The Cannabis Industry and Tax Implications of Entity Structure: Issues to Consider for Cannabis Operators
This CannaBlog is intended to provide some considerations that current and potential license holders should think about as they work with advisors to make entity selection decisions or consider potential tax elections. Please note that this article is a high-level overview and is not intended to declare the best type of entity structure for a license holding entity. Although numerous tax variables should be contemplated, tax issues are not the only concerns relevant to determining entity type. Also, some states may tax entities differently than how the entity is taxed for federal purposes.
Types of Legal Entity Structures for Cannabis Businesses
First, let’s look at the legal entity types that may be set up to hold a license, operate a business, and what that may mean for how an entity is taxed. Often, entities are set up as either limited liability companies or corporations.
Single Member LLC
If a limited liability company is organized and the entity is owned by only one owner, a single member LLC, the default tax treatment would be that the entity is disregarded for tax purposes. In other words, it would not file a separate federal income tax return. All the tax consequences of the activities within the legal entity are reported on the tax return of the entity’s owner.
Multiple Member LLC
If a limited liability company is set up, and the entity is owned by more than one owner, a multiple member LLC, the default tax treatment would be that the entity is taxed as a partnership. An entity taxed as a partnership reflects the tax consequences of the activities within the legal entity on a partnership return. The partnership generally does not pay tax on the activity, but rather the taxable income and loss are passed through to the LLC owners. The LLC owners reflect the taxable income or loss on his/her/its tax return and are responsible for paying any resulting tax. Either a single-member LLC or a multiple-member LLC may elect to treat the LLC as a C-corporation or an S-corporation for tax purposes.
How C-corporations and S-corporations Are Taxed
The default treatment for an entity set up as a corporation will be taxed as a C-corporation. An entity taxed as a C-corporation, including an LLC electing to be taxed as a C-corporation, pays the tax on any taxable income generated by activities within the entity. Additionally, any distributions of earnings from the C-corporations to the entity owners are generally considered dividends that are required to be reported as taxable income by the owners when received. In other words, the earnings of an entity taxed as a C-corporation are potentially taxed twice. Once, as they are earned within the entity, and then again upon distribution to the owners of the entity.
An entity set up as a corporation, a single member LLC or a multiple member LLC may elect to be treated as an S-corporation. Like an entity taxed as a partnership, an S-corporation does not pay tax at the entity level but rather passes the taxable income and loss through to the owner or owners. Additionally, like a partnership, distributions from an S-corporation are not taxable as dividends to the owner when received.
Since we covered how different entities are taxed based on how they are set up, and what elections they may or not make, we will explore some of the issues that should be considered when making an entity selection. We will also address potentially electing to treat an entity one way or another for tax purposes.
Tax Advantages of S-Corporation:
The advantages of an S-corporation are limited to the avoidance of double taxation associated with C-corporations, as well as some potential benefits of lower Social Security and Medicare taxes.
Tax Disadvantages of S-Corporation:
The primary disadvantage of an S-corporation for a license holding company is any non-deductible expenses resulting from 280E are passed through to the owner(s), which then reduces the ownership’s tax basis in its investment in the entity. A reduction in tax basis is to owners of an entity because the basis is used to reduce taxable income when/if the owner liquidates ownership in the entity.
Other disadvantages of S-corporations include but are not limited to restrictions on ownership of the entity, a requirement for reasonable compensation paid to owners, and a lack of flexibility in the allocations of earnings among owners.
Tax Advantages of Partnerships:
The advantages of a partnership include but are not limited to the avoidance of double taxation associated with C-corporations, flexibility in the allocation of earnings and losses among owners, and flexibility in the type of entity owners.
Tax Disadvantages of Partnerships:
Like S-corporations, the primary disadvantage of an S-corporation is any non-deductible expenses resulting from 280E are passed through to the owner(s).
Other disadvantages of partnerships include potential self-employment taxes on earnings allocated to active owners, potential complexity in the allocations of taxable income, and losses among partners in entities with many owners or different classes of ownership.
Tax Advantages of Corporations:
In contrast to S-corporations and partnerships, the tax basis resulting from the ownership’s investment in the entity is not subject to reductions from non-deductible expenses being passed through to owners. This protection of tax basis is particularly important to owners of license holding entities.
An additional advantage of C-corporation tax treatment may be a lower tax rate applied to taxable income.
Tax Disadvantages of Corporations:
The most significant disadvantage of C-corporation tax treatment is the potential double taxation of earnings that might be applicable if the entity does have earnings that are distributed.
In addition to the items address above, the advantages and disadvantages of the entity type and related tax elections, additional considerations include:
- How much of the 280E nondeductible expenses will the taxpayer be subject to?
- How many earnings will the entity be distributing to the owners?
- How complex is the entity’s ownership?
The lack of certainty regarding whether or not the qualified business income deduction (QBID) by pass-through entity owners is allowable as a deduction by owners receiving pass-through income from an entity subject to 280E.
Navigate the complicated world of legal entity tax structures with a trusted advisor
At Bridge West, we advise taxpayers to consult with skilled cannabis advisors who have experience in the industry. We have significant experience with entity structures, and we help cannabis entrepreneurs and operators navigate the complexities of tax compliance and Code Section 280E.
Calvin Shannon, CPA, CVA, a Principal with Bridge West, has over 20 years of experience providing tax, audit, estate planning, and trust services. With a deep understanding of the challenges cannabis clients face, Calvin is skilled at developing and implementing innovative solutions and addressing the industry’s unique and ever-evolving issues. He enjoys collaborating with cannabis clients to understand their business needs and provide timely and value-added services. Calvin can be reached at cshannon@bridgewestcpas.com and 651-587-5804.
