This is the second in a series of blog posts discussing Section 280E of the federal tax code and how cannabis business owners can reduce their tax liability. The content is from the recent MJ Platform webinar “280E and Tax Season” featuring Brian Cadieux, President of Cadieux and Associates, a Denver-based bookkeeping and tax preparation services firm.
Click here to watch the webinar.
As discussed in our previous post, Section 280E of the federal tax code restricts cannabis businesses from deducting “otherwise ordinary” business expenses from gross income, which makes the tax liability much higher than for non-cannabis businesses. While this puts cannabis businesses at a disadvantage when it comes to calculating business tax, there are ways to lower a cannabis company’s tax rate, such as how the company is structured.
In this post, we will discuss the different options cannabis business owners may want to consider when it comes to structuring their company — whether it be a sole proprietorship, pass-through, partnership, or C-Corp. There are pros and cons of each as they relate to 280E.
Let’s start with sole proprietorships.
Sole Proprietorships: Minimal Advantages for Cannabis Businesses
For any business structured as a sole proprietorship, the business is taxed at the individual owner level. In this instance, the owner is entitled to take the standard deduction of $12,200, as well as the Qualified Business Income Deduction (QBID). QBID is a relatively new deduction put in place for sole proprietorships and pass-through entities, enabling these businesses to deduct up to 20% of their qualified business income (on top of the standard deduction) to reduce their tax liability.
Since cannabis businesses are unable to deduct business expenses, qualified business income is higher than non-cannabis businesses — making the 20% QBID also higher. At the same time, QBID is being taken from a higher income level, so the difference between the overall tax rate for a cannabis business versus a non-cannabis business can be significant. In the example provided in our recent webinar, for instance, the tax rate for the cannabis sole proprietorship was 66.2% — more than double that of the non-cannabis sole proprietorship tax rate, which equaled 25.6%.
Sole proprietorships offer a disadvantage to all types of business owners because they also incur a self-employment tax. Because of this, it isn’t recommended that cannabis businesses structure themselves this way. A more beneficial approach would be to structure as a pass-through S-Corp or a C-Corp, which I’ll discuss next.
Pass-Through Entities and Partnerships: Reducing Tax Liability
Pass-through entities are also S-Corporations set up as partnerships, where income is passed through to each partner at the owner level. This structure offers a few advantages over sole proprietorships. First, the standard deduction a pass-through business can take is much higher because it is allowed for each business partner rather than for just one owner. The example offered in our recent webinar looked at a pass-through entity with four business partners/owners. As I mentioned earlier, with a sole proprietorship, the standard business deduction is $12,200 – but for the pass-through entity, the $12,200 deduction is multiplied by four for the number of partners, so the standard deduction would then be $48,800.
Second, pass-through S-Corps also incur no self-employment tax, which can save a good deal in business taxes. One thing to keep in mind about pass-through corporations, however, is that each partner’s wages will be added to total income — so if the four partners each have wages of $70,000, that adds $280,000 to the company’s total taxable income. But again, without self-employment tax combined with a higher standard deduction, the pass-through business comes out ahead.
In the sole proprietorship example above, the cannabis business tax rate was 66.2%. With a pass-through business, the cannabis business tax rate would be 47.69%, which is quite a bit less. The non-cannabis business tax rate would be 17.09% — also a lower percentage than the non-cannabis sole proprietorship example we saw above of 25.6%.
C-Corps: Less Risk for Start-ups
C-Corps are often the best way for start-ups to go — at least initially. While the business tax rate is a bit higher and there is certainly more complexity than with a pass-through S-Corp, the C-Corp structure shields owners from some tax liability if the business fails. For example, with any type of new business, there are a lot of start-up expenses in the first couple of years that can’t be deducted for cannabis companies. However, for a C-Corp, if the business fails and there is a significant amount of tax due, the owners are not on the hook to pay them as they would be with the other two types of businesses.
The main drawback of a C-Corp is that the business tax of 21% is calculated right off the top, from total income — and again, when no business expenses are being deducted, this amount will be higher for a cannabis business. Similar to a pass-through business, the partners’ wages are also taxed, along with any dividends paid out. Furthermore, the 20% QBID no longer applies. So taking all of this into account, if we look at the cannabis pass-through example we referenced above, which had a tax rate of 47.69%, the cannabis C-Corp tax rate would be 56.69% – which is a bit higher, but again offers some protections the pass-through structure does not. For reference, the non-cannabis C-Corp tax rate would be 33.44% in the example given in our webinar.
One approach for start-up cannabis businesses to consider is to structure as a C-Corp for the first couple of years. Once the business is successful, it can change its structure to a pass-through S-Corp to reap additional tax advantages.
If you’re still unsure which option is best for your company, I encourage you to view our recent “280E and Tax Season” webinar, featuring Brian Cadieux of Cadieux and Associates. The webinar provides tips for cannabis business owners and accountants about how best to structure a cannabis business and manage expenses to reduce their tax liability.
Disclaimer: The opinions expressed in this blog post are those of the author. They do not purport to reflect the opinions or views of Akerna or its family of companies. The information contained in this post is provided for informational purposes only and should not be construed as tax advice on any subject matter. You should not act or refrain from acting on the basis of any content included in this post without seeking tax or other professional advice.
