Wrong Tax Election for a Cannabis Company Can Lead to Double Taxation
Oct. 22, 2018
In Loughman v. Commissioner, T.C. Memo 2018-85, the operators of a Colorado cannabis dispensary argued that for a cannabis dispensary operating as an S-Corporation, Section 280E discriminates against S-Corporation shareholders by double taxing income when shareholder salary is disallowed pursuant to Section 280E as a deduction from flow-through S-Corporation income and also included on the shareholder’s individual tax return as W-2 wages. Loughman argued that that Section 280E was discriminatory because S-Corporation shareholders were required to take a reasonable salary. However the Tax Court stated that the regime was not discriminatory, in that salaries that are not attributed to cost of goods sold (COGS) were not deductible. Most cannabis companies set themselves up as limited liability companies (LLC). Albeit the tax election for an LLC is flexible, if you don’t know how to set these companies up, you could be in for a surprise come tax time.
For a cultivator, most expenses incurred are part of COGS. This would include the portion of the owner’s salary that is used to cultivate. However, for a dispensary it gets a little tricky. For medical cannabis, it is easy to set up a company and implement the CHAMPS philosophy, of splitting a company that operates under one roof. Another strategy is to have a management company that owns the building and the assets of the Section 280E business and lease them back to the cannabis company. This would allow the cannabis company to take expenses for that it ordinarily could not take.
When dealing with a cannabis company, the profit of the company could be in hundreds of thousands, or even millions. Not to mention, if the company is set up as a flow-thru company, it cannot tax the Section 199A deduction. The reason is the business is federally illegal, not to mention the flow-thru would increase the taxpayer’s adjusted gross income (AGI) to a level that would preclude the deduction anyway. Therefore, the best way to set these companies up is as a C-Corporation. Tax is only paid at 21%, and the taxpayer would save several thousands of dollars in taxes.
In order to avoid double taxation to the shareholder, and using a modified CHAMPS philosophy, you can make a large portion of the owner’s salary deductible if you were to make it part of COGS. As the Tax Court stated in Loughman, salaries attributed to COGS are deductible. The problem is that most owners spend their time managing their company. However, if a store manager is hired, and the owner were to make themselves inventory manager, salaries, payroll taxes, and benefits to the owner would be deductible.
In order to accomplish this, a dispensary would need to section off an area within their dispensary to house the cannabis inventory. Conversely, if state law allows it, the owner can set up a management company and buy a warehouse to house the overflow of the inventory. The reason for this is that the dispensary would get their inventory cheaper if they were to buy in bulk. Whichever way the owner chooses, or state law dictates, the owner would clock in and out when they are acting as the inventory manager.
Not all owners materially or actively participate in their cannabis business. However, most software that tracks the cannabis from seed to sale, has an app available that can be downloaded to a smart phone or tablet, and the owner can manage inventory.
Under Section 280E, no expenses are deductible, and the gross profit of the cannabis business is the taxable amount. You need to get creative in order to deduct most expenses. In CHAMPS, the cannabis company was found to be running an ancillary business alongside of their cannabis company. A portion of the expenses were allowed in Tax Court, that were attributed to the non-cannabis business. Finding the balance can be hard, but not impossible. It just takes careful planning.