Business entity structure and tax considerations for a cannabis business.
A common question when setting up a new business is what entity structure the business should be. Should it be an LLC? A Corporation? What other options are there and what are the differences between each one? A cannabis entrepreneur may have even more questions. Tax implications from federal restrictions, along with state by state tax and regulation differences can create many challenges and opportunities. Business entity structure and tax considerations are crucial points to consider.
With the passing of the 2017 Tax Cuts and Jobs Act, businesses have gained several avenues for tax reductions. Federal tax restrictions like IRS Code §280E for the cannabis industry are still in place however. Differences in business entity structure will directly impact the tax rate the business income is ultimately subject to. Considering total tax burdens with potential self-employment taxes and effects of state tax provisions, entity structure may require significant planning.
Those first entering the cannabis business space often hear horror stories of how high the tax rates are. A favorite question is “Is the federal tax rate really 70%?” In short, our answer is always “no”. There are no single tax rates in the United States that are close– even for cannabis businesses. However, providing a more specific response and explaining why tax expenses are higher for cannabis business requires much more detail.
Tax rates are first determined by your business entity structure.
Several additional items may also need consideration when planning entity structure, other than tax effects alone. These may include investor and funding strategies, business growth and expansion goals, and risk management, among others. Business entity structure and tax considerations, including impacts of 280E are also important planning points for a cannabis entrepreneur or start up businesses.
Entity Structures and Treatment of Taxable Income
In general, businesses are classified as sole proprietorships, partnerships, or corporations. When considering tax effects, there are three main tax distinctions to be aware of as concepts: “Self Employed”, S Corporation and C Corporation. Let’s start with “self employed”. This tax treatment by the IRS includes sole proprietors, single member LLCs and certain owners in multiple member LLCs. Though each of these types of entities may have different tax forms they are required to file on an annual and quarterly basis, the effective tax treatment is generally the same. The IRS automatically treats single owner LLCs as sole proprietors. This is always true, unless the LLC makes a special tax election (see more below). Multiple member LLCs are considered “partnerships” by the IRS without any specific tax elections.
In a partnership, the taxable income “flows through” to the individual partner – similar to a single member LLC or sole proprietor. Or, in other words, the owners ultimately report and pay the taxes on the business income as individuals. The business itself does not pay any income tax directly.
For a cannabis business, federal taxable income is generally equal to gross profit because of §280E. See our post here for more information on §280E and the concept of cost of goods sold. Cannabis businesses can not deduct other business expenses before federal taxes are calculated. Once the gross profit is determined, the federal income tax rate is then based off of the owners’ individual tax rates. For taxable income beyond $500,000 for a single individual taxpayer, the federal tax rate is 37%.
“Self Employment” Tax
For individuals considered “self employed”, they will also be subject to an additional 15.3% Self Employed (SE) federal tax rate for Social Security and Medicare tax obligations. This is the “payroll tax” required to be collected from a business with employees on payroll, each paying half. Since the self-employed business owner is both the owner and employee, the full amount is paid by the owner. However, 50% of the SE tax is deductible as a business expense. This equates to a tax expense reduction of 50% of the total SE tax multiplied by the individual’s tax rate.
For many small business owners, the SE tax burden is often higher than what they will otherwise pay in income taxes overall. As explained below, S Corporation structure that may reduce SE tax obligations.
Unique to the 2017 Tax Cuts and Jobs Act, many business owners who are sole proprietors, single member LLCs and multi-member LLLs are also eligible for a Qualified Business Income Deduction, or QBID. The QBID allows for a reduction of 20% of business income from taxable income. This can create a significant tax savings for small businesses. There are many limitations on this deduction however. Limitations include total business income, type of business, wages paid, or real property owned.
S Corporation tax status
Similar to the previous tax concept discussed, income from S Corporations is also taxed at the owner (shareholder) level. This means that taxable income from the business flows through to become taxable income for the individual shareholders. The income tax rate is the individual’s applicable income tax rate. Taxable income beyond $500,000 for a single individual taxpayer has a federal tax rate of 37%.
The key difference however for S Corporation shareholders is that all flow through income is not subject to the additional 15.3% SE tax. In order to avoid this additional tax on all income, S Corporations must pay their shareholders a reasonable salary as employees and pay payroll taxes. Both the business and the employee pay one half of the 15.3% tax, based on the total wages paid. In effect, the 15.3% total tax is then based only off of salaries and wages paid, not the entire taxable income of the business.
S Corporation income is also generally eligible for the Qualified Business Income Deduction, subject to the same limitations described above. S Corporation structure may be very beneficial and provide the lowest overall tax burden for many businesses and their owners. However, S Corporations have several additional limitations that may make this structure otherwise impractical or impossible.
One significant limitation is S Corporations owners may only be individuals. An LLC or another company can not be an owner of an S Corporation. For cannabis businesses, this may impose problems in seeking investor options. It also does not allow an owner to be one step removed from the business with ownership via another LLC. Ownership via an LLC is often a desired business strategy in the cannabis industry for reasons other than tax purposes.
C Corporation tax status
C corporation tax status differs from the previous structures discussed. Businesses structured as a C corporation pay taxes directly, at the entity level. This is different than the above structures where the individual owners pay the taxes on the business income. C corporations pay their own income tax based on their taxable income. This tax rate is a flat 21%. Above, we discussed income tax rates of up to 37% for some individuals (not including SE tax). The corporate tax rate of 21% may seem much more attractive based on this criteria alone. Also unlike the above scenarios, a C corporation tax structure does not allow for a Qualified Business Income Deduction. However, the 21% income tax rate is effectively still lower than a 37% rate with an additional 20% deduction.
So, what are the downfalls of a C corporation? While all taxable income, whether distributed or not, is taxable to owners of a flow through entity, a C corporation’s owners only pay taxes on income that is distributed to them. However, this is after the corporation itself has already paid taxes on the income. In effect, distributed retained income, dividends, are taxed twice – once at the corporation level and again at the shareholder level. The dividend tax rate is generally the capital gains rate – up to 20%. While a C corporation structure may ultimately result in higher taxes for some business scenarios, for others it may certainly be the best route to go.
Differences in state taxes and regulations also need to be considered…
So far, we have only discussed federal taxes related to business entity structure and tax considerations. State tax rates and regulations may differ from state to state. States may also offer their own income tax exceptions, credits or regulations. As an example, small business corporations in Michigan may be exempt from income taxes, up to certain thresholds and limitations. States may have operator taxes or excise taxes for cannabis businesses as well. Cultivators, processors, and retailers of regulated cannabis may each have different taxes, depending on which state the business is in. In Michigan, only retailers are subject to sales or excise taxes.
Determining the best tax structure based on your business goals requires a significant amount of planning. Different scenarios and financial models can help determine the most favorable tax strategy. Cannabis entrepreneurs also need to consider their overall tax expense due to additional federal and state tax regulations as well. Projecting various financial and tax scenarios and cash flow models can help a business determine which structure is best for them.
Important Feature of an LLC
Forming a business as an LLC allows the business to later make an election to be taxed as any of the other structure. An LLC can elect an S Corporation or C Corporation tax structure. Or it can make no elections and remain taxed as an LLC. Electing a different tax structure may occur once every 5 years. Changing from one structure to another years after business operations have begun can create many other tax implications. It is important to carefully plan any choosing of a specific tax structure. However, an LLC gives the business flexibility to make this determination at a later point in time, not necessarily before the business is formed. Beginning as a standard LLC is a great first step.
We can help!
At LC Solutions Michigan PLLC we provide our clients with unparalleled accounting support, professionalism, and industry specific knowledge that is crucial to their business operations. Our team of CPAs, bookkeepers and accounting professionals can help your cannabis business with exploring options for entity structure, tax considerations and other accounting services. We understand our client’s needs and the special purpose bookkeeping, reporting, record keeping, and industry standards they require. Business entity structure and tax considerations are necessary planning points for successful operations.
Financial modeling with 280E considerations incorporated can provide valuable insight for a cannabis entrepreneur or start up business. Having the right tools in place to make strategic decisions for all items considered in entity structure planning– from taxes and investors to growth and expansion- can help a business stay focused on its goals.
To learn more about LC Solutions Michigan PLLC and how we can help your business, please visit our site here. For regular tips, insights, and industry accounting know-how, check out our Facebook page here.
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May 22, 2019
Copyright LC Solutions Michigan PLLC
