An essential part of establishing cannabis businesses is setting up a corporate structure and choosing a tax entity status. These strategic decisions are particularly challenging for companies in the cannabis industry due to certain financial and legal complexities, which are a function of cannabis’s federal illegality.
The risk inherent to operating a Federally illegal business has implications for the degree of personal liability an owner of a cannabis business may safely assume and the legal mechanisms to mitigate that risk.
As a result, some state-licensed businesses have not been able to claim deductions, and are taxed on their gross income versus their net income like all other “traditional” businesses. This is troubling indeed.
Choosing a Tax Status
A typical small business would choose to organize either as a corporation or as an LLC in their given State of operation. The company may further distill its choice to register as a:
- Sole proprietor
- Partnership
- S Corporation
- C Corporation
The tax return form that a company files annually depends on the choice of tax status. For a C Corporation, companies are subject to “double-taxation”; the company is taxed on its income at the corporate level through its annual tax return and the owners of that business are taxed again on their tax returns for any income received from the business.
This generally leads to a higher total tax liability than other tax statuses. Different tax entity types – sole proprietor, partnership, and S Corporation – are “pass-through entities,” which means that the company’s income is not taxed at the corporate level and instead, all income “passes through” to its owners.
Thus, the tax is only due to the business owner’s income. Despite the apparent tax benefits of pass-through taxation, a marijuana business may still decide that electing a C Corporation status is the safest option and one that will minimize personal tax liability.
Choosing a C Corporation status allows for the separation of personal and business tax liability, a feature that is desirable due to tax laws like the Internal Revenue Code Section 280E.
Section 280E prevents an entity from deducting expenses on its tax returns if they are associated with any “trafficking [of] a controlled substance.” Although cannabis is legal in some states, the IRS has decided that cannabis businesses and producers fall under that category.
Setting-Up Bank Accounts
Typically, cannabis businesses set up a second entity, independent of the primary one, solely to acquire a bank account. This separate entity may provide services, such as management, banking, and even lease assets to cannabis retailers.
This type of setup must be achieved under the guidance of an attorney who has experience drafting contracts between parties to prevent government accusations of money laundering.
A two-entity structure may also be desirable when a cannabis grower or retailer produces edibles, oils, vaporizers, etc. Here, these businesses are creating associated brand identities that they may ultimately sell or license for profit to other companies’ industries.
In this way, the “brand” can operate apart and distinctly from the cannabis retailer and would either sell or license its goods.
State Laws & Their Peculiarities
In some cases, a state may require that medical cannabis dispensaries operate as non-profit organizations.
However, these same dispensaries will not be able to acquire federal non-profit status, which nearly always necessities operating as a C Corporation. State laws may also impose rules relating to funding and ownership.
The amount of funding required and the degree of risk associated with the business are essential considerations when choosing a business entity. Ultimately, Corporate structure and tax entity status are best decided on a case-by-case basis with the help of experienced marijuana lawyers and tax professionals for cannabis businesses.
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