Why Forming an LLC to Operate Your Cannabis Business May Not Be Tax Wise
August 13, 2018
Choosing the Proper Legal Structure for Your New Jersey Cannabis Business Can Be Especially Challenging Due to the Legal Uncertainties Under Both Federal & State Law
When forming any type of New Jersey business, choosing the proper legal structure is one of the most important decisions you will make. The choice is even more challenging for a New Jersey cannabis business, which still faces a number of legal uncertainties under both federal and state law.
Choosing the Right Legal Structure
When making an entity selection, there are a number of factors to consider, including personal liability for business owners, tax treatment, and administrative burdens and expenses. For business owners seeking limited liability, the traditional options include a limited liability company (LLC) or a corporation.
There are many practical reasons to use an LLC; they are (1) easy to form; (2) less formality than a corporation; (3) simplified tax reporting; and (4) protection from creditors as would a corporation. While less “formal” than corporations, LLCs still limit personal liability for business debts and court judgments against the business and shield an owner’s personal assets. In addition, LLCs also offer flexibility. Owners of an LLC can also choose how the entity will be taxed. For instance, they can elect to be taxed like a partnership, in which the owners pay taxes on their shares of the business income using their personal tax returns, or like a corporation, in which the tax obligations of the business are generally separate from the owners.
Corporations can take more than one form. S-corporations (s-corps) are more like LLCs, in which taxes “pass through” to individual business owners. S corporations (also known as small business corporations) preceded the LLC and was the entity most often used for a small business before the LLC came into existence. In C-corporations (c-corps), the tax obligations of the corporation’s business are distinct, and owners of corporations pay taxes only on profits that they actually receive in the form of salaries, bonuses, and dividends.
Corporations are more complex than LLCs with respect to both taxes and legal formalities. As noted above, income is subject to double taxation. Corporations are also required to adopt bylaws, formally define the roles of officers and directors, and keep detailed records. As a result, they can be costlier and more burdensome to run.
Tax Reform Law Changes Entity Selection Analysis
The Tax Cuts and Jobs Act of 2017 (TCJA) dramatically changed how businesses approach tax planning, including business entity selection. While the tax reform law preserves the key tax difference between traditional corporations and pass-through entities like S-corps and LLCs, it dramatically reduced the corporate tax rate and created a new deduction for pass-through tax entities.
Under the TCJA, the tax rates for entities and individuals were changed. The maximum tax rate for a married couple filing a joint return and for a single person is 37%. Of course, the brackets apply to each taxpayer differently. In some instances, under the TCJA, a pass-through entity or even an individual may be able to reduce the top tax bracket, but in no case below 29.6%. On the other hand, regular corporations, or c-corps, are taxed at a flat 21%.
The computation of business income, for the most part, is the same for an LLC, an S or a C corporation. However, how, when and under what circumstances distributions from each are made had important consequences. Therefore, it is important to consider the ultimate net benefit that will be received by the business owner from his business entity. Immediate tax savings, of course, is important but equally important is the long-term tax savings and achieving the owner business goals. Each business entity may produce a different result in the short term and in the long term. Surprising, one form may actually be well suited for a New Jersey cannabis business.
Section 280E of the internal revenue code limits deductions by businesses which sells illegal substances by providing:
“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
Because marijuana is a schedule I controlled substance under the meaning of the Controlled Substances Act of 1970, Section 280E applies to the marijuana dispensary industry, making Section 162(a) deductions unavailable to a marijuana dispenser.
Consequently, Section 280E prevents either medical or recreational marijuana dispensers from receiving Section 162(a) deductions. Even if recommended by a physician as appropriate to benefit the user’s health, selling marijuana to this person still violates.
Nevertheless, when computing gross income, taxpayers could subtract the cost of goods sold from total sales under Reg. 1.61-3(a). This subtraction is allowed even if the taxpayers are involved in an illegal activity.
While case law is limited and conflicting on the ability to deduct business expenses other than the cost of goods sold, other provisions of the Code which used in conjunction with the above-cited provisions that can reduce income distributed from a C corporation more advantageously over LLC’s and S corporations.
If you have any questions, please contact us
If you are interested in exploring these options or if you would like to discuss the matter further, please contact me, Frank L. Brunetti, at 201-806-3364.