The cannabis industry might be one of the largest industries in the next decade, but right now, it’s risky, expensive and faces uncertain legal and tax hurdles, says an accountant who specializes in the cannabis industry.
Matthew Foster CPA, a partner with Frazier & Deeter, LLC and the firm’s National Practice Leader for the Cannabis Industry, spoke about accounting and the cannabis industry earlier this year at the Georgia Association of Business Brokers.
“This is not an industry for the faint of heart,” warned Foster. “If you have a very low risk tolerance, I would just advise you to stop right now and wait until the feds open it up in about five or six years, possibly longer.”
The biggest risk? The whole industry is illegal in the eyes of the federal government.
“From a federal perspective, every one of these companies that are in cannabis are lawless citizens of the U.S.,” said Foster. “They’re all breaking the law.” Federal officials could “come in at any moment and break them up if they wanted to.”
If the company is in one of the many states that has legalized cannabis, most assume that federal officials won’t intervene, “unless they do something really out of line,” Foster said.
Georgia’s Cannabis industry
Georgia’s cannabis industry is poised for growth because the state recently passed a law legalizing the production and manufacturing of low THC CBD oil, defined as anything with a THC content of 5% or less. That’s just strong enough for medicinal use, and not strong enough for intoxication. The new law allows up to six licenses for growing medical marijuana, plus licenses to the University of Georgia and Fort Valley State University for research.
Of the six private licenses, two will be for large productions, up to 100,000 square feet, and four for up to 50,000 square feet. There’s a $25,000 non-refundable application fee for a large license, along with an initial $200,000 licensing fee and $100,000 annual renewal fee. The smaller licenses carry a $5,000 non-refundable application fee, along with an initial $100,000 licensing fee and $50,000 annual renewal fee.
“So you need a lot of capital just to hold the license in Georgia,” Foster said. “That’s before you even start with the production and the costing and everything else.”
Recently Flourish, an Atlanta-based supply chain management startup that helps cannabis companies monitor logistics, raised $2.1 million in a seed round led by 7thirty Opportunity Fund, the Atlanta Business Chronicle reported.
Georgia has made cannabis companies ineligible for any state tax incentives. “You are going to pay tax on every single dollar that you make here in Georgia,” Foster said.
Which means that companies in the cannabis industry right now must be highly capitalized. “You have to have a lot of money at your disposal to weather the storm until the feds open it up,” said Foster.
Frazier & Deeter works with clients to set up inventory methodologies that will move as many expenses as they can under current tax law from their overhead into the cost of inventory.
Another obstacle for the industry is banking. Under current laws, federally insured banks are not allowed to do business with cannabis companies.
“These companies can bank with state-sponsored banks, with credit unions, if those banks decide they want to work with this industry. But they can’t bank with FDIC-insured banking institutions, your Wells Fargo, your Bank of America, your Chase, because they are federally regulated,” Foster said.
Cannabis industry investors are lobbying legislators to pass a law that would make cannabis similar to hemp, which would open up a more traditional taxation and banking.
Foster predicted that Congress will act on banking before legalization because right now, the federal government is losing lots of potential tax revenue from the industry.
Cannabis VS Industrial Hemp
Cannabis and industrial hemp represent different segments of the market. For example, industrial hemp is becoming a very attractive option for people to invest in thanks to last November’s farm bill. The farm bill, in essence, descheduled industrial hemp, defined as a product with a less than 0.3% THC content per gram. Hemp fiber and oilseed can be used in variety of industrial and consumer products. What the bill did was deschedule hemp, meaning it’s still illegal at the federal level, unless you are producing and working in a state that has legalized industrial hemp.
Cannabis is still illegal from a federal standpoint, despite being legal for medicinal uses in 33 states and the District of Columbia, and in 11 states and D.C. for recreational uses. Because cannabis is included in Schedule I of the Controlled Substances Act, it falls under section 280E of the IRS code. “That means cannabis businesses cannot deduct any necessary or ordinary business expenses for federal income tax purposes, nor can they claim any Federal credits,” Foster said.
“You can deduct your cost of goods sold, but everything else in your return is non-deductible,” Foster said. “You can’t have R&D credits, you can’t have business credits, and you can’t have jobs credits. Take your revenues, deduct your cost of goods sold, get your gross profit, and that’s your taxable income: your gross profit.”
But companies with shrewd accountants can take advantage of certain sections of the IRS code that allow companies to capitalize their overhead, which would allow them to deduct some of the expenses for rents, utilities, property taxes, salaries, depreciation, etc.
Managing Cannabis Finances
Foster recommends that their traditional cannabis clients do full financial statement audits which allows for an opinion on what’s capitalized into the cost of inventory and what’s being deducted as cost of goods sold. If the IRS does come in and audit, “we have a lot of support for the position that we have taken.”
Cannabis companies should NOT use the name of the plant in their company name, Foster recommended, to try to minimize the red flags that the IRS will see on these companies.
“First and foremost, the words cannabis, hemp, and marijuana should not appear on your tax return, anywhere,” said Foster.
Also, these companies should not get creative in taking deductions, Foster said. If you go that way, “start putting money aside because you’re going to get audited.”
He also recommends that anybody in this space should operate as a C Corp, mainly because it’s the lowest tax rate that you can find on federal level right now. Also a C Corp allows a company to “put up a corporate wall around your investors.”
If the IRS starts attacking the company, the investors are only out what they put into the company. It won’t be able to go after their personal assets. He also recommends portioning off different sections of the business into separate entities for real estate, equipment or intellectual property.
Potential Profits Huge
Returns on investment are a mystifying 10 to 30 multiples on revenue streams in the industry. “I haven’t quite figured out what’s going on in this space,” Foster said. “This must be Toad’s Wild Ride for investors.” But last year, a lot of people made a lot of money.
“So, it depends on when you get in, what you get in to, and how long you’re willing to ride this roller coaster,” Foster said.
Big U.S. companies are awaiting new banking regulations that will ease investment into this industry. Foster said “They’re either waiting to go public, or they’re waiting for big pharma, big tobacco, or big alcohol to come in and buy them up.”Read More
By Greg DeFoor
One of the questions I get asked by aspiring or new business owners as a CPA and Business Broker is about S Corporations vs LLCs. Before deciding whether to form an S Corp or an LLC, there are a number of issues to consider. Assuming there is only one owner or a few owners and that all owners are qualified to own their respective shares or member units, here are factors to consider.
More Formal vs Less Formal
S corporations are more formal and require a little more in terms of documentation. When you form a corporation and elect S Corp status, you are required to elect officers and hold annual shareholder meetings. You need corporate bylaws in writing when you establish the corporation. You need to prepare minutes no less than annually that document decisions made during the year. It would be wise to get an attorney to help you with a form or template for completing these minutes.
LLCs are less formal. Once you form an LLC and prepare an operating agreement, there is no requirement for minutes or annual meetings.
Net Income and Distributions
Net income and distributions are not necessarily treated the same in S Corps and LLCs. In an S Corp, net income must be allocated based on ownership percentage. Distributions must be made by ownership percentage. In an LLC, there can be a disproportionate allocation of net income and unequal member draws. When there is only one owner, there really won’t be a difference. However, when there is more than one owner, S Corp shareholders are treated equally in terms of allocated items, and LLC members are treated based on how the operating agreement says they will be treated.
If you need an entity that allows for owner treatment that varies from ownership percentage, an LLC will allow that whereas an S Corp will not.
Guaranteed Payments vs Salary and Self-Employment Tax
In an LLC, you should not pay yourself a salary. Instead, you should take guaranteed payments. Guaranteed payments are subject to self-employment tax but are not paid as W-2 wages. They are treated more like a draw than as payroll. In an S Corp, you need to pay yourself a reasonable salary.
The net earnings from an LLC, except for earnings from the net rental of real estate held for investment, are subject to self-employment tax. The net earnings of an S Corp are not. One of the primary benefits of being a shareholder of an S Corp is the ability to take distributions that are not subject to self-employment tax. You are taxed on the net income of the S Corp. You pay yourself a reasonable salary, and any other net income may be distributed as a shareholder distribution.
Disregarded Entity and Tax Returns
If you are a single member LLC, you are a disregarded entity for tax purposes and the LLC income and expenses flow through your personal tax return on Schedule C. If there are more than one member of the LLC, the LLC files a partnership return. An S Corp files a corporate tax return specifically for S corporations. Both a partnerhip and S corporation are flow through entities. Neither pays income tax at the entity level; rather, both pass taxable income and other tax items directly through to the owner’s individual tax return.
To further complicate matters, an LLC can be an LLC for legal purposes but can also elect to be taxed as an S corporation for tax purposes. If an LLC elects S Corp status for tax purposes, tax matters have the attributes of an S corporation.
Distributions of Property
An S Corp is not necessarily a good entity to hold appreciating property in. That is why S Corp owners who also own the business real estate usually own the business real estate in a separate entity that is an LLC. The reason is usually a tax reason. You can’t distribute appreciated property, such as real estate, out of an S Corp to the S Corp shareholders without triggering a taxable event as if the real estate had been sold. With some restrictions and limitations, you can distribute appreciated property, such as real estate, out of an LLC to the LLC members without triggering a taxable event. In an LLC, the members assume the basis of the distributed property and there is no realizable gain or loss until the property is disposed of.
In order to be an S Corp, you form a corporation and then you file an election to be taxed as an S corporation with the IRS. The election is filed on IRS Form 2553. You must file the election within 75 days of the start of the year you want to elect S Corp status, or within 75 days of forming the entity if you want to elect S Corp status from the beginning.
If you file an LLC for legal purposes but want it to be taxed as an S Corp, you file the same type of election for the LLC you do for a corporation, with the S Corp election for an LLC also having the 75 day requirement.
The catch is, once you elect for either your corporation or LLC to be taxed as an S Corp, you cannot revoke the election. The S Corp election can only be terminated by filing a request with the IRS and receiving permission from the IRS for the S Corp status to be terminated. For this reason, electing S Corp status needs to be entered into carefully, as it cannot be easily undone.
S Corp vs LLC
In deciding S Corp vs LLC, seek advice of a tax professional and an attorney, and find out both the legal and tax reasons for electing one entity over the other. There is certainly more involved than what this article can cover, but this article should be enough to let you know there are a number of things to consider before choosing choice of entity for your business. Make sure you use an advisor that is familiar with business transaction services.
Greg DeFoor, CPA, CFE, has been a CPA for more than thirty years and is also a licensed Business Broker and Past President of the Georgia Association of Business Brokers.