By Bernard Chamberlin
The online version of Merriam Webster’s dictionary defines the word “optimize” as “to make as . . . effective, or functional as possible.” Certainly, one way to make a business structure more effective or functional from a financial perspective includes taking steps to lower the tax expense associated with the enterprise. While the tax-planning playbook for the vertically integrated marijuana enterprise has not yet been written, the tools of traditional tax planning suggest the approach described in this article.
A Systematic Approach
Step 1: Identify the business activities that make up the enterprise. This step is important because each business activity is likely to present different planning opportunities and challenges. For example, a grower might find a dispensary is willing to take delivery of its inventory at the grow site. In that case, the dispensary may be able to deduct transportation expenses the grower cannot.
Another example would be the consulting business engaged in activities prohibited under federal law (i.e., trafficking in marijuana). Such a business could be operated through an employee-owned tax partnership (e.g., a limited liability company taxed as a partnership). By being structured without payroll expenses, the consulting business would expect to significantly limit the impact of IRC 280E on after-tax profits.
What is a business activity for purposes of this initial step? A business activity for this purpose is generally the most limited set of activities that includes both income and expenses, could theoretically be sold or transferred to another person, and could be operated by that person for profit.
Step 2: Identify stakeholders of the enterprise and their tax priorities. Different owners or employees may be involved, or may wish to be involved, in different business activities. Where this occurs, tax opportunities and pitfalls should be considered.
A tax opportunity that may arise is the identification of a business activity not subject to IRC 280E. For example, expenses incurred as part of a business activity are less likely to be subject to IRC 280E if the ownership or management is different from that of affiliated trafficking business activities.
An example of a pitfall is failing to account for the personal liability concerns of outside investors for business taxes. It should go without saying that it is wise to protect outside investors from unexpected personal liability. A common securities law disclosure states that IRC 280E will disallow deduction of all or some ordinary and necessary business expenses of the enterprise. When faced with this disclosure, many outside investors choose business structures that reduce their chances of being individually responsible for business taxes of the enterprise.
Another pitfall is inadvertently saddling a key employee with unexpected income tax liability. Employees are sensitive to unexpected personal liability for taxes. In non-marijuana industries, it is not unusual to compensate a key employee with an interest in the business. Like other forms of equity compensation, the hope is the employee will be incentivized to work hard for the success of the business. However, an employee of a marijuana business is unlikely to be motivated if she discovers her expected income is offset by outsized personal tax obligations.
Step 3: Group business activities by IRC 280E-related type. Business activities within the vertically-integrated marijuana enterprise may be categorized by IRC 280E-related type. Each type presents specific challenges, and opportunities. There are four major types, which may overlap: businesses with production activities that have significant nondeductible expenses under IRC 280E; businesses without production activities that are subject to IRC 280E; businesses that consist solely of the passive holding of assets; and businesses that include no activities prohibited under federal or state drug law.
Benefits of treating businesses differently by type include obvious benefits such as identifying opportunities for increased expense deductions, avoiding unintended income duplication, and capitalizing on opportunities to be responsive to investors’ comfort levels with tax issues.
Step 4: Consider transitional challenges. More often than not, a new vertically-integrated marijuana enterprise will be made up of one or more pre-existing business activities. A failure to take into account the tax characteristics of existing businesses can lead to unexpected consequences. Two examples are the desirability of existing accounting practices of the business activity and the ability of any existing business entity to change how it is treated for tax purposes (e.g., a limited liability company may or may not be eligible to be taxed as a corporation).
Step 5: Evaluate one or more business structures. Arriving at an entity structure for a vertically-integrated marijuana enterprise requires decision makers to make informed judgments. A decision maker must be mindful of the risks being taken on behalf of the business entity and its stakeholders, but should also be aware of the cost of opting for an approach that appears to be the simplest, or the safest. As in other areas of business taxation, there are few cookie-cutter solutions.
Step 6: Optimize important agreements to account for income taxes. An often-overlooked step in the business formation process is the optimization of important business contracts to account for deductibility of expenses. Such agreements should be optimized to account for the fact that IRC 280E may not affect both parties to an agreement the same way. For example, a company that licenses its technology and brand to a local producer may be able to deduct marketing expenses, whereas the local producer likely cannot. In such a case, a few changes to the licensing agreement can increase the after-tax profits of both parties.
Step 7: Monitor income tax expense monthly. Once the vertically-integrated enterprise is operating, monitoring its income tax expense monthly can save the business. It is common for a business activity subject to IRC 280E to develop significant differences between its financial books and its tax books. Thus, a business that appears to be profitable over a course of months may in fact be incurring mounting losses on an after-tax basis. Identifying an after-tax loss early allows decision makers to make necessary changes in a timely fashion.
The reason businesses engage in tax planning is simple: when a business enterprise controls its tax expense, it has more funds available to pay employees, reinvest in the business, and return to investors. Following an approach like the one described in this article may appear unnecessarily involved or complicated to some. It should not. It has more in common with the approach to tax planning taken every day in established industries than it does with the hope-and-pray approach that is unfortunately still common in the marijuana industry.
Bernard Chamberlain is a tax attorney with Emerge Law Group. He can be reached by email at firstname.lastname@example.org.