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Do You Want to be First?

Throughout California in the cannabis industry, owners have looked to structure their businesses to give them the largest chance for success.  Often this involves the creation of 2 companies to help with their 280E tax problem.  Usually consulting attorneys for the best route leads to the creation of 2 companies.  The cannabis company subject to 280E (in California it has been a mutual benefit nonprofit but will likely be another type of company in 2018 under legalization) and a “management company”. 

In situations like these, there is a consulting rate, royalty fee, or packaging upcharge that transfers money from company to company.  With owners not involving business strategists who are familiar with audits, financial, taxes, and accounting, this can lead to 3 major problems in the future:

  1. To legitimize themselves as a management company or consulting firm, these owners need to be servicing other clients or be able to justify other ways of treating this relationship between companies.
    1. If an audit occurs on the management company (not the cannabis business created) and the IRS discovers this “management company” is only servicing a single cannabis business, they may not deem this a true consulting firm and red flags may be raised.
    2. Setting up charges for packaging may work but during an audit, the IRS may become suspicious if your gross profit margins are an outlier. Say for example, if the packaging and container industry has a gross profit margin of around 21% (csimarket.com for data on this industry) and you report a profit margin of 50% to cover the costs of everything, the IRS may want to know how your business is doing so well.
    3. The management company may also own a trademark of the name the cannabis company is using and utilize a royalty payment for use of the name. As with the gross profit margin previously mentioned, if a company is charging an absorbent amount for a royalty, red flags again will be raised in an audit.  An appropriate value needs to be placed on a trademark and it needs to be justified to the IRS in order to determine if the rate being paid to the management company is appropriate.  A royalty can be for trademark and maybe intellectual property, among others.  Any royalty tied to marketing or administrative charges deemed “fixed expenses” may not be allowed as a royalty COGS in the eyes of the IRS.
  2. Not being properly set up with a 1099 or W-2 employee system. Too often because cannabis companies cannot get payroll systems set up, they resort to signing “independent contractors”.  This becomes a problem in the future with a company that either has no employees, only wages with no payroll taxes reported, or only 1099 employees. 

          The IRS rates an employee or independent contractor based on a few factors.  They determine if the company has the right to control how the worker does his or her job (and to what extent), the business aspects of the job (reimbursement, worker’s investment in the company, the time the worker makes services available to the company), and the relationship (permanency) of the position, including how the contract is dictated and whether the company can dictate hours.

  1. There is one main factor that many owners in the cannabis industry do not consider and it may become more complicated in the future as investors become involved. If a cannabis company is created by friends or partners and a management company is created as well, joint ownership could be a large risk.  If friends or partners own both the cannabis company and the management company or if there is any address or reporting connection, the IRS will find out.  Once they do, the questions will start.  It is quite obvious to the IRS what is happening if the ownership is the same between both companies.  IRS audits can be quite extensive (especially in the cannabis industry) so businesses need to make sure that nothing can tie the 2 companies together in anyway other than a business relationship or the IRS will find it.  This will become a giant unknown as many people attempt to vertically integrate and cut tax costs instead of incurring the additional tax penalties for 280E.

Now these are just pointers and thoughts on what can happen based on years of audit, tax, finance, business, and consulting experience and training, and what many in the industry have been doing.  This is not to say that some of these approaches will pass an audit or that companies setup this way will even be audited.  Many of these approaches have not even been challenged in tax court either so they may be able to pass in the eyes of the law.

However, if your company writes off $500,000 in one year to the management company and have utilized these approaches, do you want to become the first victim in tax court?  Do you want to run the risk these approaches and red flags do not pass IRS laws?  That could mean $500,000 in expenses not written off, increasing your tax burden by close to $175,000 plus interest and penalties (not to mention the IRS can look back 3 years into your company and 6 if you have omitted more than 25% of your gross income leading to hundreds of thousands, if not millions in penalties).

Many owners will continue to run as they see fit and risk it until hopefully someone else becomes the first tax court victim and determines what the future will hold. 

Is that risk worth it to you?

Posted in Other on September 01 at 12:34 PM

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