Cannabis businesses are already behind the eight ball when it comes to banking and the online marketplace, but tax laws represent a different type of struggle altogether. Taxes don’t have to be complicated though, so I recently sat down to talk with Steve Moskowitz and Liz Prehn with Moskowitz LLP to discuss what options cannabis businesses have and why it’s a good idea to seek legal advice for businesses selling cannabis products.
The company’s primary message states, “Don’t go it alone against the IRS; and tax court is no place to learn about paying back taxes.” Moskowitz said it’s all about using the tax code to your advantage.
26 U.S. Code § 280E-Expenditures in Connection with the Illegal Sale of Drugs
Since cannabis is still listed as a schedule I drug per the Controlled Substances Act, it’s illegal on the federal level, and some states haven’t even legalized it for medical reasons. The 280E tax code was created for businesses that sell illicit substances and products made from them, like cannabis. This type of activity falls under illegal trafficking technically, which is obviously not a favorable term used to describe an innovative industry revolutionizing the world at a rapid pace. Yes, illicit businesses still have to pay taxes, interestingly enough.
The U.S. Supreme Court ruled in 1961 that any income generated from illicit activity shall be taxed just like businesses doing legal work. Worse yet, they are treated differently and subject to rules unique to the drug industry.
What Cannabusinesses Can’t Deduct
Unfortunately, cannabusinesses often find they owe significantly more in taxes than other businesses not engaged in cannabis-related activity. 280E, while not specific just to the cannabis industry, bans cannabis businesses from deducting anything besides the ”cost of goods sold.” This means no common expenses deemed necessary by other business standards. “Per Section 162 of the Tax Code, a business that sells, grows, or produces cannabis cannot take advantage of this corporate tax deduction.”
Other industries can deduct business expenses like bank fees, advertising, employee wages, rent, office supplies; anything like these items that they spend money on to run their business. Not allowing these deductions can seriously affect your taxable income.
Because of the illegal status of cannabis on the federal level, even businesses operating in states where cannabis is legal are not safe. To impose this ordinance, the IRS must first prove the trafficking of an illegal substance took place, which is probably easy to do..You can be convicted for violation of the federal schedule 1 drug law, and then 280E applies to your business.
What Cannabusinesses Can Exclude from Their Taxable Income
Businesses in the cannabis industry can exclude the “Costs of Goods Sold” or COGS. These expenses are those considered direct expenses for creating goods. Cannabis grower COGS include labor costs of cultivating the plant, incidental supply costs like supplies and material, and the price paid for cannabis.
In 2015, the IRS released a more comprehensive list of COGS deductions allowed like rent and repairs associated with cannabis production activities. Cannabis retailers can only deduct the invoice price of cannabis that they purchase, and necessary costs used in the process of gaining possession of their cannabis inventory. Here is a simple chart that illustrates the difference in taxable income between cannasdbis businesses and traditional businesses after deductions.
|Non-Cannabis Business||Cannabis Business|
|Costs of Goods Sold||$650,000||$650,000|
|Deductible Business Expenses||$200,000||$0|
|Effective Tax Rate||37%||86%|
Figure 1. Example tax structure for cannabis business versus normal businesses ().
Even the most conscientious businesses in the cannabis industry are finding themselves the target of IRS audits. It seems those misfiling or not filing Form 8300 are the ones that the IRS is focusing on to flag them for violations of section 280E instead of charging them with drug trafficking offenses. This form is used to report the receipt of currency in excess of $10,000 in a 12-month period because it’s subject to IRS examination. While it’s nice that these businesses aren’t facing federal drug charges, it’s another contentious point that needs to be addressed.
Tax implications depend entirely upon the structure of your business and the locality you’re in. While edible companies are considered manufacturers and can deduct all of their costs in Colorado, grow facilities must have retail shops attached to deduct their cultivation costs.
2018 Signals a Shift in Tax Laws and Reform
First, tax attorney Elizabeth Prehn mentioned that 2018 is generally the first year for the Tax Cuts and Job Act created to reduce tax rates as well as modify credits, deductions, and policies for businesses and individuals. The depreciation benefits backdate to 09/27/2017. States are also setting up their own initiatives. January 2019 will usher in a new, untested tax season with unknown outcomes for companies in the cannabis industry.
Prehn noted that their firm was “in the business of keeping businesses in business” first and foremost. They work for their clients, many of whom are businesses in this uncertain landscape. Most of the people that they help had no idea that there were options to help protect their businesses from tax laws like 280E. Many of whom had no hope and thought that they would likely be closing the door on satisfying work after building companies that they created from the start.
Tax Attorney Steve Moskowitz acknowledges that there are thousands of people out there that don’t know there is help available and that is the primary message that he wants to get out to cannabusinesses. For the first time ever, what you do for a living directly effects how much you pay in taxes. You can make the same exact earnings as the person next door and end up paying more or less in taxes than they do based only on what you do for a living. There are winners and losers with the new tax laws. If you’re a business, the new section 199A gives you the opportunity to pay tax on just 80 percent of qualified business income instead of 100 percent and who wouldn’t choose that option?
It’s a given that there are rules, the tax process could never be simple. The laws are more restrictive if you are in what is called a specified business. Examples of this are lawyers and doctors. Here is the problem. Any business that uses their reputation to bring in clients is considered a specified business. Businesses want to avoid be classified as a specified business. The reason for this is that non-specified businesses have restrictions that are easier to avoid than specified businesses.
Section 199A benefits begin decreasing once your qualified business income exceeds $157,500. The next $50,00 has reduced benefits and they cease entirely after $207,500. If you’re married filing jointly than the income amount doubles to $315,000 with reduced benefits for the next $100,000. After that there are no benefits.
You get absolutely no benefits if you make over these amounts, which negates all of the positive aspects of reducing the tax rates for businesses but with appropriate planning these restrictions can be avoided.
A Solution to the Specified Business Category
A limited liability company or LLC is the legal entity created under state law to manage a business. LLCs can choose to pay taxes as an S corporation or a C corporation. In most circumstances, S corporations (S corps) have certain tax advantages if set up correctly and this is what Moskowitz suggests specified businesses do if their organization’s setup meets the requirements.
S corporations are referred to as pass-through entities because the owner’s profit and loss pass through the business to their personal tax returns. One significant contrast that differs partnerships from S corporations is that the owners are considered employees for tax purposes if they perform major services for the business. The owner is a shareholder and employee of the S corporation.
So, if you’re a specified business, you break it up into separate S corps that sell non-cannabis products to the customer, the part that doesn’t make it a specified business. From there it splits into other parts like selling t-shirts, the employees being leased, the record-keeping, etc. so that your other businesses qualify under the less stringent rules.
Let’s illustrate using the $1,000,000 profit from figure 1 above. If you’re merely a sole proprietor, then you get a deduction for the lesser of the 20 percent of profits which would be $200,000 or half of the W2 wages that you pay. Even in this position, you still don’t benefit from this law, and you must pay tax on 100 percent of the profit.
Its this person that can really benefit from the S corp status. As a sole proprietor you can’t pay yourself wages, but as an S corp, you can. Using the $200,000 example with the $1,000,000 in profit, say you pay double the 20 percent or $200,000 in wages which would be $400,000. Now you can take the lesser of the 20 percent ($200,000) or the 50 percent of the $400,000 in wages ($200,000). Now you pay tax on $800,000 instead of the $1,000,000 in profits.
Additionally, Prehn pointed out that as a cannabis business you can mitigate the damage incurred by the 280E with planning and setting up other entities to avoid the restrictions. To illustrate this, say you set up a box store where in one half of the shop you sell t-shirts and in the other you sell cannabis. The t-shirts that you sell aren’t subjected to the 280E. Before you couldn’t deduct any rent that you paid for the store, but now you can deduct at least the part of the rent allocated to t-shirt sales.
Disputing an Audit
What happens when you disagree with the figures that the auditor comes up with for how much of your rent that the IRS says you can deduct based on your t-shirt sales? Moskowitz says that you tell them you disagree and file a tax court petition.
There are only 19 presidentially appointed judges in the United States Tax Court. There are a backlog of cases and judges don’t want to see you in court, so you are likely to reach an agreement with settlement officers whom you meet with prior to meeting with an IRS attorney. Of course, consulting with tax attorneys like Prehn and Moskowitz makes it more likely that the agreement will be in your favor since they’ve dedicated their professional lives to tax law, they know the law, and negotiation is part of their professional lives.
Words of Advice
Knowledge is power may seem cliché, but Moskowitz said that most people are incredibly frustrated and think that there is nothing that they can do. As tax attorneys, they advocate for their clients and can take things so much further than an accountant or a CPA can. A CPA or accountant can’t go to court to advocate for your rights like an attorney can and you can only have attorney-client privilege with an attorney. The IRS has started calling CPA’s to testify against their clients more frequently. This privilege is critical when involved in a business that is still a federal crime.
As a professional in the cannabis industry, it’s a good idea to speak with attorneys like those at Moskowitz LLP who can educate you on the legalities of your tax situation and help you navigate the system. There is a good possibility that they could save you a considerable amount of money and a lot of headaches.
Moskowitz offers the legal and consulting services of Moskowitz LLP for any businesses that need help navigating the tax process. Don’t continue to stumble through the process, because of the question of legality of what you or your business are doing. Moskowitz was a CPA before he was a tax attorney, so he has extensive tax law experience. He’s worked for a firm representing Fortune 500 companies but found that he can make the most difference with all sizes of businesses smaller than Fortune 500 companies; where Moskowitz LLP stands to protect business owners from losing a lifetime of their work.
Moskowitz and Prehn counsel and present a well thought-out tax plan tailored for each individual client. The cannabis marketplace is growing exponentially, and business opportunities are plentiful if you do your research and understand the system. At a minimum, have that plan in place. It will make tax time a time to enjoy tax savings with what was described within this article and so much that was beyond the scope of it. Prehn emphasized that success is possible with planning and preparation.
Most of the new tax provisions of the Tax Cuts and Job Act were effective as of January 1, 2018, Prehn stresses that now is the time to consult your tax attorney. Especially for those that feel hopeless that are at risk of losing their businesses and their life’s work. People like Moskowitz and Prehn offer hope to those that have given up and think that they are stuck in the situation that they are currently facing.
CPA vs. Tax Attorney
They encourage consulting a tax attorney versus a CPA for several reasons. First, the training and philosophy are different between the two. As an accountant or CPA, your trained to be conservative. If there are two examples of case law and one says that you can’t deduct a certain item, the accountant will choose not to deduct it. The CPA will say that the law says you can’t deduct a particular item while the lawyer says, “ well, of course, we can deduct that and there’s even a case that says that we can!”
A CPA can’t go as far as an attorney can. Attorneys are your advocates and can go to court. They are trying to get the best deal possible for their clients.
Some things to remember:
- Let your tax attorney explain to you how 199A and 280E apply to your business!
- File your taxes and all of the necessary paperwork appropriately.
- Make sure that you keep accurate records all year long so that you’re not stressed and overwhelmed when tax season comes around. It also helps you keep an accurate picture of where you stand financially and how much in taxes you can expect to save.
- Consult an attorney if you have any doubt as to if what you are doing is illegal or you just don’t understand your tax situation.
These tax situations aren’t new phenomena, and adequate preparation can make tax time better for yourself and tax authorities. Just remember that lack of knowledge in this area can cost you dearly in both money and the loss of the business that you worked so hard to build.