Cannabis businesses have long been at the mercy of federal laws and regulations that prevent them from leveraging any tax breaks. In particular, the Internal Revenue Code Section 280E, which inhibits cannabis companies from taking any deductions on their taxes, is a detriment to the potential success of these businesses.
But what if there were a legal way that makes these regulations irrelevant? In this article, I’ll explain how cannabis companies can experience tax benefits and strategically circumnavigate the IRC tax code to maximize financial returns and stability.
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The Tax Burden on Cannabis Businesses
IRC Section 280E states, “all deductions or credits for any amount paid or incurred in carrying on any trade or business that consists of illegally trafficking in a Schedule I or II controlled substance within the meaning of the federal Controlled Substances Act.” In short, cannabis businesses can’t deduct typical business expenses.
However, they can deduct the cost of goods sold (COGS). This is because of IRC Code Section 471(c), which is tied to 280E.
To ease the tax burden on cannabis companies, the IRS expanded the definition of COGS under Section 471(c). In cannabis cultivation, for example, you can classify certain labor costs under COGS instead of treating them as expenses.
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Consider this example: If you plant a cannabis seed that costs you 10 cents and later sell the plant for $100, your COGS isn’t just the 10 cents for the seed. It also includes the cost of the soil, manure, water, and manual labor involved in growing the plant, making your COGS closer to $10.
This means that cultivation companies (or farms) can include more costs in COGS and aren’t as heavily affected by 280E compared to dispensaries, where COGS is more limited to the product cost (e.g., $5 for a joint). Cultivators are better able to deduct more under 471(c), reducing their exposure to 280E, while dispensaries remain more restricted.
So, what can cannabis dispensaries do to mitigate the tax burden? A potential course of action is to transition into an Employee Stock Ownership Plan (ESOP) structure.
ESOPs and The Associated Tax Benefits
What is an ESOP? An ESOP is another way for a company to sell itself. But instead of selling to a private equity firm or investor, the business sells itself to its employees. Why would business leaders choose to do this instead of selling to a strategic buyer with a juicy offer?
Typically, when you sell a business to a private equity firm or investor, you need to pay capital gains tax, which can cost millions of dollars. When you sell to the employees via an ESOP, you can defer capital gains tax indefinitely. This means more money remains with the business, and said money can be reinvested into the business to further growth.
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Plus, when a cannabis company is 100 percent owned by an ESOP, it receives extensive tax benefits, such as not having to pay any federal or state income taxes forever. This enables businesses to double (or even triple) their cash flow.
How is this possible? In the 1970s, the government wanted to find a way that capitalism could work for everyone. But they realized capitalism only works if everyone has equity. As such, the government began incentivizing companies to sell to employees with massive tax benefits.
All these tax benefits mean one thing: The IRC Code 280E becomes irrelevant when a cannabis company transitions to an ESOP.
What Happens to 280E if Cannabis is Rescheduled?
Now, it’s possible that cannabis will be rescheduled to a Schedule III substance, which would make code 280E irrelevant for cannabis businesses regardless of whether they’re structured as an ESOP. That would be great news, right? Cannabis companies would then be able to make deductions on their taxes.
But wouldn’t better news be that your company, regardless of 280E being relevant or not, doesn’t have to pay any taxes, federal or state, at all? That’s the power of structuring your company as an ESOP.
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Final Thoughts
The tax burden placed on cannabis businesses continues to pull the reins in on the industry’s growth potential. However, if you know where to look and how to maneuver, you might just find a way to ensure the reins on your business loosen up. Transitioning to an ESOP structure is a surefire way to mitigate the tax burden, expedite the growth of your cannabis company, and become a household name in the industry.
*This article was submitted by a guest contributor. The author is solely responsible for the content.