Panel: Lack of Guidance Means Cannabis Industry Tax Planning Often Depends on Clients' Risk Tolerance

Chris Gaetano
Published Date:
Nov 6, 2019
With cannabis still deemed illegal under federal law, tax planning for state-level businesses often comes down to how much risk a client is willing to tolerate, as there is little guidance as to what the IRS will and will not accept, according to a set of panelists at the Foundation for Accounting Education's Cannabis Conference on Nov. 6. 

Take, for example, Section 199A. Instituted as part of the Tax Cuts and Jobs Act, it ostensibly offers a 20 percent deduction to most pass-through entities, excepting certain types of businesses such as performing arts, consulting, athletics and CPA firms. But it doesn't except cannabis. Jason Hoffman, who leads Janover's Cannabis Industry Practice Group, noted that, technically, the 199A provision is not a deduction but rather a reduction of taxable Income on a personal tax return. With this in mind, he said, there might be an argument to be made that a cannabis company can indeed take advantage of 199A. But, he said, it's a risk, especially since the IRS has said that it would like cannabis businesses added to the restriction list as a technical correction. 

"So whether or not that's allowable is up to the individual tax practitioner. I have been OK if clients are up for the risk of taking it because we do believe we can be successful in arguing in front of a court," he said. 

He added that different clients will have different risk appetites, sometimes even within the same business. For example, he talked about a pair of clients who are partners in a cannabis company. One was willing to take the risk and claim 199A on his personal income tax, while the other was not. There's nothing stopping either from making their own choice on the matter, he said. 

When an audience member noted that these are the sort of decisions and analysis that their clients pay them for, another panelist, Bridget Kralik, a PKF O'Connor Davies senior tax manager, said that, as CPAs, part of the job is to interpret the tax code for their clients and educate them about their choices, but ultimately it is their choice. 

"It's really important to make sure we're educating our clients and taking a team decision, because I can't just be [saying,] 'Based on this, this is what I think you should do'; it is, 'This is what i think you should do and why, but it's not black and white, so you need to communicate with me.' So I think that's a big part of our job," she said. 

At the same time, it's important to be flexible and respond to sudden changes. Another panelist, John Pellitteri, a Grassi & Co. partner who leads the cannabis service practice, noted that for many years cannabis businesses had tried to reduce tax costs through Section 263A's cost of goods sold (COGS) provision, as these too are not technically deductions.  But Pellitteri said that recent case law has severely limited businesses' ability to do this. 

"So that became, at first glance, a good opportunity, but won't work in this instance," he said. 

Thomas Riggs, the panel moderator and a PKF  O'Conner Davies tax partner, said that there have been several "seminal" court cases around this area recently, and what they all seem to be saying is that "if something is not deductible, it does not become deductible by sliding it into cost of goods sold." 

Pellitteri went over a recent case, which involved a business called Alternative Health, which had a number of different lines of business, including a cannabis dispensary. The company, he said, set up a separate management company to take on all non-COGS expenses and contract with Alternative Health to provide services that would have been done by the operating company. By moving these costs to another entity, Alternative Health believed that it could deduct these expenses, not only through its dispensary but also through the other entity it had set up as well. The courts, however, did not agree. 

"They not only disallowed the deductions through the dispensary for paying the management fees to the second entity, but then they made them pick up the income from that second entity and disallowed deductions again. ... Not only was there tax involved, but accuracy-related penalties, and it became very expensive. At first glance, it sounded like a good opportunity, but as you dug into it there were some complexities," he said. 

Riggs said that the IRS is likely going to use this case to "nip in the bud" the idea that cannabis businesses can contract with outside service providers in order to change the nature of the expense. The courts said it is the same type of expense, which "puts some cold water on some of the structures we've seen out there." 

But, following the panel's recurring motif, it's not entirely black and white. Hoffman said he doesn't think the case completely eliminated this strategy, just certain applications of it. While the case was indeed "pivotal," he said that facts and circumstances can still win the day. He said the only times he has ever allowed this sort of structure was if the management entity would get outside management fees from third parties so that they genuinely and truly are an independent business, with at least 51 percent of revenues coming from the third parties. 

"I believe the facts and circumstances might be different enough that this case might not necessarily apply directly. So you have to look at the facts and circumstances of ever individual," he said. 

Kralik agreed, saying that in this case, the court saw a company just moving one operating part of the business to another with nothing else besides that business, which was effectively seen as trafficking. 

"If you're going to have the separate structure, you need to have maybe a few levels of services you provide, different types of services, and provide it to multiple places," she said. 

Regardless of what the client chooses to do, Riggs advised caution, noting that the IRS plans to make enforcing cannabis tax issues a priority in the coming years. It has begun forming teams, recruiting and educating agents, and drafting a Compliance Initiative Project, which is a comprehensive audit guide that outlines specific techniques to use for this industry. Riggs noted that these guides are generally only produced if they intend to use them. 

"So I think we can expect a lot more audit activity going forward, and that will also affect [what] you explain to your client when making a decision," he said. 

He added that he has heard that the IRS will also begin more aggressively enforcing rules on reporting cash transactions. Under federal law, any cash transfers in excess of $10,000 must be reported on the Form 8300, which so far hasn't been something that the IRS hasn't  paid much attention to in the cannabis sector, "but as part of this new audit initiative, they're going to be asking specific questions." 

Hoffman has already seen this starting to happen, saying that "we've seen that a lot and gotten calls from a lot of people in California that the IRS is going after those 8300s." 

While this might be distressing, Kralik said it is good that people know this is coming because it gives them time to get ready. 

"Knowing this is coming and it's inevitable, now is the time to advise a client that this is when you really want to focus on record keeping and making sure they have some kind of language as to rules and responsibility of the labor force—who is doing what—to make sure they have the support needed not to fail that 280E test," she said. "So that's what we should be focusing on right now."

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