In recent elections, Mississippians overwhelmingly voted to pass Initiative 65 legalizing medical marijuana. This paves the way for an entire new business industry to operate in Mississippi, creating opportunities for business owners, investors, and those who serve them. With businesses possibly being allowed to open sometime in the summer of 2021, it will be important for owners of businesses operating in the medical marijuana industry to begin planning.
The marijuana industry is one where there are a number of unique legal issues – tax, banking, leasing, insurance, etc. Most of these unique issues involve the conflict between state and federal laws due to the status of marijuana as a Schedule 1 narcotic under the Controlled Substances Act (“CSA”).[1] This conflict creates a situation where state law permits the sale of marijuana, but it is still prohibited by federal law. To date, the federal government does not appear to have any desire to pursue sellers of marijuana who operate legally under state law provided that the sales are not being made in a way that endangers public safety.[2] The purpose of this writing is to discuss some of the important tax and business law related issues marijuana business owners need to consider.
Income Tax Considerations
IRC § 280E
- 280E provides that “no deduction or credit shall be allowed for any amount paid or incurred in carrying on any trade or business” consisting of “trafficking in controlled substances” which are classified as Schedule 1 or 2 under the CSA. The result is that deductions are not allowed for any (1) trade or business, (2) trafficking, (3) a controlled substance.
As stated above, marijuana is classified as a Schedule 1 narcotic under the CSA. Further, the Tax Court has construed “trafficking” broadly as being “to engage in commercial activity – buy and sell regularly”[3] as well as “dispensing medical marijuana” pursuant to state law.[4] Certainly, a dispensary fits within these definitions. It is unclear how broad these definitions may reach to limit deductions to businesses which do not actually sell marijuana. There is limited authority on point. Since IRC §61 provides that income is taxable “from whatever source derived” and deductions are a matter of legislative grace, the Tax Court has held §280E constitutional.[5]
Cost of Goods Sold
Notwithstanding §§ 61 and 280E, only gross income is taxable rather than gross receipts.[6] As a result, businesses may deduct from their gross income their cost of goods sold (“COGS”). This is an important distinction for marijuana businesses. To the extent costs can be included in COGS, the business receives the effect of a deduction notwithstanding § 280E.
IRC § 263A deals with inventory costs which must be included in COGS, serving to broaden the types of costs which may be inventoried as COGS. However, § 263A states that “any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as described in this paragraph.” As a result, § 263A is inapplicable to convert expenses non-deductible under § 280E into COGS. Marijuana businesses must use rules of IRC § 471 to determine what costs are included in COGS. § 471 generally divides businesses between (a) resellers which only can include direct costs of acquiring inventory (the price paid for inventory plus any transportation or other necessary charges incurred in acquiring possession of the goods), and (b) producers which may include direct and indirect costs incident to and necessary for the production or manufacturing the goods sold.[7] We have previously written about the Richmond case addressing this issue.[8]
A recent tax question was created by the addition of IRC § 471(c) under the Tax Cuts and Jobs Act. § 471(c) allows a taxpayer with less than $25 million in revenues (other than a tax shelter and public company) to account for inventories according to their applicable financial statements or, if none, their books and records prepared in accordance with the business’ accounting procedures. The question this raises is whether marijuana businesses may include items in COGS more broadly under their “applicable financial statement” (which may be limited depending on why they are created such as GAAP based financial reporting to lenders) or their books and records. If so, § 280E may become a non-issue. Based on this, it is possible that the IRS will argue that COGS must be determined as per the § 471 rules in effect when § 280E was adopted which appears to be a position taken on other issues.[9] The Treasury Inspector General for Tax Administration has reported to the IRS that this issue should be addressed.[10] To date, the IRS has issued no guidance specifically addressing the interrelation of §§ 280E and 471(c). In the meantime, marijuana business owners should consider their exposure and risk tolerance in determining how to report COGS using § 471(c).
IRC § 199A
The Tax Cuts and Jobs Act provided that owners of sole proprietorships and pass-through entities are entitled to a 20% deduction for qualified business income (“QBI”). A discussion of the QBI deduction is beyond the scope of this writing. However, an important question arises with respect to marijuana businesses. Given the limitations of § 280E, can the owner of a marijuana business benefit from a QBI deduction?
As it relates to pass-through business entities, deductions are taken at the entity level. The QBI deduction is taken at the individual level of the business owner. This may lead to a distinction whereby the QBI deduction is available to marijuana business owners notwithstanding § 280E. Further, § 280E denies deduction or credit “for any amount paid or incurred.” Since the QBI deduction is not for any particular expense item, does the deduction “for any amount paid or incurred” as opposed to granted to put owners of applicable businesses on par with the newly enacted 21% flat C corporation income tax rate? As with § 471(c), there is no formal guidance as to the interaction of §§ 199A and 280E. Business owners simply cannot know whether what may appear a fair reading of the statutes will prevail or, alternatively, whether § 280E will be construed broad enough to eliminate a QBI deduction.[11]
Planning Considerations
Separation of Business Activities
In order to avoid many of the issues outlined above, taxpayers may seek to separate their business activities to limit application of § 280E only to the actual sale of marijuana. Other activities (counseling, non-marijuana product sales, delivery, business management, etc.) may be conducted through other entities. If this business separation is successful, otherwise disallowed deductions may be taken.
A number of cases have addressed this issue. In most cases, the taxpayers have lost with the Tax Court finding all activities of the broad enterprise conducted through separate entities to be covered by § 280E as “trafficking.”[12] At least one case, however, has been a success for the taxpayer in separating business activities.[13] In the CHAMP case, the taxpayer operated a community center for paying members suffering from debilitating diseases such as AIDS and cancer. The community center had an executive director with years of experience in health services and outreach programs, had multiple group meetings each week, one-on-one consultations, social events such as movie nights and field trips, etc. All of this was provided for a membership fee. For this same fee, the members also received a fixed amount of medical marijuana. Providing marijuana was only a small part of the overall business activities which allowed the Tax Court to find there to be two, separate trades or business. Only the marijuana sales business was limited by § 280E.
Choice of Entity
As with any new business, marijuana businesses will need to consider what tax form to use. The basic choices include partnerships, S corporations, and C corporations. Many operating businesses operate as S corporations. A primary reason for this choice of entity is that business owners, after taking a reasonable salary, may distribute to themselves the rest of the business’ profits as a distribution free of self-employment tax. The problem for a marijuana business is that the “reasonable salary” portion is subject to being taxed twice at ordinary income tax rates. At least one taxpayer found out the hard way when the S corporation was denied a deduction for the owner’s salary due do § 280E; however, the owner was required to pay income tax on both the pass-through income earned by the S corporation as well as the reasonable salary received from the S corporation.[14]
Based on this, marijuana business owners may desire to operate in either a partnership or C corporation. Using a partnership formed as an LLC for state law purposes, it is possible that all of the partners will be subject to self-employment tax on all income of the business. Therefore, forming as a state law limited partnership and dividing ownership between the active general partner income and investment type income from limited partnership interests should allow for similar self-employment tax consequences as an S corporation.[15] Alternatively, after the Tax Cuts and Jobs Act, C corporations are subject to a flat 21% income tax rate. Given the lack of deductions available to marijuana businesses, it may be important to capture this lower rate. Combined with qualified small business stock benefits for C corporations[16], this may be a proper entity choice in some cases. In any event, it will be important to calculate tax consequences of these options in various alternative scenarios to make the best choice understanding that uncertainty about potential tax changes following recent national elections makes it hard to accurately calculate anticipated outcomes.
Asset Protection
As with choice of entity, all business owners should consider protecting their assets from third-party claims. However, some business owners are at a heightened risk. Certainly, business owners in the marijuana industry should exercise care in protecting their assets. Especially given that the sale of marijuana remains illegal under federal law, exposures are greater in this industry than other industries. This is for any number of exposures: (1) marijuana businesses are not able to file for bankruptcy protection since the U.S. courts cannot be used to assist in the sale of illegal assets[17]; (2) business owners could be pursued by the federal government resulting in the possibility of civil asset forfeiture, criminal prosecution, etc.[18]; or (3) business owners may be pursued for the acts of their customers similar to dram shop type liability applicable to sellers of alcohol.
A discussion of the various asset protection strategies available to individuals is beyond the scope of this writing. However, simple planning steps may be useful. Business owners should have sufficient insurance, operate through legal entities, and administer their businesses to benefit from those protections. Also, trust planning should be considered. Mississippi is a state that allows the creation of self-settled asset protection trusts which allow someone to place their own assets in trust, remain a beneficiary of the trust, and have the trust assets protected from creditors assuming the statutory requirements are complied with, no exceptions apply, and the trust was not funded through a fraudulent transfer.[19] Another planning option is to cover certain business risks with a captive insurance company when traditional sources of insurance are not available or are cost prohibitive. With various sources of potential liability, owners of marijuana businesses should consider how best to structure and administer their affairs for maximum protection.
Succession and Estate Planning
In any highly regulated business, succession planning is important. Although we do not yet know what restrictions Mississippi will place on transfers of interests in marijuana businesses, nor what requirements may exist to obtain a license to conduct such businesses, we know that limits will be in place. This makes it critically important that marijuana business owners work with their legal advisors to structure a workable succession plan. When there are business partners or others in business who can purchase interests at death, disability, or other events, buy-sell arrangements should be considered.
If assets will pass to beneficiaries through an estate, a number of issues arise. Of course, the successor will need to be able to hold a license under applicable state law (and this could include the executor of an estate, trustee of a trust, etc.). This may be limited by the age of the beneficiary, the state where the beneficiary resides, any prior criminal history of the beneficiary, or other factors. If any corporate fiduciary is involved, they may have reporting obligations under requirements imposed by FinCEN in certain 2014 guidance, including filing Suspicious Activity Reports and other paperwork. Also, given fears of aid and abetting violations of federal law or breaching fiduciary duties[20], many professional fiduciaries may refuse to serve if they would be required to hold marijuana assets. Therefore, special purpose executors and/or trustees may be needed to hold marijuana assets separate and apart from other assets.
Conclusion
Anytime there is an opportunity for a new industry to enter a state, considerations particular to that industry must be considered. With the unique legal issues for the marijuana business, there are a number of items to analyze as businesses prepare to open in 2021. Tax and related planning should be a big part of the process of opening any marijuana business. The IRS has recently opened a new website for the marijuana industry[21] as well as an FAQ.[22] Those resources are helpful and address a number of relevant issues. However, as described in this writing, there are many more, and often complicated, tax issues to be resolved. Following recent elections, there are 15 states which have legalized recreational marijuana and 21 states that have legalized medical marijuana for a total of 36 states legalizing the sale of marijuana in some form.[23] While not all of those states currently allow retail sales (in some, like Mississippi, the measures just passed in November 2020), lessons can be learned from the experiences of marijuana businesses in other states. It would serve marijuana business owners well to meet with their tax and legal advisors early to create the most beneficial plan.
[1] 18 U.S.C. § 801 et seq.
[2] See the “Ogden Memorandum” issued on October 19, 2009, by former U.S. Deputy Attorney General David W. Ogden advising U.S. Attorneys not to focus on enforcement against those who are acting in conformity with state law. https://www.justice.gov/sites/default/files/opa/legacy/2009/10/19/medical-marijuana.pdf Further, see the “Cole Memorandum” issued on August 29, 2019 by former U.S. Deputy Attorney General James M. Cole indicating the Justice Department would not enforce federal marijuana prohibitions in states where marijuana was legalized as long as states and local governments protected certain specifically identified public safety concerns. https://www.justice.gov/iso/opa/resources/3052013829132756857467.pdf But note that former Attorney General Jeff Sessions formally revoked this prior guidance on January 4, 2018. https://www.justice.gov/opa/press-release/file/1022196/download
[3] Californians Helping Alleviate Med. Problems, Inc. v. Comm’r, 128 T.C. 173, 182 (2007) and Alternative Health Care Advocates v. Comm’r, 151 T.C. 13 (2018).
[4] Olive v. Comm’r, 139 T.C. 19 (2012).
[5] Northern California Small Business Assistants, Inc. v. Comm’r, 153 T.C. 4 (2019), but note that 3 judges of the Tax Court disagreed finding § 280E to constitute an excessive fine in violation of the Eighth Amendment.
[6] See Doyle v. Mitchell Bros. Co., 247 U.S. 179, 185 (1918); Rodriguez, T.C. Memo 2009-22; IRC § 61(a)(3), Treas. Reg. § 1.61-3(a); and CCA 201504011.
[7] See Patients Mutual Assistance Collective Corporation v. Comm’r, 151 T.C. 176 (2018); Richmond Patients Group v. Comm’r, TC Memo 2020-52; Treas. Reg. § 1.417-3; and CCA 201504011. For a detailed discussion of inventory accounting for marijuana businesses, see Madison, Christopher J., Inventory Accounting for Cannabis Businesses: Section 280E and the Impact of Tax Reform, The Tax Advisor, August 1, 2018, https://www.thetaxadviser.com/issues/2018/aug/inventory-accounting-cannabis-businesses.html.
[8] Allen, Charles J., Tax Court Denies Deduction for Business Expenses of Operating a Marijuana Dispensary, May 21, 2020, https://esapllc.com/richmond-280e/.
[9] CCA 201504011.
[10] https://www.treasury.gov/tigta/auditreports/2020reports/202030017fr.pdf
[11] See Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Comm’r, 151 T.C. 11 (2018) for a case where a very broad interpretation of § 280E caused a taxpayer to lose substantial deductions.
[12] See Alternative Health Care Advocates v. Comm’r, 151 T.C. 13 (2018) (separate employee leasing entity deemed to be “trafficking” when its employees engaged in purchase and sale of marijuana even if for a separate business entity); Olive v. Comm’r, 139 T.C. 19 (2012) (single trade or business where other services (movies, yoga classes, snacks, counseling, etc.) all complimentary to marijuana sales and not charged for separately from sales of marijuana); Canna Care, Inc. v. Comm’r, 2015-206 (where the sale of t-shirts, books, and hats, to be merely incident to marijuana sales and not a separate trade or business, especially where the taxpayer could not prove amount of income from these sales); and Patients Mutual Assistance Collective Corporation d.b.a. Harborside Health Center v. Comm’r, 151 T.C. 11 (2018) (many services or products provided at no separate costs to customers and using the same staff, bookkeeping, systems, etc.; also, for sales of non-marijuana items which constituted 25% of sales, they were only available in the restricted part of the store where marijuana is sold, using the same employees, within the same legal entity, and other factors).
[13] Californians Helping Alleviate Med. Problems, Inc. v. Comm’r, 128 T.C. 173, 182 (2007) (“CHAMP”).
[14] Loughman v. Comm’r, TC Memo 2018-85.
[15] See IRC § 1402(a)(13) exempting distributive earnings allocated to a limited partner to be exempted from the calculation of self-employment tax.
[16] For a discussion of qualified small business stock tax benefits, see Edmondson, S. Gray, A Refresher on Qualified Small Business Stock, August 1, 2019 https://esapllc.com/qsbs-2019/
[17] In re Way to Grow, Inc., 210 B.R. 338 (D. Colorado 2019); and In re Basrah Custom Design, 600 B.R. 385 (E.D. Mich. 2019). See also Garvin v. Cook Investments, NW, SPNYW, LLC, 922 F.3d 1031 (9th Cir. 2019), where a lessor to a marijuana business was able to obtain bankruptcy protection.
[18] See supa note 2.
[19] Mississippi Qualified Dispositions in Trust Act at Miss. Code Ann. § 91-9-701 et seq.
[20] Among other concerns, see Restatement (Third) of Trusts § 72 providing that a trustee has a duty not to comply with trust terms which are “unlawful;” Uniform Trust Code § 404 that a trust may be created only “to the extent its purpose are lawful;” 21 U.S.C. § 854 making it unlawful to invest income from illegal drug activity in any enterprise engaged in interstate commerce.
[21] https://www.irs.gov/businesses/small-businesses-self-employed/marijuana-industry
[22] https://www.irs.gov/businesses/small-businesses-self-employed/marijuana-industry-frequently-asked-questions
[23] Williams, Sean, A State-by-State Look at Where Marijuana is Legal, Nov. 7, 2020, https://www.fool.com/investing/2020/11/07/a-state-by-state-look-at-where-marijuana-is-legal/
