Entities Subject to 280E Taxed as a Partnership – Issues to Consider
CannaBlog by Calvin Shannon, CPA, CVA, Principal
Bridge West LLC CPAs & Advisors to the Cannabis & Hemp Industries
Over the last several years, the capital structures of high-THC license holding companies have become increasingly more complex. If the entity is taxed as a partnership, unexpected and challenging tax consequences can arise. In this CannaBlog, I will review issues that cannabis businesses have confronted regarding K-1 allocations, and I will address considerations for license holders in the entity set-up stage of their venture. I will also provide guidance to operators who have started business activities.
In a ‘best-case scenario’ example, the license holders have engaged advisors who are experienced in the cannabis industry and knowledgeable about partnership taxation. There are numerous tax related issues to consider when setting up an entity and capital structure. To follow are two issues that often lead to surprises for license holders:
(1) as dictated by the language within the entities’ governing documents and tax law, the K-1 allocations of taxable income and loss to partners/members are not always based on the pro-rata ownership; and
(2) the actual book earnings or losses for a reporting year can often be very different from the amount of taxable income and non-deductible losses due to Code Section 280E.
Too many times, difficulties arise when cannabis companies realize book losses or only small positive earnings during the early years of operations but report and allocate unexpectedly large amounts of taxable income and non-deductible expenses to owners. This can cause frustration to K-1 recipients who do not expect taxable income since the company is not generating cash flow for distributions. In addition, the owners’ tax basis is being reduced to the extent there are net tax basis losses (non-deductible expenses in excess of the taxable income). This can result in a higher capital gains tax when the investor liquidates.
What can a start-up entity do to mitigate some of these problems? First, the ownership group, management, and advisors should consider setting up the entity as a corporation or consider making an election to treat an LLC as a C-Corporation for tax purposes. If C-Corp tax treatment is not a good fit, and there may be valid reasons why it is not, then planning and communication are key. Realistic projections of book earnings and taxable income that are clearly communicated to investors can be very helpful in managing expectations and avoiding surprises and uncomfortable conversations.
For license holders already operating, the importance of ensuring the K-1 allocations reflect the language contained within the entities’ operating agreement. As discussed above, to the extent the K-1 allocation of taxable income is problematic, it may be prudent to perform a detailed analysis of a potential election to treat an entity set up as an LLC as a C-Corp for tax purposes.
Bridge West, LLC understands the complexities within the cannabis industry and provides a wide range of accounting, tax, and advisory services to license holders across the nation to address their specific needs. If you would like to learn about Bridge West’s cannabis industry expertise or to schedule a consultation with a member of the Bridge West team, please contact us.
Calvin Shannon, CPA, CVA, is a Principal with Bridge West LLC CPAs & Advisors to the cannabis and hemp industries. With over 20 years of experience Calvin has a deep understanding of the challenges cannabis clients face. He is skilled at developing and implementing innovative solutions and addressing the industry’s unique and ever-evolving issues. Calvin can be reached at firstname.lastname@example.org and 651-587-5804.