By Rachel Wright, Simon Menkes, & Abraham Finberg- CPAs licensed in California of AB FinWright LLP & 420CPA, and Andrew Gradman, Esq of Andrew Gradman Tax
This is Part II of II of our series entitled “Unexpected 280E Dangers in Farm Service Management Arrangements.” This series is intended to educated cannabis business owners, professionals, and their advisors on federal tax issues surrounding this emerging area of the cannabis industry.
Review of Part I
In Part I we introduced the concept of the federal income tax dangers of farm service management arrangements for the consultant providing these services (Outsource Co) to the licensed entity (LicenseCo). In Part II, we’ll delve into the issues a bit further as well as provide some solutions to effectively structure the partnership.
LicenseCo & OutsourceCo do not have the same 280E Problem
LicenseCo at least can take the position that it is a “licensed cannabis producer;” thus, it can offset gross receipts by capitalizing much of its costs into inventory and later recovering them as cost of goods sold. Cultivators actually do not have much of a 280E issue- other than selling expenses, which the code is clear that no cannabis businesses can take. Arguments can be made for how aggressive a cultivator can be in capitalizing costs, but they do not have the same problem arguing what is considered cost of goods sold- certainly not the same one as cannabis retailers, delivery services, and other businesses along the vertical do.
By contrast, as mentioned earlier, OutsourceCo cannot capitalize costs into inventory, as this would be inconsistent with its unlicensed status under state cannabis law. Additionally, it is not a producer as it does not have title or ownership of the product and therefore has no inventory. Producers, however, can claim that they are changing the form of the product, thereby allowing for inventory capitalization. In contrast, OutsourceCo’s very existence depends on providing a service. The problem is that there is no concept of inventory in a service based business that does not sell a product. 280E will bar any potential reduction of gross income- IF they provide cannabis-touching employees on their own payroll to LicenseCo.
The IRS will likely throw the 280E book at OutsourceCo for having cannabis-touching employees. From the point of view of the IRS, if an employee touches cannabis, then automatically, the company that has hired that employee is subject to Section 280E. Thus, OutsourceCo must be careful to avoid being treated as “drug traffickers” for tax purposes.
Take A Warning from Alternative Health Care Advocates!
The dispensary, Alternative Health Care Advocates, paid a related company, Wellness Management Group, to employ personnel, maintain bank accounts, and pay expenses. Hauled into tax court, Alternative stated that, “as a management services company, Wellness did not itself engage in the purchase and sale of marijuana.” The court rejected that argument. It noted that “Alternative acted only through Wellness,” and that the only difference between the companies was that Alternative had legal title to the marijuana, a distinction which it concluded was immaterial. The Tax Court acknowledged this meant that “deductions for the same activities would be disallowed twice;” nevertheless it dismissed the taxpayers’ assertion that this was “inequitable,” pointing out that the tax consequence was “a direct result of the organizational structure petitioners employed.” (See Alternative Health Care Advocates et al. v. Commissioner 151 T.C. No. 13 (2018)) for more info.)
Based on the Alternative Health Care case, ideally, LicenseCo should take on the cannabis-touching employee costs itself, rather than having the OutsourceCo pay for them. This is the most straight forward way to avoid the complex 280E minefield we mentioned earlier. However, we realize that the business model for some may completely disappear if they were to do that. Another option is to have a type of company for Outsource Co that simply leases its labor- such as a temporary agency. It may also act as what is a type of professional employer organization, or a PEO company. For all other services, Outsource Co may form another entity entirely. In this case, there may be an argument, albeit not a bullet-proof one, that only the deductions in the new employment company (Let’s call this new company EmployeeMgmtCo.) would be disallowed. OutsourceCo can offer the remaining services apart and separate from EmployeeMgmtCo. with less of a risk of being considered a cannabis-touching business.
California Licensing & Other Considerations.
The purpose of this article is to discuss tax, however, we thought it notable to mention other important considerations as well.
Although California has come out of the Dark Ages and made cannabis fully legal, there may be licensing risks for OutsourceCo. California views cultivation and distribution of cannabis as a privilege granted to the holder of the license exclusively, not to another party with whom they contract. Assembly Bill 266 says, “A person engaging in commercial cannabis activity without a license shall be subject to civil penalties.” Assembly Bill 64 goes further and looks closely at who employs the cannabis-touching employee, stating (with respect to distribution but with inference to cannabis cultivation, manufacturing, and retail), “The driver of a vehicle transporting cannabis or cannabis products shall be directly employed by a licensee authorized to transport cannabis or cannabis products.”
There are a number of other issues involved to be ironed out as well- accounting and CDTFA reporting to name more. These are also important topics that must be ironed out within these arrangements, and the accounting team on both sides must be on board and communicative for a seamless arrangement to follow.
Some Light at the end of the Tunnel…and it’s not a Train.
In our experience, arrangements should rarely be done with a handshake- especially the farm service management arrangements discussed here. With knowledgeable tax and legal counsel, as well as some openness to suggestions on behalf of the cannabis service and cultivation businesses, an arrangement can be reached that will serve both sides well.
(Disclaimer: The article is not intended to give tax advice. As always, rely on the expertise of a licensed tax professional that can advise in your personal and business situation.)