CANNABIS TAX MANAGEMENT
Cannabis Tax Management – this article is the third of four articles that were prompted by the COVID-19 induced depression’s acceleration of the collapse of the cannabis industry. Our second article explained how the financial efficiency of store-front and delivery-only dispensaries is improved through operational and structural and changes to these businesses. In a depressed, highly competitive business economy, economic efficiency will be critical to long-term success. This article describes techniques for enhancing financial efficiency in the movement of cannabis from cultivator to consumer.
For reasons we have already described, we will focus on the issues facing California cannabis businesses. Qualified legal and accounting professionals can readily adapt our approaches to California’s cannabis laws and regulations for other jurisdictions. We must emphasize, as we have on other occasions, our deliberate use of the adjective “qualified.” The cannabis industry in California and elsewhere has been given far too much advice from individuals who willfully opine above their level of competence.
The most tax-efficient structure for converting raw materials into thousands of units for retail consumption is mass production through a vertically-integrated business structure in which the profits generated from the retail products are subject to a single level of tax. Some raw materials more easily convert into consumer products through vertically integrated structures than others. The conversion of cannabis as an agricultural commodity into units for retail sales does not easily fit into conventional business models. As a consequence, business planning for the movement of cannabis from cultivators to consumers presents serious challenges.
Cannabis Tax Management
Business planning for the cannabis industry is particularly challenging for two reasons. Cannabis businesses are criminal activities under federal law, and cannabis legalization involves comprehensive regulation by state and frequently local governmental agencies. California’s regulation of cannabis is particularly complicated because, in most instances, cannabis businesses have to address comprehensive local regulation in addition to state-level control.
In some cases, there are both city and county regulations in addition to the regulations imposed by the State of California. In any such instances, cannabis businesses must comply with three sets of regulations.
In addition to being a highly regulated industry, cannabis businesses are invariably subjected to special tax regimes. Legalization in California was accompanied by the enactment of a Cannabis Cultivation Tax (“CCT”) and a Cannabis Excise Tax (“CET”). The Legislature also authorized the imposition of special taxes on cannabis by local governments. Similar to the regulatory complications, cannabis businesses are frequently subject to special local taxes imposed by both counties and cities in addition to CCT and CET imposed by California. It has always been our opinion the adage, “Be careful what you ask for, you may get it.” is aptly applied to California’s legalization of cannabis.
Consumers pay directly or indirectly, all of the costs of cannabis regulation. Consumers also pay directly or indirectly all of the taxes imposed on cannabis and cannabis businesses. Taxes on cannabis are recovered from consumers either as an addition to the cost of the cannabis at the point of sale or as part of the purchase price of the product. CET is collected from the consumer at the point of sale; CCT is included in the purchase price. Local taxes are usually collected through both of these methods. The costs of the regulation of cannabis and cannabis businesses are recovered from consumers as part of the cost of the product.
In most instances, taxes will represent 25%-45% of the total amount a consumer pays for cannabis, and the costs related to regulation will represent 2%-5% of that amount. From the perspective of a consumer, in most instances, 30%-50% of the total amount a consumer pays for cannabis in a legal sale in California is supposed to find its way into the coffers of a tax agency. The taxes imposed on legal sales of marijuana in California, of course, are one of the reasons California will have a substantial underground cannabis industry for the foreseeable future.
Cannabis Tax Management
As a commodity, cannabis is not easily converted into units for retail sales to consumers through conventional arrangements for mass production. The ownership and operating structures that are most financially efficient for the mass production of consumer products from a commodity such as tomatoes are not well suited to cannabis. Cannabis is most efficiently grown in relatively small batches. State and local regulations relating to the ownership and operation of cannabis businesses also complicate the selection of ownership and operating structures. The special taxes imposed on cannabis, as well as Internal Revenue Code (“IRC”) §280E, add further complexity to the selection of structures for the ownership and operation of cannabis businesses.
Before the passage of Proposition 64 [See “Implementing Proposition 64: Marijuana Policy in California”], the most financially efficient structure for the movement of cannabis from cultivator to consumer in California was a limited liability company (“LLC”) reporting for income tax purposes as a grower-owned partnership through which cannabis was sold directly to consumer/members. The use of this structure in California was based on Proposition 215 [See “Keeping Proposition 215’s Promise”], which legalized medical cannabis in California in 1996. Various legal entities were used to operate under Proposition 215 to facilitate the use of cooperatives and collectives for the organized distribution of medical cannabis in California before Proposition 64.
Some variation on a limited liability company reporting as a partnership, which is a pass-through entity for income tax purposes, and which is vertically integrated from cultivator to consumer, is likely to be the most financially efficient structure for the ownership and operation of cannabis businesses in states other than California. Such an arrangement is no longer the most financially efficient structure for the movement of cannabis from the cultivator to a dispensary in California. A Cannabis Cooperative Association (“CCA”) is now the most financially efficient structure for the ownership and operation of business operations that move cannabis from cultivators to consumers in California.
A CCA is a special form of corporation enabled for the benefit of cannabis cultivators as part of Proposition 64. A CCA is more financially efficient than a pass-through limited liability company, although the effective use of such a structure is not intuitive. [“CCA’s Create Profits”} Qualified professional advice is critical for the use of a CCA.
A CCA is the equivalent of incorporated agricultural marketing and processing cooperative. CCAs were created by the California Legislature solely for the benefit of cannabis cultivators. Restrictions are imposed by statute on the ownership and activities of CCAs. These restrictions limit the benefits of using this unique form of corporation to cannabis cultivators. These restrictions make CCAs a little more challenging to use than general stock corporations or nonprofit corporations. These difficulties are easily overcome with qualified professional assistance, and the advantages of the utilization of a CCA more than justify the additional effort required to use this structure.
Cannabis Tax Management
A CCA can be a substantially more financially efficient vertically integrated structure for the ownership and operation of the cannabis businesses that move cannabis from cultivators to consumers than a limited liability company reporting for tax purposes as a partnership. We have already published multiple articles describing the advantages of a CCA over other business structures. [See CCA Advantage! ]
The financial efficiency of CCAs flows from the reporting for federal tax purposes of such organizations under Subchapter T of the Internal Revenue Code. For California income tax purposes, CCAs file corporate income tax returns utilizing one of three different forms applicable in California for income tax reporting for cooperatives. For California and federal income tax purposes, all of the business activities of a CCA are reported in a single income tax return. The California alternatives for a CCA depend on whether the CCA is an exempt or non-exempt cooperative for federal income tax purposes under Subchapter T. We earlier discussed income tax reporting for CCAs.
Unless and until IRC §280E is repealed as a special income tax burden imposed by the federal government on the cannabis industry, dispensary operations should be separately owned and operated from the other businesses that move cannabis from cultivator to consumer. The IRS has historically limited the application of IRC §280E to the retail sale of marijuana by dispensaries. The IRS has also been generous in allowing the reduction of gross revenue by COGS in the computation of gross income for dispensaries.
In 280E – NOT A PROBLEM! we explained how a dispensary could utilize IRC §280E to minimize the taxes imposed at the retail sale level. The separation of the ownership and operation of a dispensary from the ownership and operation of the business activities that move cannabis from a cultivator to a dispensary creates a clear demarcation of wholesale activities from retail activities for the purposes of IRC §280E. Such a separation provides a foundation for arguing that IRC §280E should not be applied above the dispensary level in those instances in which there is a clear demarcation between a distributor that makes a wholesale transfer of cannabis to a dispensary that in turn sells the cannabis products acquired at wholesale in retail sales.
Cannabis Tax Management
The analysis of the preceding paragraph exposes a flaw in the utilization of a micro-business structure in California to move cannabis from cultivator to consumer. The cannabis micro-business structure authorized under California law for small cannabis cultivators blurs any separation of wholesale and retail functions for IRC §280E. Utilizing a micro-business structure for the movement of cannabis from cultivator to consumer exposes such an integrated cannabis business structure to the possibility of a disallowance of ordinary and necessary business expenses under IRC §280E.
A CCA is treated in the same manner as any other vertically integrated structure. A CCA will utilize a distributor as the last transferor of cannabis to a dispensary in order to maintain a clear distinction between wholesale and retail for the purposes of IRC §280E. A CCA has an advantage over conventionally integrated ownership structures because the transfers from one business unit to another business unit within the CCA structure are treated as internal transfers for income tax reporting purposes provided the controlled business units within the CCA are treated as wholly-owned for income tax purposes.
CCAs were enabled by the Legislature for California’s cannabis industry because some individuals realized the importance of agricultural cooperatives for small farmers. As we pointed out in an earlier article, a significant portion of corporate business in the United States was founded on agricultural cooperatives. [See “CCA’s Good or Better,” CCA’s Create Profits, and “CCA’s Beat Underground” ] CCAs have been under-utilized to date, but we are confident this will change as part of the consolidation occurring in California’s cannabis industry. The economic pressure of the COVID-19 induced depression will likely accelerate this consolidation as well as the utilization of CCAs. Finally, see “Medical CCA’s 101.”
The business strength created for small growers by a processing and marketing cooperative is undeniable. The materials we have referenced in this article explain why CCAs are so financially efficient as operating structures. There is a third reason CCAs create an opportunity for individuals interested in financial success in California’s cannabis industry.
Cannabis Tax Management
CCAs are subject to the General Corporation Law of the California Corporations Code except to the extent these general provisions of corporate law conflict with or are inconsistent with the express provisions of the California Business and Professions Code (“B&P Code”) applicable to this unique form of corporation. Consequently, CCAs are general business corporations. CCAs have all of the rights, powers, and privileges of other California corporations except to the extent specific provisions of the B&P Code modify general corporate laws.
A CCA can own and operate a business other than a cannabis business. In general, a CCA can engage in any business activity in which another California corporation could engage. This aspect of a CCA appears to have been largely overlooked by the many advisers to California’s cannabis industry. We are confident the financial pressure of the COVID-19 induced depression will cause some to realize how this aspect of CCAs can be utilized in addition to taking advantage of the financial efficiency created by the use of Subchapter T for income tax reporting and the business strength inherent in an agricultural cooperative.