Cannabis businesses, while legal in many states, face many challenges due to federal law. One of the significant challenges is federal effective tax rates that can easily exceed 50%. The high effective tax rates are caused by Section 280E of the Internal Revenue Code.
Background
Section 280E generally denies all tax deductions and credits for businesses engaged in the trafficking of Schedule I or II controlled substances, including cannabis. This means normal expenses such as rent, utilities, marketing, etc., may not provide any tax benefit. Instead, cannabis businesses generally pay tax on their gross profit, or their gross receipts less the cost of goods sold (“COGS”).
An Employee Stock Ownership Plan (“ESOP”) is a qualified retirement plan that allows employees to become indirect owners of their employer. ESOPs are tax-exempt entities and serve as a retirement plan for employees.
Cannabis ESOPs
If a cannabis business is an S corporation, the S corporation itself does not pay tax; the income flows through the S corporation and is taxed in the hands of its shareholders. When one of the shareholders is an ESOP and itself is tax-exempt, the income of the S corporation escapes taxation.
In short, ESOP ownership of a cannabis business effectively nullifies the impact of Section 280E. At the same time, the ESOP motivates employees and improves retention.
There is, however, a cost to setting up an ESOP for a cannabis business. The current owners of the business need to sell part, or all, of the equity in the business to the ESOP. To the extent that the historic owners of the business retain ownership, Section 280E will continue to apply to their ownership.
Section 471(c)
For cannabis businesses that do not wish to pursue an ESOP transaction, there are other ways to mitigate the impact of Section 280E. Without changing the ownership of the cannabis business, the business may be able to include additional costs in COGS, so that such expenses are not denied under Section 280E.
Section 471(c) allows for certain “small businesses” (those with average annual gross receipts less than $31 million, averaged over the past three years) to use an alternative method of accounting for its inventory. The inventory accounting method used may include certain costs that would otherwise not be included in COGS. Section 280E will continue to apply to the business, but it would deny a smaller portion of deductions.
While utilizing Section 471(c) to account for inventory differently will not reduce tax to the extent that ESOP ownership would, Section 471(c) can allow for certain cannabis businesses to have an effective tax rate much closer to an average business not subject to Section 280E. In addition, implementing the inventory accounting method change is much simpler than setting up an ESOP and allows ownership of the cannabis business to remain unchanged.
