Knowing the rules can help business operators reduce tax obligations
Trying to understand tax laws related to the cannabis industry can make one dazed and confused. It is critical to consider the right ways to structure the ownership of these businesses and know the tax rules in order to reduce the taxation impact for investors.
Here are a seven tips cannabis business owners should take into consideration when investing:
1. Be prepared to pay a high tax rate. Since all expenses, other than cost of goods sold (COGS), are disallowed, your effective tax rate will be high. In fact, the tax could exceed the gross profits, meaning your business could be losing money and you still have to pay taxes.
- Maximize your COGS. An often overlooked component is the additional Section 263A cost. This enables a portion of certain costs to be converted into inventory. When the inventory eventually gets sold, that’s called COGS.
- Understand how to allocate your expenses for COGS. There is guidance amongst IRS literature and tax court cases.
- Not all entities are the same. Because of basis rules, C corporations work better, tax-wise, than partnerships. Here’s why:
– Using a partnership vehicle to invest in cannabis could be a mistake because the “basis” rules do not work in your favor. High basis comes from income and capital contributions — it reduces your taxable income upon the sale of your partnership interest. Low basis comes from losses and withdrawals — it increases your taxable income upon the sale of your partnership interest. So the fact that non-COGS expenses are not deductible and cause a decrease in your basis is bad for your business.
– Your basis in a C corp is the amount of your investment. The basis does not change, despite the activities of the C corp, including when non-deductible expenses are incurred.
- Consider non-traditional business arrangements. Would your non-COGS vendors want to be co-owners with you? Maybe they do. Rather than having your business pay them without getting a tax deduction benefit, you may be able to offer these vendors participation in your venture if they forego payment. These vendors may want to swap their income for a profits interest in your venture — and there could be some upside for them.
- Diversify your businesses. Move away from just selling cannabis. For example, offer non-cannabis food and products, as well as therapy services. You might have some non-COGS expenses which could be allocated to non-cannabis products and services, which makes that allocated portion tax-deductible.
- Capitalize on investment opportunities. Can I invest with my IRA and defer the gains? Yes, you can buy cannabis-related stocks which trade in the marketplace. The stocks are C corps. Indirectly, real estate investment trusts — which rent out space to their cannabis tenants — are another way to invest in this industry.
Knowing the tax rules for allowing recovery of a portion of non-COGS expenses and structuring one’s investments are critical. An investor, working side by side with a trusted tax professional, can develop optimal strategies for minimizing taxes.
Peter Metz is a principal at the tax practice Grassi & Co. and brings more than 20 years of accounting experience to the firm. He has expertise in financial reporting, auditing, preparing financial statements, reviews, compilations, tax preparation and projections, forensic work and international tax compliance. He can be contacted at firstname.lastname@example.org