Posted by Jeffrey Feingold on 12.20.18
With legalization spreading rapidly around the globe, the United States cannabis industry is only just beginning to prosper. Thirty states, and Washington, D.C., now allow cannabis to be sold for medicinal uses, and since the 2018 November elections recreational use is now legal in 10 states: Alaska, California, Colorado, Maine, Massachusetts, Michigan, Nevada, Oregon, Vermont, Washington, and the District of Columbia. The number of companies operating in the cannabis market has increased greatly over the past few years due to the high demand for both medical and recreational use. Producers are focused on growing their customer base through geographical expansion and by offering a larger selection of products. Products currently being offered include a variety of strains and extracts such as oils, tinctures, resins and consumables. As a result of the legalization in certain states, new businesses in this industry are seeking the services of CPAs to help guide them through the tax laws and state regulations. Cannabis, is classified as a Schedule 1 controlled substance under the federal Controlled Substances Act of 1970 and is subject to federal prosecution. Historically, the majority of cannabis is sold through illicit channels. To control this illegal market, state governments have started legalizing cannabis as a way to monitor the products that enter the supply chain and reap benefits through taxes collected on these products. As the cannabis industry has expanded rapidly with legalization, tax implications have become important considerations. With careful planning and the understanding of applicable state tax codes, cannabis entrepreneurs can take proactive steps to reduce their state tax liabilities.
There are many business categories in the cannabis industry:
The cultivation, distribution and processing of Cannabis Sativa (Marijuana) currently remains illegal at a federal level. Cannabis is currently classified as a Schedule 1 restricted substance, with the Justice Department's Drug Enforcement Agency (DEA) assigning it in the same legal status as narcotic drugs like heroin and LSD, yet in a more restrictive category than cocaine, which is Schedule 2. Even though a “cannabusiness” is illegal under Federal law, it remains obligated to pay Federal income tax on its taxable income, because Internal Revenue Code (IRC) § 61(a) does not differentiate between income acquired from legal sources and income acquired from illegal sources. The 16th Amendment of the U.S. Constitution authorized Congress to lay and collect taxes on income (regardless of a characterization of legal or illegal sources), and the Supreme Court of the U.S. has consistently held that income means gross income, not gross receipts. Section 162(a) of the Internal Revenue Code (26 U.S.C. § 162(a)), concerns deductions for business expenses. It is one of the most important provisions in the Code, because it is the most widely used authority for deductions. If an expense is not deductible, then Congress considers the cost to be a consumption expense. Section 162(a) requires six different elements in order to claim a deduction. It must be an ordinary (1), and necessary (2) expense (3), that was paid or incurred during the taxable year (4), in carrying on (5) a trade or business activity (6). These elements have been interpreted by the courts and administrative agencies to determine if an expenditure is deductible as a business expense.
Each of the states that have legalized marijuana businesses have their own unique set of rules, restrictions and regulations. It’s important for any cannabusiness to know the forms of legal entities and the income tax consequences of operating a marijuana business in that form. Each legal form or company entity has its own pros and cons.
Sole Proprietorship: A type of business entity that is owned and run by one individual and there is no legal distinction between the owner and the business.
General Partnership: A pass-through entity whose taxable income is determined and allocated to each of its partners in accordance with the partnership agreement and reportable by each on their income returns.
Limited Partnership: Like a general partnership with taxable income determined and allocated to each of its partners in accordance with the partnership agreement and reportable by each of them on their income returns. Family partnerships are a form of limited partnerships that have been used for certain income and estate tax planning purposes.
Corporation: Legal entity created under state laws and designed to establish the business as a separate legal entity having its own privileges and liabilities distinct from those of its shareholders.
Limited Liability Company (LLC): An unincorporated business of one or more persons who have limited liability for the contractual obligations and other liabilities of the business. All states have limited liability company laws that govern the formation and operation of an LLC.
Once establishing an entity, marijuana businesses can then begin to explore the tax benefits their state may offer as well as getting to know how the R&D tax credit can benefit them come tax season.
While it is a challenging time for over 28,000 cannabusinesses across the United States, it’s an even more daunting task to understand both Federal and state income tax laws and state and local government regulations. But with the the help of their CPAs and Tax Point Advisors’ National Cannabis Industry Specialization Practice, cannabis businesses across the U.S. have substantial support available to manage and mitigate their income tax liabilities.
Tax Point Advisors provides R&D tax credit study services and other specialty tax services to CPA firms and their clients throughout the U.S. To learn more about R&D tax credits from the experts at Tax Point Advisors, please call us at (800) 260-4138 or please leave us a message below.