The IRS has made it daunting for an investor to make an after-tax profit in the marijuana business. Aside from the criminal laws, which are essential to know, trying to understand the tax laws can be a challenge. It is therefore critical to consider the right ways to structure the ownership of these businesses in order to reduce the tax impact for investors.
According to the IRS Office of the Chief Counsel’s Memorandum 201504011 (Jan. 23, 2015, http://bit.ly/2wBJ6Mv), businesses that deal in controlled substances, including marijuana, are entitled to deductions only on costs of goods sold. The Ninth Circuit affirmed the Tax Court’s opinion that IRC section 280E precludes a tax-payer from deducting any amount of ordinary or necessary business expenses associated with operation of a dispensary involved in trafficking in a controlled substance prohibited by federal law [Olive v. Comm’r, TC No. 14406-08 (2015)].
Taxation at the Operating Level
Since selling marijuana in any form is prohibited by federal law, the seller must pay taxes on the revenue less cost of goods sold; administrative, marketing, and other costs are not deductible. Marijuana could be considered a very high gross margin industry, perhaps close to 90% or higher; businesses require personnel, administrative overhead, sales agents, advertising, marketing expenses, outside professional services, and regulatory compliance costs. Depending on the numbers, it is quite possible for a business’s income taxes to be greater than its pretax income.
Exhibit 1 depicts a sample set of income/expenses, with an assumed 35% federal income tax rate. In this example, the effective tax rate on pretax income incurred by the owner equates to 116.67%, or a $35,000 tax on $30,000 of pretax income, because the $35,000 tax is based on $100,000 of taxable income. (Note that this ignores self-employment tax, as well as taxes paid by vendors on income received.)
Income/Expenses of a Marijuana Business
Depending on the numbers, it is quite possible for a business’s income taxes to be greater than its pretax income.
Several potential strategies exist to mitigate the tax burden for marijuana businesses. This article focuses on the most advantageous strategies for the ownership structure of a marijuana business. The cases below compare whether investors place personal or retirement funds into the investment vehicle that owns the marijuana business directly or indirectly.
Generally, certain investments can be held through retirement accounts, and certain investments cannot. How one invests in a retirement fund or what types of investments are made in a retirement fund can determine whether the retirement fund is undertaking a “prohibited transaction.” In addition, leveraged investments in retirement accounts, as well as trade or business income that is either not exempt or is considered as unrelated business taxable income (UBTI), could trigger taxation. At the moment, there are publicly traded companies involved in the selling of marijuana; based on that fact, it appears likely that IRAs and other qualified plans can invest in them. It is not known, however, whether they can invest in a limited partnership whose business is marijuana. If such an arrangement were exempt from UBTI, then it would seem to make sense that one could invest in an unleveraged partnership whose operating income was derived from marijuana sales, so that taxation would only occur at the ordinary rate upon distributions only, not upon business operations.
There would seem to be no restrictions as to which vehicle a U.S. citizen or trust can use to invest in a marijuana business. Popular choices for individuals include proprietorships, single member LLC’s, C corporations, S corporations, and partnerships. For trusts, the popular choices are C corporations and partnerships. Regardless of the vehicle used, however, the taxation of operating income does not allow any expenses other than costs of goods sold. From the perspective of operating income, the vehicle to invest in does not seem to matter, but there is still the basis rule to consider.
The Basis Rule
The general basis rule is as follows: when adjusted cost basis is increased, then either taxable gain is reduced or tax losses upon disposal of investments are increased. Exhibits 2 and 3 demonstrate how basis can affect the taxation of partnerships and corporations differently. Per IRS Publication 541, a partner’s adjusted basis decreases for “partner’s distributive share of nondeductible partnership expenses that are not capital expenditures.” In essence, partners receive no tax loss for non deductible expenses at the K-1 level and consequently recognize a larger taxable gain upon disposition of the partnership interest because of the lower adjusted basis derived from the nondeductible expenses.
Received Basis and Taxation, Partnership (Initial Investment: $100,000)
Received Basis and Taxation, C Corporation (Initial Investment: $100,000)
In Exhibit 2, the partner invests $100,000 of capital into the partnership and is in the 35% income tax bracket and 23.8% bracket for long-term capital gains. After two years, the partner has lost $20,000 and leaves the partnership, receiving $80,000 back in basis; he now has a $0 long-term capital gain on the disposition of his partnership interest and pays no capital gains tax. In addition to the investment loss, he has lost $17,500 to taxation and received a $4,760 tax benefit upon disposal, leaving him with $67,260 after taxes.
In Exhibit 3, the individual again invests $100,000, and both he and the corporation are in the 35% (income) and 23.8% (long-term capital gains) tax brackets. After two years, the corporation is dissolved; the investor has a capital loss of $37,500, which is essentially the same as a sale in this case. In summary, although the investor lost $37,500 through the business, he could recover $8,925 in tax benefits, for a total after-tax amount of $71,425. In this particular example, a C corporation is a more advantageous ownership vehicle than a partnership.
An investor working with a trusted tax professional can develop optimal strategies for maximizing after-tax cash flows within the marijuana trade while still complying with U.S. tax law.
Choice of Owner
Would it be advantageous for the employees and vendors of marijuana business to be co–general partners in the venture and be taxed accordingly? Exhibits 4 and 5 examine this scenario. In Exhibit 4, the employees and vendors are not co–general partners; every party is taxed at 35%, and Social Security taxes for vendors are assumed to have been paid in income earned elsewhere. With the separate taxation of partners, employee salaries, and vendors for rent, advertising, and administration, the total taxes incurred are $70,550, quite a large amount. Assuming a similar scenario where the employees and vendors are co–general partners, as shown in Exhibit 5, the total amount of taxes incurred by all parties ($44,020) would be significantly less.
Tax Analysis of Partnership with Employees and Vendors
Tax Analysis of Partnership Where Employees and Vendors Are Co–General Partners
Businesses that offer nonprohibited products and services believe that they can justify allocating a portion of expenses not attributable to costs of goods sold to these products and services. But this has been disproved; the court in the Olive case, as mentioned above, determined that selling marijuana and offering complimentary nonprohibited products and services did not create a second line of business, and as a result, all non–cost of goods sold expenses were nondeductible. A business must charge fees for the nonprohibited products and services in order to successfully deduct expenses; the court referred to the CHAMP case as a clear example (Californians Helping To Alleviate Medical Problems, Inc. v. Comm’r, 128 T.C. 2007).
As for the calculation of inventory and costs of goods sold, the “full absorption” method under IRC section 471 and the Uniform Capitalization Rules under IRC section 263A, is useful for marijuana business, as it presents the full picture of the business’s deductible and nondeductible expenses (and is also required under U.S. GAAP).
By considering the above and other tax considerations as an integral part of the ownership form and structure, an investor working with a trusted tax professional can develop optimal strategies for maximizing after-tax cash flows within the marijuana trade while still complying with U.S. tax law.