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In December of last year, Congress passed the most extensive overhaul of the U.S. Tax Code since 1986. The new act is known by a number of different names, such as the Tax Cuts and Jobs Act or as PL-115-97, though it’s more commonly referred to simply as The Act. While The Act may go by many names, the reforms that took effect in 2018 are far-reaching and affect businesses in nearly every sector. Most importantly, businesses that deal with the sale of cannabis, cannabis byproducts, and related paraphernalia are faced with tax regulations that can affect their businesses.
IRC 280E Still Applies
There has been talk of repealing IRC 280E, which makes it unlawful for individuals to claim deductions or tax credits from the expenses of selling or distributing controlled substances. Although support for the repeal of IRC 280E came from both conservatives and those in the cannabis industry, congress left the law intact. The most probable reason is that repealing the law would eliminate revenue, which would require developing a system for supplementing that loss elsewhere. IRC 280E is unlikely to be repealed, until that problem can be resolved. However, The Act does lower the federal income taxes that cannabis businesses will be expected to pay, so that may mitigate the consequences of keeping IRC 280E intact.
The Act Makes a C Corporation Structure More Appealing
Previously, C Corporation businesses paid taxes equivalent to those of a corporation, while also taxing dividends to shareholders at a 20% rate. The double tax burden often made this type of business structure less appealing, but The Act lowers the tax placed upon C Corporation businesses to 21%. Adding the benefits of protection against audits to shareholders and more flexibility in employee benefits, the C Corporation structure may now be the way to go for cannabis businesses.
Be Wary of Choosing a Limited Liability Structure
Many businesses operate as a limited liability company, because of the tax breaks this type of structure provides. Typically, the income earned from the business can “pass through” to the owner of the business, allowing them to claim the income on their individual income taxes, which gives them a 20% deduction on their business income.
For instance, a ancillary cannabis business owner may be in the 24% bracket, while operating the business as the sole owner. A business income of $100,000 will earn a deduction to allow the business owner to pay $19,200 in income taxes. The $20,000 (or 20%) is deducted from the total of $100,000, leaving $80,000 to be multiplied by the 24% tax rate.
However, this must be an ancillary cannabis business like Life Patent CBD, because direct growers, manufacturers, distributors, sellers of cannabis are still subject to IRC 280E. This prohibits them from claiming the limited liability tax deduction. Additionally, there are other, more complex exceptions to this deduction that can further penalize some cannabis related businesses.
The benefits of a limited liability structure apply more readily to businesses that engage in capital investments, as opposed to those that provide direct services or rely on a heavy labor force. As such, ancillary cannabis businesses that provide real estate or equipment may find it more advantageous to operated as a limited liability company than those who directly deal with the cultivation, processing, and sale of cannabis products.
Debt Financing Deductions Are More Restricted
Previously, all ancillary businesses could deduct interest on loans, but IRC 280E also prevents ancillary cannabis businesses from claiming these types of deductions. This is especially problematic, because investors in cannabis related businesses often prefer to act as lenders. The Act limits how much can be deducted, based on a few different factors:
- Income from interest
- 30% of “Adjusted Taxable Income”
- Interest expenses incurred through “floor plan” financing options
Even under The Act reforms, adjustable taxable income makes allowances for interest income and expenses, certain types of capital investments, and losses. In referring to ancillary businesses, the restrictions on floor plan financing options should not inhibit the advantages.
On a loan for an ancillary business, the interest may come to $5,000 annually. If the business has an adjusted taxable income of $18,000, it can deduct the entire sum of its interest expenses. The formula would factor $18,000 at a rate of 30% to allow for $5,400 in interest expenses. However, a business with a lower taxable income of $15,000 would be permitted to only deduct $4,500 (or $15,000 * 30%).
An exception to this restriction allows a real estate business to take the deduction, if they employ a less advantageous depreciation formula on their properties. Similarly, any business with fewer than a $25 million annual gross receipts average can also deduct all of its interest expenses.
Since this is the first year of The Act, the IRS and Congress will likely be making helpful resources available to businesses and individuals. As with any new tax reforms, there will likely be some confusion and the government hopes to resolve frustration with the new reforms efficiently. Whether this will mean a repeal of IRC 280E in the coming year remains to be seen.
Written by Abajian Law