By Cory Parnell, CPA, Chief Operating Officer of Bridge West, LLC
Over the past 12 months, Bridge West has been leading numerous conversations with their cannabis clients regarding organizational structure and entity selection. These conversations have benefited both start-up organizations, as well as, established cannabis operators.
During this time, Bridge West has observed that most cannabis companies have created a multi-entity structure. At least one entity within this organizational structure, a Service Provider Entity (or SPE), is set-up to provide services to the operating entity (the plant touching company) for a fee. Subsequently, the operating entity takes the position that this service fee should be part of cost of sales, and thus, not be subject to 280E. The operating expenses of the SPE (selling and general and administrative expenses) are then offset by the service provider fee. The strategy is to avoid the limitations of 280E by moving such costs into a related entity that is not subjected to the 280E limitations.
On the surface, this multi-entity structure appears to circumvent the 280E rules. However, this strategy poses significant audit risks to operators as the IRS has many weapons available to collapse this organizational structure, such as the economic substance doctrine or the step transaction, just to name a few. Losing an IRS audit on the above strategy is costly and will certainly result in the payment of unpaid back taxes, interest, and potentially significant penalties.
We also gain an understanding of the IRS’s position relating to these tax structures from the following quote from an IRS attorney addressing the cannabis industry, “we will follow the money.”
C Corporation Conversions
The choice to operate as a C corporation or to elect to have your LLC taxed like a C corporation has become a hotter subject after the Tax Cuts and Jobs Act (“TCJA”). Under the TCJA, the federal corporate tax rate is now reduced to 21% (down from 35%) for tax years beginning in 2018. With this law change, more of Bridge West’s cannabis clients have requested conversions to C corporation status to lower their income tax obligations. We hear the same recommendations from other cannabis consultants as well. However, after a deep dive with management, owners, and legal counsel, we have only converted a few clients to C corporation status.
The key to deciding entity structure and the selection of an entity is primarily strategic and to ensure the most efficient tax entity is used to minimize income taxes. The process to arrive at a conclusion on entity selection requires careful planning and input from all parties involved.
Please contact Cory Parnell, CPA, Chief Operating Office of Bridge West, LLC at firstname.lastname@example.org for additional information regarding organizational structure and entity selection.