Cannabis Companies Can Save Millions With One Tax Code Section
At 420CPA, we like to highlight cutting-edge advisors we work with closely. Here’s a recent article from Bloomberg.com by Michelle Mabugat and Zackary Nolan of the L.A. law firm Greenberg Glusker. The piece examines the sale of Qualified Small Business Stock and how, if handled correctly, sellers can exclude $10 million of profit while avoiding capital gains taxes.
(Reprinted with permission of Bloomberg.com)
The burgeoning cannabis sector can reap significant tax advantages by using the qualified small business stock rules in Section 1202 of the tax code, which allows investors to exclude the greater of $10 million or 10 times their basis in the stock. But cannabis investors must navigate several uncertainties if they want to pursue them.
The first uncertainty is Section 280E, which denies any “deduction or credit” for cannabis businesses. Considering Section 1202 provides an exclusion, which is neither a deduction nor a credit, Section 280E shouldn’t affect a cannabis company’s ability to claim an exclusion under Section 1202 based on a plain reading of the statute. This position isn’t free from doubt, however, as there is no guidance on this issue.
Another hurdle lies in Section 1202(e)(3)(C), which denies a QSBS exclusion for any farming business. Unfortunately, the tax code doesn’t provide a comprehensive definition of farming in a single section. Further, it doesn’t provide any definition for farming under Section 1202(e)(3)(C), nor does Congress clarify its meaning in any of Section 1202’s legislative history.
Private Letter Ruling 202114002 establishes that undefined terms in Section 1202 are assumed to carry their “ordinary and common” meanings, and courts may rely on popular dictionary definitions to determine the plain meaning of such terms. Merriam-Webster defines farming as the practice of agriculture or aquaculture, with agriculture referring to the cultivation of the soil, crop production, and “in varying degrees, the preparation and marketing of such resulting products.”
While this definition implies that farming encompasses the typical activities one would associate with it, such as planting and harvesting cannabis, it’s unclear if tangential activities such as the preparation, management, or marketing of cannabis qualify as farming activities under Section 1202.
Taxpayers seeking to shed light on this ambiguity may look to other sections of the tax code. While these definitions aren’t binding for Section 1202 purposes, they may offer valuable insights into the scope of the definition of farming intended by Congress:
Section 2032A(e)(5): Farming includes handling, drying, packing, grading, or storing commodities, and preparing trees for market.
Section 464(e): Farming activities exclude non-fruit/nut-bearing trees.
Section 6420(c)(3): Farming activities may involve managing, conserving, improving, or maintaining farms, including tools and equipment.
Treas. Reg. 1.263A-4: Purchasing and reselling plants grown entirely by another party does not constitute farming.
- Reg. 1.263A-4(a)(5): In determining whether a plant is held for further cultivation and development prior to sale (i.e., considered a farming activity), consideration will be given to all of the facts and circumstances, including value-added by the taxpayer to the plant through agricultural/horticultural processes, length of time between the taxpayer’s acquisition of the plant and the time the plant was made available for sale, and whether the plant is kept in the container in which purchased, replanted in the ground, or replanted in a series of larger containers as it is grown to a larger size.
- Reg. 1.263A-4(a)(5)(ii)(B): Farming does not encompass product processing that goes beyond activities typically associated with growing, raising, or harvesting.
Treas. Reg. 1.175-3: Farming activities may include managing farms for profit through direct ownership or leasing arrangements.
As illustrated above, the tax code has taken numerous approaches to the definition of farming, so it’s unclear what farming-related activities may ultimately qualify for purposes of Section 1202(e)(3).
Mixed-use businesses involving farming and non-farming activities face even greater uncertainties under Section 1202(e)(3). However, recent guidance has indicated that Section 1202 may be more flexible than initially perceived. Private Letter Rulings 202221006 and 202125004 found that activities “merely incidental” to prohibited businesses wouldn’t violate Section 1202(e)(3).
Furthermore, in Private Letter Ruling 201436001, the IRS held that a qualified trade or business must not be primarily within a prohibited field, such as farming, operating a restaurant, or providing medical or legal services. These pieces of guidance show the IRS has historically interpreted the provisions of Section 1202(e)(3) in a liberal and taxpayer-friendly manner, which makes sense given Congress’ initial intent when drafting Section 1202 was to encourage investment of new capital into new and risky businesses.
Based on this information, we’ve outlined three broad categories to help taxpayers determine whether their farming activities are prohibited for Section 1202 purposes. If they’re mixed-use companies, we strongly recommend consulting with tax counsel to properly determine if there is a qualified trade or business.
Farming activities: Planting, growing, cultivating, germinating, or cloning cannabis plants; harvesting, trimming, and preparing plants for processing; and irrigation and fertilization.
Unclear if farming activities: Pest and disease management; breeding and strain development, such as creating new cannabis strains through selective breeding and genetic engineering to achieve specific traits or characteristics; microbusiness activities that include cannabis cultivation as a revenue stream; and ancillary services like marketing, management, leasing agreements, retail packaging, and storage.
Non-farming activities: Processing and manufacturing cannabis plants into various products, such as oils, edibles, topicals, and concentrates; distribution and logistics, including the transportation and delivery of cannabis products from manufacturing facilities to retail stores or end consumers; retail operations, such as brick-and-mortar dispensaries or online platforms for selling cannabis products; operations of consumption lounges, where onsite retail sales and consumer consumption of cannabis are permitted on the same premises; and research and development focused on scientific research to develop new products, improve existing formulations, or study the potential medical benefits of cannabis compounds.
Cannabis companies may face some big challenges and uncertainties when assessing QSBS eligibility or defending one’s position upon audit. While this uncertainty may generate excitement or anxiety, depending on one’s risk tolerance, it’s undeniable that cannabis companies that properly tailor their structures to their specific operations to maximize their Section 1202 tax benefits can potentially save millions in taxes.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
For Further Information, the Authors May Be Contacted Through These Links:
Zachary M. Nolan is a tax counsel at Greenberg Glusker in Los Angeles who advises clients on a wide range of tax issues, including entity selection and formation, financing, restructurings, mergers and acquisitions, cross-border planning, and tax-efficient dissolution.
Michelle Mabugut is co-chair of the firm’s cannabis industry group and is a corporate and transactional attorney representing entrepreneurs, start-ups, and middle-market companies.
