By Ben Condon, CPA
Executive Summary
Executive Summary
Ben Condon, CPA, Founding Partner of BC Consulting, LLC walks through a hypothetical legal entity structure for a vertically integrated cannabis company and highlights the need for upfront tax structure planning in order to avoid disallowed expenses and plan for future growth, investment and sale.
One of the first questions every entrepreneur
should ask themselves when starting a new business is: "Which type of
legal entity should I setup?" In the cannabis industry, you should
ask yourself "Which types of legal entities should my businesses organize
to maximize tax savings?” Entities? Yes, plural.
Most of us are familiar with the common types of
entities: Limited Liability Companies (LLC), C-Corporations, S-Corporations, Limited
Partnerships, General Partnerships, etc. Due to IRC Sec. 280E, the only avenue for cannabis companies to recover their costs is through costs of goods sold (COGS), therefore it is necessary to employ multiple strategies including varied entity types. Costs such as sales, advertising, and delivery, commonly referred to as "SAD" costs, have no avenue to inventory/COGS. As a result, careful tax planning is necessary in order to absorb costs into inventory throughout the entire value chain.
In this post we will walk through an example of a vertically integrated life cannabis company founded by three individuals. The company will produce, process, distribute, and sell high quality cannabis products in addition to branded apparel and paraphernalia. The three founders are direct owners of Life Cannabis Company ("Life") which in turns owns three major subsidiaries: Licensed Cannabis Producer ("Producer"), Licensed Cannabis Wholesaler ("Wholesaler"), and Licensed Cannabis Retailer ("Retailer").
Life's functions will be various, however at no point will it engage in the trade or business of trafficking cannabis. Those functions will be reserved for the underlying licensed cannabis companies. Life will advertise and hold the intellectual property, lease personal and real property, perform management, procurement, supply chain/logistic, and finance services for the underlying companies, and be the holding company and investment conduit. This will allow investment into a single entity and allow founders to easily sell ownership.
Producer will cultivate cannabis and sell exclusively to wholesaler at an "arm's length" (fair market) price. Producer's non-cannabis supplies will be purchased from Life with a procurement fee added, Producer and each other underlying company will lease it's property from Life (whether or not Life owns its property or leases it from a 3rd party and subleases to Producer).
Wholesaler will purchased branded packaging from Life and then package cannabis purchased from Producer with this packaging. This allows Life, a non-cannabis entity, to deduct its advertising as regular cost of doing business, and also categorizes the cost to Wholesaler as part of inventory/COGS. Wholesaler will then sell the branded and packaged inventory to Retailer and other 3rd party licensed cannabis retailers.
Retailer's store will be more than a cannabis store, it will be an experience of the lifestyle portrayed by Life's branding. Only a small portion of Retailer's square footage will be dedicated to cannabis products, while the majority of the store will house non-cannabis, Life branded items. This will minimize the non-deductible expenses that are deemed sales/trafficking related and allow for a bifurcation of expenses between non-cannabis and cannabis business lines. The non-cannabis business line will be able to deduct expenses similar to any other business, further reducing the impact of Sec. 280E. (See CHAMPS v. Commissioner)
One important thing to highlight is that this structure allows for quick expansion as the intellectual property can be licensed and non-cannabis branded packaging can be sold across state lines to either 3rd party affiliates or to wholly owned licensed cannabis companies entities yet to be formed regardless of state.
The C-corp in this structure is necessary in order to create regarded tax partnerships at the cannabis business level in order to be able to have 3rd party transfer pricing. Without this, each entity would be a Single Member LLC under Life, and would be treated as divisions of Life; the operations of Producer, Wholesaler, and Retailer would consolidated and reported with Life's tax return. The inter-company transactions would be eliminated resulting in an increased Sec. 280E exposure.
In this scenario, we would advise that Life either become either a C-corp or S-corp in order to avoid Self-employment tax. This choice would not be cut and dry and would depend on various factors such as the state, tax situations of the individual owners, and fringe benefit desires of the owners among others.
In summary, there are many factors that require careful consideration, and the sooner the issue is addressed, the more opportunities there are to avoid Sec. 280E disallowed expenses and plan for future growth.
For assistance, email info@B-Cconsulting.com and visit BC Consulting website
