when we account for the fact that every business will have different processes and procedures. On top of that, there are different tax rules for all verticals in the industry. Those different rules are beyond the scope of this post. Just understand the general goal: Accounting and Bookkeeping to Maximize COGS.
So that is the basic strategy in a nutshell. Now let’s get into the fun stuff!
Possibly the Best Entity Selection for Cannabis Companies: C-Corporations
One of the first decisions every cannabis company must make is what their entity structure will be. There are many options, and no true one-size fits all answer. However, there are certain entity types that generally don’t work well in legal cannabis, and certain ones that tend to be best. Being deliberate and selecting the best option can give you a tax advantage over everyone who gets this wrong. The pros and cons of each entity is beyond the scope of this discussion, so I’ll keep this short and to the point.
The most common entity structure for cannabis companies is the C-Corporation, and this is for a few different reasons:
· Liability protection and separate taxation from owners – no tax in personal name
· Flat tax rate – 21% regardless of taxable income
· Possible exclusion of $10,000,000 on capital gains
The liability protection is a huge plus for the owners. This is because 280E causes cannabis taxation to be very high. With other entity structures, like S-Corps, Partnerships, and LLCs, that tax flows directly to the owners. As we saw earlier, a cannabis company can owe more tax than it can pay. If the owners are responsible for this, it can be problematic. Something that commonly happens is that somebody will invest into a cannabis start up or dispensary and be liable for their share of tax, even if there are no profits or dividends to pay the tax. With a C-Corporation, this does not happen, because the owners do not pay the tax, the corporation does.
The other nice thing is the 21% flat tax rate that C-Corporations get. Most businesses must pay the 21% tax rate on C-Corp profits, and then pay tax on dividends received at their individual income tax rate. This results in “double taxation”. However, most cannabis companies don’t pay dividends. The profit is generally distributed when the company exits, so the infamous “double taxation” is effectively eliminated.
Selling an investment for more than it costs is how cannabis companies get capital gains on exit, and this is usually when profit is realized. This is generally taxable as a capital gain. However, if the stock is from a C-Corporations, cannabis company owners can exclude up to $10,000,000 of capital gains. This often means no tax is paid for gains on exit.
In general, C-Corporations are the best entity structures for cannabis companies across verticals. They reliably reduce risk, protect assets, and tend to maximize profits. Unless there is a particular reason to use another tax vehicle, the C-Corporation tends to be the most tax-efficient.
Advanced Entity Structuring: Cannabis and Non-Cannabis Divisions
While separating cannabis and non-cannabis entities can be a great strategy for managing taxable income, it can be a tax trap if done incorrectly. Not every company has the opportunity to utilize this approach, but those that do can reduce taxable income while also adding some extra layers of protection.
There are instances where a cannabis plant touching business can make a real estate LLC. Under 280E, indirect expenses incurred in using real property are not deductible. So if your dispensary, for example, is paying for utilities, property taxes, repairs, etc, those would be disallowed.
However, cannabis is a volatile industry, and an operator may want to protect their assets from risk exposure. If a cannabis company owns property, they may set up a separate LLC to protect it. Then they could lease it to the plant touching business, and operate the separate real estate LLC as a legit second business.
This would result in two separate entities: the Cannabis Plant Touching LLC, and the Real Estate LLC. And real estate businesses are not subject to 280E, so they can deduct ordinary business expenses. This would include utilities, depreciation, repairs, property taxes, etc. There may even be staff to manage the LLC, and those wages can be written off too.
The reason this works is that cannabis real estate LLCs are made simply to avoid taxes, they protect and manage assets. This is often agreeable to the IRS. Discussing other types of non-cannabis entities is another topic for another time, but for now I just want you to see the audit-safe way to set up a non-cannabis LLC.
How Cannabis Company Cost Segregation Studies Can Rapidly Accelerate Depreciation
Real estate is one of the best investments for tax efficiency due to depreciation. But before we go into how to maximize this write-off, I just want to give a quick recap on how depreciation works for those who don’t know, or need a refresher.
Property purchases are considered capital investments – not deductions. Those asset, however, go through wear and tear over time. This aging is referred to as depreciation, and it is deductible. We write off depreciation over time, and different assets age faster than others. For example, furniture doesn’t last as long as land improvements do, and land improvements tend to depreciate faster than buildings.
In reality, real estate gains value over time. It appreciates. Despite this, we still get a depreciation write off for buildings. So while the investment appreciates, we get to take depreciation deductions on it. This is really nice, but it can be supercharged.
You see, the IRS has categorized assets into different classes based on their useful lives ranging from 3 to 39-year assets. 39-year assets depreciate over 39 years. That means you can write off 1/39th of the investment each year.
Commercial real estate is generally a 39-year asset, which means it gets written off very slowly. Not ideal. However, when you buy a building, you don’t just get a building – the price includes air conditioners, furniture, fixtures, land improvements, etc.; and those have shorter class lives.
Therefore, when we buy a building, we can separately identify each asset. Then we depreciate them separately from the building. This means we can get faster depreciation! How much faster? On average, after everything is broken out, we can write off an additional 20-30% of depreciation in the first year. For example, we would deduct an additional $200-$300K on a $1,000,000 building. And that’s on in addition to the depreciation we’re already getting. Big benefit.
This is achieved through cost segregation, and it’s one of the most powerful tax planning tools available to owners of real property. The tax benefits are generally enough in the first year alone to finance the cost study, and the tax benefits are ongoing. This frees up capital that would otherwise be locked in the building, and lets you invest it however you please.
A few notes:
1) The IRS requires a qualified engineer to do this. So it must be outsourced to either an accounting firm with a staff engineer or a cost segregation firm.
2) With IRC 280E, if there is not a separate real estate entity, the depreciation would need to be included in COGS. For cultivations and manufacturers, this is viable. In the case of a dispensary, this would be a poor strategy, as depreciation is generally not allowed to go into COGS.
3) This can be done retroactively or prospectively, with benefits differing on a case-by-case basis. Again, accounting methods have a large impact on tax outcomes, so consult with your tax advisor.
Unlocking State-Specific Credits: Tailoring Strategies for Regional Advantage
280E disallows traffickers of any controlled 1 substance from claiming tax credits, but generally, cannabis companies in nonconformant states can claim tax credits on their state income tax return. This will only apply to cannabis companies in 280E nonconformant states, but for those that meet that criteria, there are a host of different possibilities.
Every state has its own rules when it comes to taxation, but there are some general possibilities, and some state specific opportunities.
One state credit that is that is useful in the cannabis space is the Research and Development Tax Credit, A.K.A. the R&D Tax Credit. And while this is getting a lot of attention, it is still wildly underused for how helpful it can be. This is where a company that is engaged in the research and development of technological information gets a tax credit on expenses for activities that meet a 4 part test:
1) Purpose - The research must impart new or improved functionality, performance, reliability, or quality to a product, process, formulation, invention, software, or technique.
2) Experimentation - The activities constitute a process of experimentation with the intent to resolve the technical uncertainty through the systematic evaluation of alternate solutions.
3) Technological - The activity undertaken relies on the principles of “hard” sciences including physics, biology, engineering, chemistry, or computer science.
4) Eliminates Uncertainty - From the outset of the project, the development team must encounter technical uncertainty regarding the optimal design, methodology, or capability to achieve project specifications.
Expenses that qualify include wages, contractors, supplies, and data storage. Generally speaking, 25% of these expenses may be taken as a credit, and the R&D credit caps at $250K. For example, $500,000 wages can result in a $125,000 credit. That’s a dollar-for-dollar return. And any credits not used can be carried forward. The amount of time allowed for that varies by state. For example, in California, unused R&D credits can be carried forward indefinitely, while in Massachusetts, they can be carried forward for 15 years.
For companies that pay a lot in state taxes, this can be a game changer. And as you can see, the requirements are not entirely difficult to meet. Legal cannabis is a new industry in a lot of ways. So almost everything done to improve processes can qualify as research and development.
Nice opportunity for cannabis businesses in 280E nonconformant states.
And there are also some state specific opportunities, but they are constantly changing. For example, in California, there is currently the High Road Tax Credit. This is a credit for dispensaries and microbusinesses worth 25% of qualified expenditures, up to $250,000. And in Connecticut, the Angel Investor Tax Credit was available to investors who paid into cannabis companies. This was worth $25,000, but has recently been repealed after the state decoupled from 280E.
So even though 280E is rough on the federal side, cannabis companies can get state tax relief. State regulations are constantly changing, but opportunities may exist to reduce taxes, protect capital, and gain a competitive advantage. It’s often best to err on the side of caution, but doing this right can land you a nice state tax benefit.
Putting it All Together
We’ve covered a lot. Cannabis tax laws are tricky. While a lot of CEOs are managing 280E as best as they can, most companies neglect tax breaks that can substantially reduce federal or state income taxes. Leveraging tax breaks can unlock an audit safe competitive advantage that investors love.
The best financial systems in the cannabis industry use cost accounting to maximize COGS, minimize 280E, and stay audit ready. For extra protection and reduced taxes, the best entity structure for cannabis companies are C-Corporations, and some companies can further reduce their tax burden by separating cannabis and non-cannabis entities. The real estate LLC is a common choice for owners of real estate, and cannabis companies can reap substantial tax benefits with accelerated depreciation by taking advantage of cost segregation studies. And although every state has different tax laws, some 280E nonconformant states offer tax relief and tax credits to cannabis companies, namely the R&D credit.
It’s obvious that cannabis industry bears a heavy tax burden, but every cannabis plant touching business must follow the same rules, and the CEOs that manages their tax situation the best have the edge over those that don’t. It all starts on the financial side of things, and cannabis companies need strategic accounting designed to manage 280E if they want to secure success.
And if you want to streamline your cannabis tax accounting system, then it’s time to take action. Don't leave your financial success to chance—reach out to take control of your situation. Our team of cannabis trained CPAs are here to guide you. Whether you have questions about 280E, accounting, COGS, entity structuring, depreciation, credits, taxes, or compliance, our experts are ready to provide tailored solutions. Reach out today and book a discovery call to get started.
