The Best and Worst Entity Structures under 280E

Introduction

Selecting the right entity is a set-it-and-forget-it move that can increase profits without necessarily changing revenue, procedures, or even cash flow.  And yet, most companies miss this high leverage opportunity, needlessly paying higher taxes, exposing themselves to legal risk, and dealing with audit issues, all because they chose the wrong vehicle and never fixed it.

It’s not their entirely their fault, though.  They don’t teach taxation in school, and they certainly don’t teach it for cannabis companies.  CEOs try to understand it more once they see that their biggest expense is tax, and that selecting the right entity structure can result in immediate and long-lasting tax benefits that can help grow their companies.

So whether you’re a seasoned operator looking to get your entity structure correct, or a start-up that never wants to overpay in the first place, this article will be a crash course in entity selection for cannabis companies.  We’ll explore the options, how to choose the best one, and see what to do moving forward.

So let’s start from the top by answering the most fundamental question…

What is an Entity?

Merriam Webster defines an entity as “a thing with distinct and independent existence.”  Your business can be made up of one-to-many entities, depending on the goals and functions of the business.  Each entity may serve a different purpose and fulfill a unique function.  A good entity structure will provide 3 main benefits: tax efficiency, legal protection, and audit defense.  A suboptimal entity structure will be lacking in one or more of these areas. 

Here are our main options:

• Sole proprietorships

• Partnerships

• LLCs

• C-Corporations

• S-Corporations

And here’s an overview of how each functions under 280E:

Sole Proprietorship

This is someone who owns an unincorporated business by themselves.  These structures offer pass through income and avoid double taxation.  The issue is that it forces the individual to file a Schedule C on their personal tax return, which flags them for audit.  This entity type also leaves the owner fully exposed to legal liability, and liable to debts if the business fails.  Overall, I generally don’t recommend this structure to anybody, especially cannabis operators.

Partnerships

These multi-owner businesses are treated as a separate entity from the owners.  Tax passes through directly to the owners based on the partnership agreement drafted at the inception of the business arrangement.  The tax return is reported on form 1065, and the K-1 is reported on the owner’s personal tax return.  From an audit and tax perspective, this is not a terrible choice.  The audit risk is lower than the sole proprietorship, since income is reported on Schedule E instead of Schedule C.  This is also a better schedule for tax reductions.  But from a legal perspective, partnerships are an absolute nightmare.  If a partnership exists, structure it as a multi member LLC to reap the tax benefits without dealing with the legal risk associated with this entity structure.

Limited Liability Companies

The IRS defines a Limited Liability Company (LLC) as a legal entity that "may be classified for federal income tax purposes as a partnership, corporation, or an entity disregarded as separate from its owner." 

LLCs can be owned singly or by multiple parties. 

When an LLC has a sole owner, it is by default considered to be a single member LLC (SMLLC).  This is an entity that is disregarded by the IRS and is filed directly on the owner’s personal tax return.

LLCs owned by multiple parties are taxed as separate flow through entities.  This means that they file a 1065 by default, but they can also elect to be treated as C-Corporations or S-Corporations for tax purposes. 

For tax purposes, multi member LLCs are great options, as you get the benefits of partnership taxation without the legal headache.

C-Corporations

A separate taxable entity in the eyes of the IRS, C-Corporations pay income tax on profits generated, while the owners pay tax on the dividends received from the corporation.  Since taxes are assessed on dividends, which are distributed from post-tax profits, a dividend received is effectively taxed twice: once on the corporation level, once on the personal level.

In general, C-Corporations are not ideal for companies looking to compensate owners with dividend distributions, which is a good deal of companies.  That said, cannabis companies tend not to be dividend heavy, so this is not an issue.  The audit risk is lower than Schedule C filers, and tax accumulated by the corporation is the responsibility of the corporation.  This is great for companies with high tax debts, as they can declare bankruptcy without leaving the owners responsible for delinquent taxes or harming their credit.  For taxpayers with heavy tax burdens, like cannabis companies, this is an excellent benefit.

S-Corporations

These are separate entities that pass income and deductions through to the owners on form K-1.  They protect owners from liability exposure, and generally are reserved for “small, simple businesses”.  This means that an S-Corp cannot have foreign owners, greater than 100 owners, or multiple classes of stock.  If any of those conditions are present, S-Corporation status is revoked.

The taxation from these entities is generally favorable, as the passive income generated from them is passive, preventing the 15.3% self-employment tax that general partnerships and Schedule C filers are subject to.  However, the IRS has been auditing these entities more often due to the reasonable compensation requirement that owners are subject to. 

Legally they offer liability protection, but also result in a host of limitations on financial flexibility.  Again, these are generally best for “small simple” businesses.  And in general, cannabis companies are not small or simple.

Entity Structuring for Cannabis Companies

When we take entity structuring to the cannabis industry, we must consider the implications of IRC 280E and 471.  Retailers encounter less favorable tax provisions than processors, manufacturers, and cultivators do.  This is because retailers, which I am defining as dispensaries and delivery companies, are considered “resellers”, and therefore are not allowed to capitalize indirect production costs under IRC 471-3.

Cultivators and manufacturers, however, are allowed to capitalize these costs under IRC 471-6 and 471-11, respectively.  This generally means they pay a lower effective tax rate than resellers.

So let’s go over some good and not-so-good ideas for each vertical in terms of entity structuring.

The Smart Entity Selection for Cannabis Retailers

Since resellers can’t capitalize indirect production costs under 471-3, they are forced to recognize inventory at cost.  That means they are going to have high gross margins, and for the purposes of 280E, a high tax burden.

I’m assuming that a reseller is selling a lot of weed, so gross margins in the multi-6 and 7-figure range are fully expected.  Profitability, however, is not as easy to attain for these businesses.  Since resellers fundamentally are selling commoditized products, they are forced to compete on market prices, which are not in their control.

In times of high prices, gross margin may not change much, but profitability will.  This is because operating expenses remain steady on a per unit basis, regardless of the sales price.  This means that when prices are high, they will sell products for higher prices, while maintaining operating expenses, effectively increasing profits.  In times of high prices, the pre-tax profits may even be enough to cover the tax bill, which will be relatively high due to 280E.

However, when prices drop, as we’re seeing lately, resellers really suffer.  They must sell for low amounts, and therefore realize low profits.  Those low profits, however, don’t provide any tax relief for cannabis resellers.

This exposes owners to high tax risk.  A year with no operating profits can still result in a 6-figure tax bill.  While a good year will hopefully result in some post-tax profits if everything goes smoothly.

This is why, for most resellers, unless they have an advantage that keeps them profitable even in hard times, I generally recommend them to structure the business as a C-Corporation.  This is because, if all goes wrong, at least the corporation is left with the tax bill, and not the owners.

The other thing is that the asset with the highest fair market value that a retailer has is usually its customer base and brand.  Loyal, recurring customers that will consume products, spend money, and refer their friends.  They represent a piece of the cannabis industry, and that piece of the cannabis industry is likely much more valuable than the financial assets of the company.

This is why cannabis companies are able to exit the market at large gains even when they have operated at losses for years.  They’re selling a piece of the market with their business.

This results in capital gains for tax purposes, which are taxed anywhere from 0-28%.  But capital gains can be excluded for C-Corps up to $10M.  That means that a retailer with a strong customer base can sell their business for large gains free of tax.

All of this is why I recommend C-Corps for most cannabis resellers.  And by the way, the deadline to elect C-Corp status for the year is March 15th.  As I write this, that is a month from now.  If you are incurring taxes from your cannabis business in your personal name that you can’t keep up with, you may want to get that squared away sooner than later.  Hint, hint.

Entities Structuring for Cultivators and Manufacturers under 471-6 & 471-11

In a vacuum, manufacturers and cultivators face a smaller threat of being crushed by a tax bill than resellers do since they are allowed to capitalize indirect production costs, but they tend to be larger operations than dispensaries are.  Pair this with 471-6 & 471-11’s capitalization flexibility, and we have a very different conversation when discussing entity structures for these verticals.  Given the fact that there are so many different ways to use these verticals, there is really no one-size-fits-all answer, and no general recommendation I can give.

Small edible kitchens, for example, may benefit from an S-Corps’ provision that can reduce self-employment taxes.  However, that same strategy would not make sense for a 10-room processing facility that pays owners in wages above the social security limitation.  A large indoor grow may use a C-Corp to reinvest profits, but it may want the flexibility of a multi-member LLC in the case of expanding operations and becoming an MSO.  And selecting an entity structure for that goal will vary depending on the business structure, ownership structure, current tax status, etc.

I can go on and on, but the answer remains the same: it depends.

I’ll just say this though: you almost always want to avoid using sole proprietorships or partnerships not structured as multi-member LLCs.

Furthermore, if an operator wants to structure a C-Corp, I’d generally not steer them away from this option.  That’s because C-Corporations tend to have the best “worst-case-scenario”.  The downside risk is low.  C-corps may miss out on some benefits in certain cases, but they are probably safe in most cases.

Multi-Entity Structure Considerations for Cannabis Companies

It’s fairly common now adays to see cannabis companies set up as multiple different entities, including intellectual property entities, real estate entities, management companies, and other types of non-cannabis divisions.  These entities ultimately combine to comprise the business as a whole.  Assuming the set-ups are legal and reasonable, the consideration for how to minimize tax across these consolidations is important to have. 

One thing to keep in mind is that C-Corps may not be good to have at multiple levels in an organization for 280E companies.  This is because earnings and profits transferred between C-Corps will result in dividends received, which are taxable to the receiver, and non-deductible to the distributing entity.  Normally this isn’t an issue, since related companies that share ownership qualify for the dividends received deduction, which neutralizes double taxation.  However, since cannabis companies are not allowed any deductions or credits, this provision is not allowed.  This means profits can easily be double, triple, or even quadruple-taxed before reaching the owner’s pocket.

Also, if there is an S-Corp in the structure, having a C-Corp may result in the termination of that entity’s Subchapter S status, since S-Corporations cannot be owned by C-Corporations. 

Therefore, if there is going to be S-Corporations used in multi entity structures, they should generally be the parent entities to avoid inadvertently converting to a C-Corp, and facing high taxation as monies flow through entities.

In general, C-Corporations are fine parent entities, while LLCs are good subsidiary structures.  For example, a cannabis manufacturing plant with an intellectual property entity can have both the plant touching business and IP entity structured as C-corps without facing heavy tax consequences (assuming arm’s length transactions).  However, if that same business owns multiple verticals along the supply chain, it should be careful not to have any C-Corporation subsidiaries.  Simply running those subsidiaries as LLCs will likely be optimal.

Conclusion

Obviously, there are a lot of considerations when selecting your entity structure.  The pros and cons must be weighed from different angles, including tax benefits, legal protection, and audit risk.  Some entity types are almost always suboptimal, like sole proprietorships and partnerships, but other entity types have different applications for different companies.

It will largely depend on your companies’ goals and what your end game is.  If you’re a retailer, it is likely wise to structure your dispensary or delivery as a C-Corp.  If you are a manufacturer or cultivator, you will have many options, and only one of them will be the best for you.

And if you are looking for help in structuring your cannabis entities for tax optimization, legal protection, and audit defense, then we would love to talk with you.  Just head on over to www.ourgreencpa.com and book a call with one of our CPAs to see how we can help.

Thanks for reading and I hope you got a lot out of it. 

Stay Smart,

- Jonathan Sussman CPA