Big changes may be coming to the business of marijuana.
Cannabis is currently listed as a Schedule I substance, similar to heroin and LSD. Schedule I and Schedule II substances are both subject to negative tax implications under Internal Revenue Code Section 280E, whereas those that are Schedule III substances, such as most prescription drugs, are not. But that could change quickly if the Biden administration's proposal to reclassify cannabis from its current status to a Schedule III substance comes through.
"Anyone trafficking in a Schedule I or Schedule II substance is generally prohibited from taking ordinary and necessary expenses as a deduction or credit," said John Fraser, a member of the cannabis group at law firm Dykema. "The Tax Code restrictions, once lifted, will be a boon to those in the trade, particularly marijuana retailers," whose profitability has been artificially depressed. "Although they're allowed these deductions at the state level, their federal tax rate approaches 70% because of the restrictions of Section 280E."
The restrictions affect retailers more than growers and producers, according to Scott Kocienski, a member of the tax group at Dykema. "The result has been to drive many of these businesses into the unregulated market. It has also generated a number of unsuccessful constitutional challenges to Section 280E, based on the Sixteenth Amendment."
The Sixteenth Amendment permits taxation only of income, and Section 280E results in the taxation of something that is other than income. According to the challenges, the tax disallows deductions for labor and rent, so the calculator of the amount subject to tax is not income, because income means gain, and the tax is on something other than gain.
The action to reclassify cannabis will not only increase profitability for retailers, it will substantially enhance their value as a going concern, according to Fraser: "As a result of Section 280E, the profitability of many cannabis businesses has been negatively impacted by excessive taxation."
Many retail cannabis facilities are structured as C corporations, since retail stores have an extremely high effective tax rate, Kocienski said.
"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%," he explained. "Since growing facilities and processing centers are less impacted by Section 280E, they therefore are often structured as limited liability companies."
Since retail stores will be more profitable businesses once rescheduling takes place, many owners will want to take advantage of the increased value as a going concern.
The scheduling must follow administrative rules, according to Fraser. "They've already proposed the change accompanied by an opinion letter explaining why they believe rescheduling would be lawful," he said. "So it seems to be moving forward. The administration likely wants it to happen before the November election. They would like to use it as a concrete selling point — that it's something they actually delivered, not just talked about. So I would expect that things will move very quickly once it happens."
"I would expect that retailers that are structured as C corporations will want to explore the opportunity to migrate their entities to some form of flow-through when rescheduling is finalized," he said. "In a perfect world they would probably do this beforehand because theoretically, most retailers have a depressed enterprise value due to their significant tax burden. It is better to do this now when the values are depressed."
The devil in the details
"It will depend on the current structure and the method used to convert, but if it's a taxable conversion, it would be better to do it now when the values are depressed," said Fraser. "This would minimize any tax implications from the conversion."
Of course, there is a bit of risk associated with this, he remarked: "If something catastrophic happens and the rescheduling doesn't take place, you're moving from a low-taxed C corporation to a higher-taxed individual rate. But there's a low likelihood that this will happen."
"At this point I don't have any expectation that will go backward on this," said Fraser. "I don't have any reservations about telling people to start preparing. The homework that needs to be done should be started now: They should have conversations with CPAs and legal counsel. Once there's a public hearing and notice, and comments, we'll have a better sense of when to do it. But if everyone waits until the last minute to react, that's a recipe for disaster for the CPAs and legal professionals that need to look at the structure. Some entities have very complicated structures, and they need time to discuss with their accountants and legal team the timing and the form of the restructured entity. You want to start planning for the effective date of the restructure so when the rescheduling happens, you're ready to start implementing the new structure."
"Generally, a buyer prefers acquiring a business' assets, not the equity of the business," said Fraser. "There are two reasons for this: First, a buyer would be cautious about assuming the risks associated with a business, particularly those risks that may be currently hidden from view. For example, past regulatory infractions, labor issues and tax history, among other things. Second, a buyer generally prefers to acquire assets because the adjusted basis of the purchased assets is increased to fair market value based on the purchase price. This allows the buyer to monetize its acquisition cost through immediate depreciation and amortization deductions."
The sale by a C corporation of its assets results in income tax on the resulting gain, as well as incurring income tax on the dividend distribution to the equity holders on the after-tax sale proceeds. But after the proposed rescheduling, the tax landscape will change, according to Kocienski: A buyer will want to immediately monetize its investment through depreciation and amortization deductions, and will therefore prefer asset purchase transactions, which will result in a double tax at the federal, state and local levels for cannabis businesses taxed as C corporations.
A tax-efficient asset sale requires the seller to be classified either as a partnership or an S corporation for federal income tax purposes, which would result in a single level of tax at an overall lower effective tax rate than would be the case in the C corporation context, he noted.
"Generally, transitioning from a C corporation to a partnership or S corporation can be done fairly easily and with minimal or no tax cost," said Kocienski. Of course, the timing is critical. "It's important to make the change from a C corporation to a partnership or S corporation before the enterprise value significantly increases. There's no 'one size fits all' approach — each situation needs to be individually examined. But a timely change in tax classification will cause future asset appreciation to be captured in a more tax efficient operating structure, thus freezing or eliminating the lower enterprise value associated with the C corporation."
