Derek Davis discussed his first-hand knowledge on how to structure your cannabis business to avoid costly mistakes, as well as how 280E impacts your business.
If you have any specific questions about structuring your cannabis business, then please contact us to get started.
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Full Webinar Transcript:
We’re really excited to present our topic today, which is taxes and 280E. What are your responsibilities? Just as a quick disclosure of the information contained in this powerpoint is meant for guidance purposes only and is not professional legal or tax advice. Remember, we are a CPA firm and unfortunately cannot give legal advice. We can only talk to the tax issues further. We, unfortunately, cannot give personalized legal tax investment or any business advice in general during this powerpoint presentation and we can simply talk about the issues themselves. Let’s jump into it. The topic for today’s discussion will be taxes and 280E. What are your responsibilities?
So a little bit about our agenda today. We’ll go over who we are as a CPA firm. We are called Green Growth CPAs and we are a full-service CPA firm servicing the canvas industry. We’ll briefly talk about business structuring 101, which will include a nonprofit mutual benefit corps as well as cannabis tax responsibilities. We will cover 280E and cost of goods sold. We will then chat about what deductions you can and cannot claim. And then we’ll briefly talk about penalties and benefits as well as bookkeeping and best practices. So with that, let’s get started. We are GreenGrowth CPAS. I personally and Derrick Davis. I’m a CPA at the firm. I have personally been licensed since 2012 as a CPA licenses in the beautiful state of California. I have almost a decade of corporate taxation experience. And I started my tax career at Deloitte taxes, was PricewaterhouseCoopers in 2015. I was fortunate enough to testify on Capitol Hill regarding tax policy reform and I’ve been quoted in several tax policy and tax referendums as well as my personal involvement in cannabis starting in 2010 when it was previously on the ballot to be fully legalized in the state of California. And that’s also when to eat. Came out as many of you know, unfortunately, cannabis was not passed in 2010, but we did finally pass recreational licensing in 2016.
So let’s talk about business structuring. We’ll briefly talk about nonprofits or cooperatives as they are usually known. Some pros of these structures is that they may be subject to lower tax benefits, but one thing that’s really important to remember is that even if you are a nonprofit, you will generally not be allowed nonprofit tax exemption. So a lot of clients will come to us and say, Hey, we’re a nonprofit, therefore we don’t have to pay tax. Unfortunately, that has never been the case with cannabis operators. If you are a cannabis operator, we have never seen a case or they have been granted not for profit status. So it’s really important to remember that even if you are legally incorporated as a nonprofit, you will still have to pay taxes as a for-profit company. One of the biggest cons of being a nonprofit is that you cannot take a distribution and you also cannot buy and sell your nonprofit entity, which also includes a ton of additional paperwork that goes along with being a nonprofit.
So one of the drawbacks of that is that if you are a nonprofit, and let’s say you build up a huge brand name and you have a great brand and you have, you know, tens of thousands of customers that love your product, being a nonprofit will not allow you to sell your company so you can’t cash out at the end of the day because technically under the nonprofit rules you don’t own the company. Another type of business structure that a lot of companies look at is B-Corps really the only really good tool that we’ve seen for B-Corp is that a great tool for marketing. So a lot of people like to see B-Corps being more economically resilient and sometimes it is more attractive to potential investors as well as hiring and retaining top talent. The obvious cons of B-Corps, of course though, is that it’s a really hard process to go through and get B-Corp certified.
They also face higher levels of scrutiny both internally and externally and shareholders generally tend to have more power than a normal C-Corp or S-Corp. In determining, you know, if a B-Corp is right for you, you really want to determine if that additional certification will really move the needle in terms of your sales. If you really believe that you can increase sales by being a B-Corp, then that may be of interest to you, but otherwise, it’s just a lot more paperwork and it’s a lot more restrictive. C-Corps and S-Corps are obviously the two most common business structures that we see. The pros of a C-Corp is that it reduces the potential liability of the individual owners. The cons of a C-Corp, of course, is that there’s double taxation and there are higher federal and state filing fees. Generally in the cannabis industry, you generally see a retail-based operator being a C-Corp specifically because if they ever were to be audited by the IRS and the IRS, disallowed a lot of their expenses and said that these are nondeductible under 280E that the liability may become so big on the owner that the company goes out of business and if you’re a C-Corp, generally speaking, you will have that tax liability absorbed by the C-Corp itself and it won’t be passed on to the individual owners.
But again, for these specific legal requirements, we suggest that you talk to a lawyer as-as we are not a law firm and we cannot give legal advice. We can only speak to Tax Implications. S-Corps are generally good companies for product producing companies. So you know whether you make your prerolls, you are a cultivator, you are a manufacturer. Anytime you produce a tangible product, S-Corps usually makes sense because of the main pro that it is not subject to double taxation. So you as an, as an owner of the S-Corp and as of the company, all the profits and losses will flow through to you individually. There’s also some personal liability protection, which was also great to have. The real big con of an S-Corp is that there’s, there are rules and fees that apply and you’re required to pay yourself a reasonable salary. So let’s say at the end of the year, $100,000, generally speaking, you want to pay yourself at least a 60 to 70 percent salary, so 60 to $70,000 will be a W-2 wage and the remaining amount will be taken as a distribution which will not be subject to self-employment tax and those are really the benefits of S-Corp.
And luckily we can model out what the two different scenarios will look like, whether it be S-Corp or C-Corp and what your potential taxes will look like. And then we can also talk about what a potential tax liability would look like if you were in the event of an IRS audit. And there huge adjustments with penalties and interest. A sole proprietorship is another form of an entity which has really no entity at all, and a sole proprietor just means that an individual’s like, “hey, I’m going to start my own, you know, let’s say pre-roll brand and I’m going to go out into the marketplace and I’m not going to set up any legal entity”. The pros of that is that’s really simple because you, you know, you may have to file some respected filings based on how you’re operating, but beyond that all of the profits and losses will float your schedule c, the main con, of course, of a sole proprietorship is there’s a huge level of personal liability, so if you were ever potentially sued, they could just go after you personally and they could potentially take away your house if you own one, your car, any and all assets that you do own.
If you were to be sued, they would just come after you individually. The next type of business structuring as a general or limited partnership and LP, there are a lot of tax benefits for partners of an LP. Generally, a limited partner in a limited partnership can have very favorable tax benefits and they may not be subject to self-employment tax so they can just take a distribution. So there are definite advantages for limited partners. The cons are that there are compliance challenges and the risks may be passed on to the general partners, so in any limited or general partnership, you always need to make sure to have one general partner and that general partner can also be personally liable for the debts of the company. So if you’re a general partner and you get sued, they could potentially go after your personal assets. So depending on who you’re working with and what your team structure looks like will generally dictate the terms of that arrangement.
And last but not least, let’s talk about LLCs and LLPs. I’m starting to see a lot of questions coming in the chatbox and we’ll try to answer all the questions at the end of our Webinar, but of course, if we’re unable to get to them, please reach out to us GreenGrowthCPAs.com. Our phone number will also be listed at the end of the slide deck, so please don’t be a stranger and please reach out to us. LLCs are probably one of my most favorable entities from a tax perspective simply because it allows for a flexible management structure. You do have some limited personal liability and you have various different tax options available to you, so for example, you can be an LLC and taxed as an S-Corp or C-Corp so it or you could just be taxed as a general partnership, so there’s a lot of different ways to be taxed and an LLC will give you that flexibility.
The only cons, of course, is that there may be special taxes levied at the state level and then there’s also less structure and investors aren’t as comfortable with LLCs as they generally are C-Corps. Generally, an investor will like to have special terms and preferences and those can oftentimes be more easily laid out in a C-Corp. I’d say on the event of a dissolution, the investor may get paid out first or they have may have first rights to the assets, so there are various different structures that are C-corp can provide that an LLC may not, but of course, you can always amend the operating agreement. So you know, if an investor wants specific preferences, you can put that in the operating agreement to provide that to them. But overall I think LLCs are a generally safe choice. So we’re going to briefly talk about mutual benefit nonprofit corporations.
These were prevalent in California prior to this year and so we still see a lot of these entities sitting around. So we want to talk about the structure and the assets associated with these corporations, but more oftentimes than not especially going into 2019, you want to dissolve your nonprofit mutual benefit corporation and turn it into a for-profit entity as we previously discussed earlier in the slides. Some defining characteristics of course, of nonprofit mutual benefit corps, is that the assets of the corporation can only be distributed to the members upon dissolution of the corporation, not during the operations. So what that means is that if you are set up as a nonprofit mutual benefit corps and you know you’re one of the partners of the company or when you’re one of the potential directors and you want to exit the company, unfortunately, can’t get your assets. You know, let’s say you have a large CO2 two extraction machine.
You cannot get that asset until you until the corporation dissolves. So you know when thinking about structuring and dissolution, more oftentimes than not, nonprofit mutual benefit corps is not the goto entity.
So as a cannabis operator, you may be responsible for different levels of taxes. So you will obviously have your sales tax, you’ll have your federal and state income tax, you’ll have your state corporation filing fees, and then you’ll have your normal cannabis taxes that are generally assessed at the local level. The best thing to do more oftentimes than not, if you do have a nonprofit mutual benefit corporation, is generally to dissolve the corporation and not convert it. But of course, if you’re looking at both the options you want to read through your articles of incorporation, oftentimes a more sophisticated attorney will set up a C-corp and they’ll have a nonprofit section and generally, our attorneys that we work with have recommended that structure because if you wanted to convert, all you’d have to do is ask that section out of your articles of incorporation.
But again, check with your attorney as that is more legal base and we can only speak to the tax finance and money related issues. Some other things you may want to look at is the depreciation of fixed assets. Sometimes, you know, if you depreciate your CO2 extraction machine, you’ll get a great tax benefit. But upon dissolution, if you have to sell it, there may be a gain that you sell it for and you’ll have to pay taxes at that game. Some other things you may also look at as the basis of the property. So you know, if you’re specifically looking at whether to dissolve or convert, definitely check with your lawyers. Also, check with your tax advisor to make sure that you won’t be subject to a ton of taxes upon dissolution. Okay guys, so now we’re going to talk about taxes and 280E.
So as you can see in the side by side comparison, you have an ordinary business and the cannabis business, they both make a million dollars in sales and they both have $400,000 in costs of goods sold, they both also have $500,000 in sales and marketing expenses. But the ordinary business can deduct that and the cannabis business cannot deduct that. So what you can see is that, and this is simply at the federal level, it also flows down to the state levels as well, but the business only pays $35,000 in taxes while the cannabis business has to pay over $210,000 in taxes. So the discrepancy between the two is huge. And without proper tax planning and tax structuring, you may find yourself on the wrong side of the, on the wrong side of the fence, come taxes and time. So it’s really important to understand 280E and how do you work with it.
280E is pretty much a federal regulation that forbids, your sales and marketing expenses. It is there because of the Reagan era, “just say no” campaign that allowed drug dealers to deduct their costs of goods sold, but did not allow them to deduct their sales and marketing expenses. And this is unfortunate because of the case because cannabis is still a schedule one drug for 280E to go away, it would have to go from schedule one to schedules three.
So let’s talk about potential sales and marketing expenses. Any amounts that you paid a weedmaps is nondeductible. Any amounts you paid to Leafly or any other marketing platform is nondeductible any type of sales brochures, sales catalogs, product catalogs, those are all generally not deductible as well as the headcount. You know, if you have a sales team, those expenses are nondeductible. So it’s really important to understand how 280E negatively affects your business.
And it’s really important to understand the how to structure it correctly. So when it comes time for April 15th, you don’t have this massive tax liability. This is, unfortunately, the case, you know, from, from our perspective for the foreseeable future. So you know, unless you know, in the midterm elections congress flips and they decided to reschedule cannabis, it’s probably here to stay for the next couple of years. Another thing to be mindful of is that when thinking about either starting your company or operating your company, you want to see how each city will tax their cannabis operators. So for example, if you’re thinking about going into the City of Los Angeles, it’s important to remember that there’s a five percent, generally a five percent topline tax that’s levied for the operators. Whereas if you go to Oakland, there’s a five percent tax on medical, but there’s a 10 percent tax on recreational.
So tax has become a really important issue because they can really muddy up your cash flow. And if you want to charge out the taxes at the city charges to you, you’re obviously more than free to do so. But then you’re going to have to pass that cost on your consumer. And so you know, if the price, if you decide that you’re a cultivator and you know your price per pound is $1200, but then you charge out all the cultivation taxes, all of the city taxes to the respective customer, your price is going to go from, you know, $1,200, let’s say $1,700 and that may just price you out of the market. So it’s really important when you’re thinking about running your business and starting it, how the local taxes will affect you. Oftentimes you’ll generally see about three different types of taxes. You’ll, you’ll see a tax on the square footage, you’ll see a tax based on sales.
And oftentimes it’ll be an absolute dollar amount. And then you’ll oftentimes see a tax on a percentage of sales. So it’s really important to evaluate, you know, how much is real estate, how much are taxes, and how long it’ll take to get started. Because these three factors will generally dictate and the long-term whether your company will win or potentially lose. So for example, sometimes you know you can go out in the desert and they’ll be cheaper access to real estate, but then the taxes that are levied on you’re so high that you might not even turn a profit. Whereas, you know, if you go to the city, the real estate may be more expensive but the taxes are lower and so you may be more competitive. So it’s really important to understand how the taxes are being levied at the local level to determine if you will make a profit in the long-term or you’ll make a loss in addition to all of these taxes, you have to be mindful of the sales and use tax.
So this is, this is sales and use tax for everything. So you know, generally you go to any sort of store when you buy any sort of product, they’ll generally have a sales and use tax. And so the sales and use tax is an additional tax and it’s different from the local cannabis taxes. It’s, it’s another layer of tax. So you know, at times it’s a little bit disheartening that taxes are being levied on taxes. But it’s really important to make sure that your company’s structured correctly so you don’t get slaughtered and all these taxes and not of course sales and use taxes generally based on your top-line revenue. So say for example, you sell $100 worth of product and your local city taxes nine percent, and then your local cannabis tax is five percent, so you’re effectively paying 14 percent, which is a huge percentage of all your income to taxes, whether it be to the local cannabis tax or the sales and use tax costs of goods sold is pretty much your best friend across the board in terms of saving money from taxes.
What you generally can deduct is your product packaging and anything directly related to the sale. The cannabis product, the invoice for cannabis is generally less any trade and other discounts that you provide. So those are other deductions that you can take against your net sales. Electricity bills are obviously really great if you’re a cultivator and you have a high electricity bill, high water bill, those are things that can absolutely be deducted against your cost of goods sold. Some other things that you may also want to think of as your transportation costs, picking up the product can be considered if you’re a distributor, a cost of goods sold, but then distributing the product to the end retailer, the end deliveries generally at a cost of sales and cannot be deducted. Some things you generally cannot deduct or you need to be very clear on his payroll office supplies, any, anything that does not directly relate to the cost of the product, so I’m at the end of the year or towards the end of the year.
When you’re thinking about tax planning and you’re trying to figure out how much tax you will make sure that you go line item by line, item down all your expenses and determine whether you believe it’s related to the cost of product or cost of sales. And if you’re confused, obviously reach out to your tax advisor will reach out to us. We’d be happy to help go through all your line items and determine what we reasonably think can be applied to the cost of goods sold or what we reasonably think should be a selling expense. Unfortunately, we always have to talk about penalties because they’re a huge aspect of the space. Unfortunately, if you are a licensed operator, we’re seeing out of Colorado that are actually around 21 percent of operators have been licensed. There’s a lot of rumors in the space that it’s based on this new ministration, which we obviously can’t independently verify, but what we’re seeing is that as licensed operators that are really easy to get to get picked off and to be audited, for those of you that are super geeks on tax taxes such as myself, check out the and tax case.
This was a recent tax court ruling for a dispensary and fortunately, they went back to their 2013 tax period. I think the biggest takeaway from that tax court ruling is that they had no documentation or very little documentation to support the costs of goods sold expenses. And so what happened as a result of that is that the IRS came and said, okay, you have no documentation on your expenses. We’re going to disallow all of your expenses that you took on your tax return and we’re going to assess a huge penalty. Plus interest plus the adjustment itself and I believe it pushed them out of close or go out of business and what we found is at least 90 percent of the cannabis companies aren’t doing the cost accounting throughout the year and they’re not properly documenting as well as keeping track of all the records that they need to make sure that in the unlikely event of a tax audit that they can have all the supporting documentation that they need.
Okay, so now we will chat about the cost of good sold best practices, one of the best practices to create separate account ledgers for the cost of goods sold expenses as well as your regular business expenses. You really want to break out your expenses into two categories. Things that you can reasonably deduct as the cost of goods sold and other business expenses that you don’t believe would qualify under the cost of goods sold. And it’s really important to reconcile the two and determine, you know, can you reasonably allocate this to the cost of goods sold? Or is this really a sales and marketing expense?
The next thing you want to do is you want to set a system for checks and balances to verifying your cash flow and making sure that reconciles to your point of sale system. Oftentimes because it is a cash-based system will see that a lot of the…There’s a lot of points of failure along the way or cash can be siphoned off, maybe intentionally, maybe not intentionally, but because we operate in a strict cash-only environment, there are many points along the way or cash can be potentially stolen, so it’s really important that you set up independent checks to make sure that all the cash reconciles to your point of sale system.
The next thing you want to think about setting up is a strong inventory management and record-keeping system. It’s always great to have backup records and documentation for all your expenses in the cloud or off-site. That’s not just paper. What we find with a lot of our clients is that the paper trail and keeping all your receipts and keeping all the paperwork or get lost and so when it comes to getting audited, you know you can’t find any of your paperwork, so it’s always important to keep digital copies and digital backups of everything.
The next thing is you want to obviously set of controls to prevent fraud and theft, whether that be the cash or the product itself and making sure you have clear reporting and clear reports on who handles what and making sure that you know, if you have an inventory manager, that they own the inventory and people are independent auditing their work. The last thing you want to do is make sure you reconcile your general ledger with the different accounts either on a daily, weekly, or monthly basis. I would generally say a biweekly basis, depending on the volume of your transactions, is usually the best. But you know, if you’re doing less than let’s say a $250,000 a month, then maybe you can do that weekly or monthly. The last thing you want to do is you want to make sure to keep a strong paper trail with receipts signed by the vendors as well as the payslips signed by the employees.
This is really, really important when it comes down to the resale certificate. So let’s say you are a manufacturer for example, and you don’t provide timely resale certificates. If you were to undergo a sales and use tax audit, they could come in and say, “hey, we don’t know if you sold these products to a dispensary or you sold it to the consumer and because there was not a timely resale certificate provided that you know you’re going to be subject for the sales and use tax” even though you provided it to the end retailer. And what they’ll then do is they’ll say, okay, now you owe nine percent sales and use tax plus penalties plus interest and assess a huge amount. So it’s really important that you have backup and you have a really strong paper trail generally in a cloud environment to make sure that, you know, five years down the road if you do get audited, you can easily pull all your backfiles.
So some key takeaways is that nonprofits, regardless of if it’s a California cooperative or nonprofit mutual benefit, is that you still have to owe tax code 280E generally only means you can deduct your cost of goods sold and your cost of goods sold is limited to certain specific business expenses. You know, unfortunately, you, if you’re a licensed operator, you may likely be subject and audits. So make sure you keep really strong records and you also keep digital backups of all your files. And when in doubt, you know, consult with this cannabis-specific expert. You know, oftentimes cannabis operators, and I’ve heard this time and time again, or cannabis consultants charge more money, but in the long term, they’ll save you the headaches at a non-cannabis operator just doesn’t have the industry insight. So I do see that we have a bunch of questions coming in, but I do see that we’ve also ran over our time, so if you have any follow up questions, please reach out to a screen growth cpas.com. Feel free to give us a call. We’re here to help and I hope you enjoyed the webinar. If you have any future recommendations or suggestions, always reached out to us. We’re here to help. Thanks all.