Cannabis Taxation – Reality Check
Cannabis Taxation – Reality Check – We spend quite a bit of time discussing taxes with business owners who are involved in California’s cannabis industry. We are appalled by the amount of misinformation that has formed the basis for business decisions and tax reporting by this group. We have yet to see a cannabis business owner that in our opinion was keeping financial records and reporting in accordance with best practices. The California Department of Tax and Fee Administration (“CDTFA”) bears a substantial portion of the responsibility for the misinformation as a consequence of its failure to proactively educate and inform. The first year of full regulation and taxation has been completed. We have not yet encountered a cannabis business owner who in our opinion filed an accurate tax return based on the financial records we believe are required for a licensed California cannabis business.
The misinformation comes from a wide range of sources. Unqualified consultants and advisors are a major source of misinformation. The sources of misinformation we find most troubling are inadequate announcements and explanations of CDTFA and other regulatory agencies. Cannabis business owners who were trying to do things right on numerous occasions have directed us to announcements and regulations that they misunderstood. Frequently these misunderstandings occur because agency announcements and explanations address only the simplest of issues. The inclusion of a disclaimer at the end of an announcement or explanation may be a required practice for a regulatory agency, but a disclaimer neither informs nor educates.
Let’s begin by addressing the commonly held belief that a cannabis dispensary should be structured as a California nonprofit corporation. Such corporations are frequently and erroneously referenced as tax-exempt organizations. California has two forms of nonprofit corporations – Nonprofit Mutual Benefit Corporations (“NPMBCs”) and Nonprofit Public Benefit Corporations (“NPPBCs”). NPPBCs are the form of corporation that should be utilized by a charitable organization because the assets of such a corporation are irrevocably dedicated to public benefit and cannot inure to the benefit of an individual. NPPBCs are for charitable organizations and educational institutions. NPPBC are subject to the jurisdiction of the California Attorney General. All further discussion in this article solely relates to NPMBCs.
An NPMBC was frequently the corporate form of choice for a California cannabis business, particularly for a dispensary. A decision to use an NPMBC was a poor decision for a California dispensary prior to 2018, and such a decision became an even worse decision in 2018. An NPMBC is supposed to apply for tax-exempt status with both with the Internal Revenue Service [“IRS”] and the California Franchise Tax Board [‘FTB”] in order to be recognized as a tax-exempt organization. In some instances, such an organization must register with the California Attorney General’s Registry of Charitable Trusts. It is prudent practice to check both of these repositories in addition to the California Secretary of State’s [“CASOS”] Business Search before becoming involved in such a business.
An NPMPC that has established tax-exempt status files a Form 990, or a variant, with the IRS if it has secured tax-exempt status. Exempt organization returns are available for inspection by the public. An NPMPC files Form 199 with FTB and Form SI-100 with CASOS.
A convenient resource to review the returns and additional information about a tax-exempt entity is Guidestar. If an NFPC does not have those tax returns on file, further inquiry is appropriate as there may be a problem.
If an NPMBC has not secured tax-exempt status, it is taxable by California and by the federal government in the same manner as a for-profit corporation. An NPMBC may use “tax-exempt” in its name or claim to be tax exempt, but an NPMBC that operates a cannabis business is fully taxable on its income. Such a corporation is also subject to the draconian provisions of IRC Sec. 280E which is a topic we have extensively addressed. The tax costs for a California dispensary that is utilizing an NPMBC become substantially greater in 2018 as a consequence of the Tax Court’s decision the case involving Harborside for its tax periods that ended in 2012, and of the restrictions on packaging, labeling, and testing promulgated by the Bureau of Cannabis Control [“BCC”] effective beginning in that year.
Let’s turn to another issue where misinformation has created unnecessary turmoil. The California Cannabis Collective law sunset on January 9, 2019. The sunset of this law and the sometimes overreaching attitude of the cannabis regulatory agencies created unnecessary confusion and turmoil. Proposition 215 is alive and well. It was preserved in Proposition 64. As a consequence of the sunset of the California Cannabis Collective law, a collective that is going to be involved in any way in commercial cannabis activities needs to establish a licensing arrangement. There are multiple options. We have discussed the procedure for converting a not-for-profit medical cannabis collective to comply with this change.
Let’s turn to another topic where the failure of cannabis regulatory agencies to provide guidance and a wealth of misinformation has caused turmoil. We have not yet seen a copy of a receipt issued by a California cannabis dispensary to a consumer in which it appeared to us that the dispensary “Got it Right” in connection with its collection of taxes. The failure of dispensaries to issue receipts to purchasers of cannabis that establish they properly collected and accounted for all of the taxes dispensaries are required to collect will ultimately prove to be fatal errors for many, if not most, California dispensaries. The failure of dispensaries to properly collect, account for and pay-over taxes is also the beginning of a trickle-down of inaccurate information relating to Cannabis Excise Tax (“CET”) that CDTFA has allowed developing.
How could CDTFA expect dispensaries to collect and pay-over to distributors the correct amount of CET unless it explained to both dispensaries and distributors on an integrated and coordinated basis the record-keeping and reporting practices and procedures that are required for dispensaries to accurately collect, report and pay-over CET to distributors, and for distributors to account for, report and remit CET to CDTFA?
It appears to us in some complex instances a dispensary could not be certain it was collecting the proper amounts of tax from consumers even if it tried. There are too many difficult questions that have not been answered. Do all or any local taxes (excise tax, gross receipts tax, and cannabis business tax) get added for the purpose of computing CET? Are all of these local taxes included in the tax base for computing Sales and Use Tax? How is the jurisdiction determined for Sales and Use tax for sales and deliveries through a delivery-only dispensary? If cannabis is delivered from one local tax jurisdiction to another local tax jurisdiction that has a different Use Tax rate than the first jurisdiction, which Use Tax rate applies?
CDTFA failed abysmally in its analysis of CCT and CET. As a consequence, CDTFA did not educate and inform its stakeholders on a timely basis. CDTFA appears at this late to not have tackled the difficult questions relating to how CCT and CET should be determined, reported and remitted. A number of cannabis businesses tried to get it right, but the inadequacies of CDTFA’s analysis and education have made it virtually impossible for even those who made a serious effort to get it right to do so. As CDTFA is well aware but seems to have forgotten, taxpayers invariably resolve questions in their own favor.
c A NPMBC is a legal entity incorporated in California and governed by the California Nonprofit Mutual Benefit Corporation law. It is established and operated for the benefit of its members. Groups of individuals or businesses seeking to advance a common goal will establish frequently utilize this type of corporation. For example, a homeowners’ association, a chamber of commerce, a fraternal society or a social club will frequently utilize an NPMBC as the entity of choice for the conduct of such activities. Two features distinguish an NPMBC from other types of corporations. The assets of an NPMBC can only be distributed to members upon dissolution of the corporation. An NPMBC can be established for any lawful purpose and is not limited to a charitable or public benefit purpose.