Cannabis businesses, like other businesses, must make an important decision when starting a business: What type of entity should they conduct their business operation through?
The major forms of business entities are partnerships, limited liability companies, S-Corporations and C-Corporations. Each entity type has its own unique tax and legal advantages and disadvantages. S-Corporations and partnerships are called “pass-through entities” due to income, deductions, credits and losses passing through to the respective owner individual tax returns, with the entity generally not being subject to federal income tax. C-Corporations pay income tax at the entity level and income generally is not reported by the owners unless wages or dividends are paid to them. Limited liability companies with more than one member can elect either partnership treatment or C corporation treatment, and single-member limited liability companies can elect to be ignored altogether. Another advantage for a C-Corporation is its lower immediate tax rate and the owners individual tax returns are not complicated by a pass-through income or loss. The owners also are not personally liable for the C-Corporation income taxes.
Choosing an entity type is even more important to cannabis companies that commonly deal with IRC Sec. 280E. For federal income tax purposes, IRC Sec.280E denies deductions and credits to cannabis businesses, except for cost of goods sold (“COGS”), since cannabis is still federally illegal.
One advantage certain C-Corporations have over other entity types is IRC Sec. 1202. This Code Section allows an eligible shareholder to potentially exclude up to 100% of the gain on the sale of eligible qualified small business stock (“QSBS”), potentially saving a taxpayer significant federal tax dollars when he or she sells the stock.
In order to qualify as QSBS and thus be eligible for the IRC Sec. 1202 exclusion, the stock must satisfy all of the following:
- It must be issued by a domestic C-Corporation with no more than $50 million of gross assets at the time of and immediately after issuance;
- The corporation must use at least 80% of its assets (by value) in an active trade or business, other than in certain personal services and types of businesses;
- The stock must have been Issued after September 28, 2010 for the 100% break (see below);
- The stock must be owned by an individual or an entity other than a C-Corporation;
- The stock must have been acquired by the owner on original issuance; and
- The stock must have been held for more than five years.
The percentage of gain on the sale of QSBS that is excluded from federal income tax is determined as follows:
- QSBS issued from September 28, 2010 – Present = 100% gain exclusion.
The amount of gain eligible for exclusion is limited to the greater of $10 million or 10 times the taxpayer’s basis in the QSBS. (You can make certain transfers to increase this amount.)
If all requirements of Sec. 1202 are met, will a cannabis business be eligible for this tax break?
IRC Sec. 280E states:
“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 consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act) that are prohibited by federal law or the law of any state in which such trade or business is conducted.“
Since IRC Sec. 1202 operates to exclude gain from recognition, it is neither a deduction nor a credit. Although the Internal Revenue Service has not provided any official guidance, a reasoned answer from reading the tax law is that if the cannabis business meets all requirements of IRC Sec. 1202, a cannabis business owner may be eligible for the tremendous gain exclusion.
Most cannabis businesses have been recently formed and may not meet the five-year test, yet IRC Sec. 1202 is a tempting reason to consider formation, or election, as a C-Corporation.
If you are a limited liability company taxed as a partnership but want to consider switching to C-Corporation and be eligible for § 1202, you need to meet with a competent tax advisor.
The choice of entity is a complex area, as are the requirements of IRC Sec. 1202. A qualified tax professional should be consulted to provide entity choice consulting and determine potential eligibility for IRC Sec.1202.
Stacy Campbell, CPA
Partner, Tax Services