Right now, cannabis remains a Schedule 1 substance, which means that anyone trafficking in it needs to operate under the restrictions of Internal Revenue Code Section 280E — but that will change if the Biden administration's current attempts to get it rescheduled are successful.
Until then, though, businesses are prohibited from taking ordinary and necessary business expense deductions and credits if they traffic in controlled substances, despite their legality under state law. Most states have chosen to legalize, in varying degrees, the sale of cannabis.
The effect on these businesses, which are already heavily regulated, is a federal tax rate approaching 60-70%, driving many into the unregulated market. Over the years, a number of businesses have unsuccessfully challenged Section 280E on constitutional grounds. The challenges are based on the Sixteenth Amendment, which permits taxes only on income, and Section 280E results in being taxed on something other than income. According to the challenges, the tax disallows deductions for labor and rent, so the calculation of the amount subject to tax is not income because income means gain — they're being taxed on something other than gain.
The prohibitions of Section 280E impact the retail sector of the cannabis industry the most, according to Scott Kocienski, a tax partner at law firm Dykema.
"The reason is that for growth facilities and processors, most of their costs are included in the cost of goods sold, but for retail stores, the only thing they can deduct is the cost of purchasing the inventory," he said. "All of the other expenses, such as payroll, rent, utilities, that a normal retail store would deduct are not deductible."
This results in a dilemma for retailers, according to Kocienski. "Many of them end up using their excess cash to pay operating expenses instead of paying their tax, and they accumulate a huge liability," he said. "They have to decide whether to keep the business afloat, or pay down their tax liability. And it can lead to notices, liens, levies and other problems with the IRS."
That is one of the main reasons that cannabis retail stores are often structured as C corporations, he suggested: "Retail stores have an extremely high effective tax rate. If it's a flow-through partnership or S corporation, it can go as high as the individual tax rate at 37%, but if it's a C corporation, the tax rate is limited to 21%."
"But growing facilities and processing centers are less impacted by Section 280E and therefore are often structured as limited liability companies," Kocienski said. "The increased attractiveness of these businesses will lead to more sales. The most tax-efficient way to structure a deal is as an asset sale."
This would require the acquirer to be a partnership or an S corporation for federal income tax purposes, resulting in a single level of tax at a lower tax rate than would apply to a C corporation.
But timing can be crucial, according to Koscienski: "What we are looking for is the opportunity or mechanism to effectively convert a real store or a C corporation into a pass-through partnership or S corporation. A lot of cannabis retail stores should be looking at different ways to accomplish this once rescheduling takes place. The way to do it will depend on the particular facts of each case — there's no 'one size fits all' approach. One option could be, for fairly new retail stores or those that aren't even operational yet, a corporate liquidation followed by conversion to a partnership. There are numerous possibilities depending on the particular circumstances of each case."
