Business Structure of Marijuana Business
Harborside Health Center, one of the nation’s biggest cannabis dispensaries located in Oakland, CA, is challenging the IRS’s efforts to collect a $2.4 million tax bill resulting from an audit of its returns from 2008 and 2009. The IRS claims that Harborside was not allowed to take business deductions under Section 280E of the Internal Revenue Code (the “Code”). While the case is currently pending before the U.S. Tax Court, many sources predict that the DEA will reclassify cannabis as a Schedule II drug in August 2016.
Legal Status of Cannabis – Federal
Under the Controlled Substances Act, (the “CSA”), cannabis is currently classified as a Schedule I drug.
Schedule I classification requires that the U.S. government make the following findings:
- The drug has a high potential for abuse;
- The drug has no currently accepted medical use; and
- There is a lack of accepted safety for use of the drug.
This classification also includes heroin, methaqualone LSD, MDMA and mescaline.
Legal Status of Cannabis – State
Despite its classification under the CSA, medical marijuana is now permitted under state law in 25 states. Recreational use is allowed under state law in four states plus Washington, D.C. If California green-lights recreational use this November, one in six Americans would live in a state where adults would not be prohibited by state law from using cannabis.
Effect of Section 280E
Section 61 of the Code clearly states that gross income must be reported to the IRS whether it is from legal or illegal gains. In addition, Section 162 of the Code provides that taxpayers engaged in illegal activities are allowed to deduct otherwise allowable expenses incurred in the activity in calculating taxable income unless a specific provision prohibits deduction of such expenses.
However, Section 280E of the Code, enacted well before any states had legalized marijuana, prohibits the “deduction or credit for any amount paid or incurred during a taxable year in carrying on any trade or business if such trade or business consists of trafficking in controlled substances (within the meaning of schedules I and II of the Controlled Substances Act) which is prohibited by Federal Law or the Law of any State in which such trade or business is conducted.” Therefore, businesses selling marijuana generally cannot deduct their expenses. However, this prohibition does not apply to deductions for costs of goods sold. (See IRS Memorandum ILM 201504011) Business that traffic in controlled substances and also engage in other unrelated activities are not prohibited by Section 280E from taking deductions for business expenses from such other activities. (See CHAMP, 128 T.C. 173 (2002))
The IRS has taken the position that Section 280E will continue to apply as long as marijuana remains illegal at the federal level. Even if cannabis were moved down the controlled substances list to the least-restrictive category, the industry would still likely face business and regulatory hurdles. A survey released in 2015 by the Marijuana Business Daily found that more than 6 percent of cannabis companies reported being audited [by the IRS] — well above the 1.4 percent average rate for all U.S. businesses. Based on this observation, companies engaged in marijuana business should carefully structure their business model to reduce legal risks and mitigate adverse tax consequences.
Legal Structure for Marijuana Businesses
For most marijuana businesses, a Limited Liability Company (LLC) structure offers greatest advantages, including limited liability, tax advantages and great flexibility in operations. Since Section 280(E) only apply to “trafficking in controlled substances”, we suggest that marijuana businesses use separate entities for each section of their operations. Another benefit of this structure is that having a holding company allows the business owners to allocate risk among different subsidiaries. This could be very valuable to business owners considering the inherent legal risk of the marijuana business.
Organizational Document Drafting
It is highly recommended for any business owner to seek professional help in preparing the operating agreement for an LLC. This is especially true for marijuana business because of the recommended complexity of the business structure and the potentially high legal and tax risk of the industry. Below we list some considerations for drafting an LLC operating agreement for marijuana business:
- Who provides the capital?
- Anything of value recognized by the members can be capital contributed to the LLC.
- The operating agreement should clearly define the value of all capital contributed.
- Who can be the members of the LLC?
- In many states, good moral character is a basic requirement for members.
- The LLC should retain the right to remove members for cause.
- Consider an expulsion provision coupled with allowing the company to purchase a defaulting member’s interest.
- How is the operating agreement amended?
- It is not uncommon to require unanimous consent for an amendment. However, this can provide undue influence to a minority member.
- Consider requiring a super majority vote.
- How are membership interests transferred?
- State law often contains specific requirements about the transfer of membership interests in a marijuana business.
- Company usually want to keep the business closely-held.
- Consider right of first refusal for membership transfers or outright restrictions on transfer (subject to member consent).
- How are disputes resolved?
- We suggest to include an arbitration clause in the operating agreement
- Arbitration has many benefits for marijuana businesses, including confidential proceedings, limited discovery and faster resolution than courts.
- How to handle Direct and/or indirect loans?
- Many states require marijuana business to disclose all financial interests, whether direct or indirect.
- Loaning money to a marijuana entity should not give the lender confidence of ownership or actual contact with the marijuana business.
- State-specific considerations
- Be sure to check state law before operating a marijuana business within a state.
- Colorado, for example, requires each owner of a marijuana business to apply for an Associated Key License.
- California requires any business delivering or selling medical marijuana be formed as a non-profit collective or cooperative.
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