There is a widespread of IRS audits.
The IRS is expanding its audits beyond cannabis operators and is looking at landlords and other cannabis-related businesses. People start their entities as LLCs to realize that the 280E liability is stuck to them personally.
I guess in this industry, it is better to admit that audit is inevitable. Is there a business structure that will allow us to survive the IRS audit and even win it?
When you look at the entity planning, the general starting point is to answer the following question: Do you want to be a flow-through or a C-corporation?
- Double taxation. Double taxation happens when C corporations pay their tax on their earnings and then transfer what is left onto their owners as dividends. Dividends are taxed again on the individual level. So, owners end up paying taxes twice. Generally, people want to stay away from double taxation. However, this discussion changed since introducing the 21% tax rate. You can lower your tax by paying 21% in some situations, depending on whether you are profitable or not.
- The C corporation is liable for the 280E tax. In other words, if the C corporation fails, its owners won't be responsible for 280 E tax.
- Limitation on taxation on capital gains on the sale of an entity. Under Section 1202, there is a possibility of excluding income from selling your stock as long as you keep your stock for over five years. Most of the businesses out there are to sell, and it could be much better if you have C Corp in mind.
- California 280E addback. California allows C Corps to take 280E deductions on their state taxes. This means less money paid for California tax. No other entity is allowed to have these deductions.
- You need to be a C corp if you want to be owned by a Canadian company.
Flow-Through Entity (Partnership or S Corp)
- Single level taxation at the owner level. The owner receives a K-1 that shows a share of income and he puts it on his personal tax return. If the owner has a K-1 from 280E business, his/her income is going to be much higher.
- Reduction of basis - dollar for dollar, which is recognized on the sale of the entity. If your end game to sell the entity, the flow-through may not be a good option for you, since you may not have any basis left.
- The issue with an S corp. In the Cannabis world, an S Corp may be a wrong choice due to reasonable compensation to the owner. Reasonable compensation is mandatory for S Corporations but in the Cannabis industry, this expense most likely won't be deductible. So, there could be 200k of salary and the IRS can disallow this deduction. Generally, I do not recommend S Corporations.
- If a pass-through entity gets into a financial problem and cannot pay its tax liability, the owner becomes personally liable for unpaid taxes. The tax liability can be collected from the owners' assets ( home, mortgage, credit history).
- If the IRS audits your flow-through company, your personal tax return will also be audited. The IRS will be looking for LUQs ( Large Unusual and Questionable Items).
280E cannot be eliminated but it can be contained. We can look at different entities and choose the right structure based on the individual situation of the owner.
Daria Nagal, Cannabis CPA