Social Equity, Opportunity and Strategic Tax Planning
The below updates provide additional clarity on the considerations needed prior to investing in a QOF for a MRB.
Entrepreneurs intending to operate an adult use (recreational) business under the Michigan Regulation and Taxation of Marijuana Act (MRTMA) may be able to combine features of the state’s social equity provisions with other tax incentives available, depending on their business model, investment structure and risk tolerance.
The regulated marijuana industry commands high barriers to entry without sufficient upfront capital. Michigan’s medical marijuana facilities have upfront capitalization requirements of up to $500,000 per license. This requirement along with annual regulatory fees and tax expenses prevent many from entering the market.
In an effort to further open the market to entrepreneurs, Michigan’s adult use businesses have reduced regulatory fees compared to their medical counterparts. Additionally, the state has implemented cost savings opportunities for business owners living and operating in selected communities across the state. Combined with strategic tax planning, several business owners may also qualify for additional savings. By maximizing cost reductions where possible, cost barriers to entry reduce significantly to more manageable levels.
Michigan’s Social Equity Program
Michigan’s social equity program requires “a plan to promote and encourage participation in the marijuana industry by people from communities that have been disproportionately impacted by marijuana prohibition and enforcement and to positively impact those communities.” Participating in the program allows qualifying applicants a reduction of up to 60% off the application fee, the initial license fee, and also future renewal fees. The reduction is available to certain individuals and calculated as follows:
- 25% reduction for those who have been a resident of one of the selected disproportionally impacted communities for the past five years AND whose marijuana establishments will be located in disproportionately impacted communities.
- An additional 25% reduction if the individual(s) holding majority ownership have been a resident of one of the 19 disproportionally impacted communities for the past five years AND have a marijuana-related conviction.
- An additional 10% reduction if the individual(s) holding majority ownership have been a resident of one of the 19 disproportionally impacted communities for the past five years AND were registered as primary caregivers for at least two years between 2008 and 2017.
Michigan has chosen 19 communities for which the social equity program will be qualified in. These communities include:
- Benton Harbor
- East Lansing
- Highland Park
- Mt. Morris
- Mt. Pleasant
- Muskegon Heights
- River Rouge
Individuals who are residents of one of the above communities qualify to participate in the social equity program. With the maximum criteria met, business owners can reduce their upfront license fees anywhere from $6,000 to $27,600. Qualified applicants may also take advantage of accessible business educational resources provided by the Marijuana Regulatory Agency and volunteer businesses. The state is actively promoting educational outreach programs in order to bring awareness to the opportunities available through the social equity program. Additionally, professional service providers such as CPAs, attorneys and architects can also participate to offer certain services at reduced rates or no cost.
Michigan Caregivers are the only individuals who can take full advantage of the state’s social equity program.
Federal Opportunity Zones and Qualified Opportunity Funds
Included as part of the recent Tax Cuts and Jobs Act of 2017, investing in Opportunity Zones allows investors to defer or even eliminate taxable gains on these investments. According to the IRS, “An Opportunity Zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.” Opportunity zones are nominated by the states before being formally approved by the United States Treasury for inclusion in the program.
The purpose of an opportunity zone is to spur economic development. Investors look to invest in these areas because of the tax savings that can be achieved.
Investors must first invest any taxable gains into a Qualified Opportunity Fund (QOF). A CPA can help ensure your business structure meets the criteria for a QOF. For any gains invested into the QOF, the taxable gains become deferred or reduced. With the new investment held for longer than 5 years, the deferred gain reduces by 10%. Additionally, with the investment held for more than 7 years, the deferred gain reduces by 15%. Both cash and property qualify for investment into a qualified opportunity fund.
Deferring the taxable gain makes the tax payable in the future. First, this is a savings in terms of the time value of money. It also allows for additional cash to be used in the business operations in the earlier years, instead of being paid out in taxes. Holding the investment for at least 5 years reduces the amount of the taxable gain, resulting in even more tax savings.
Federal Opportunity Zones and the Cannabis Industry?
Are marijuana related businesses eligible to participate in an opportunity fund and zone investment strategy? This is a question best discussed on a case by case basis with your CPA and attorney.
Let’s start with how a QOF works first:
In order to be eligible as a qualified opportunity fund, a business must first elect the correct entity tax structure and complete the appropriate IRS forms. Let’s assume that an entrepreneur did this, with the assistance of a qualified professional. The entrepreneur then cashed out their stock portfolio and invested the full amount of the gain into the QOF business.
The business entity that is structured as a qualified opportunity fund then decides to purchase and substantially renovate a building in an opportunity zone community. The investment funding from the entrepreneur’s previously liquidated stock gain indirectly pays for the building purchase and renovations. Once completed, the improved building will be rented for occupancy by another business(es).
According to IRS guidance and regulations surrounding the use of opportunity zone incentives, a business as defined by IRC §162 may qualify.
Businesses specifically prohibited from qualifying as a qualified opportunity fund business are those defined by IRC §144(c)(6)(B). Specifically prohibited businesses include any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.
With recreational marijuana likened to alcohol, the IRS may consider retail recreational marijuana establishments a prohibited business. Interestingly, the code specifically states that the sale of alcohol for consumption offsite is a prohibited business. Designated consumption establishments are not included under this restrictive provision.
Additionally, §280e prohibits marijuana businesses from taking deductions or credits in the ordinary course of business. Will a qualified opportunity fund business that leases building space to a marijuana business be disqualified from participating in the program because the marijuana business is subject to §280e?
Many questions and uncertainties surround the eligibility of the cannabis industry to participate in qualified opportunity zone incentives. Business owners and investors should carefully consult with their CPA and attorney about the risks, potential benefits and strategies for setting down this path.
What are the tax benefits of investing in a Federal Opportunity Zone?
Back to our previous example, let’s assume upon the liquidation of their stock investment, the entrepreneur had a $200,000 gain. Before tax reform, the entrepreneur would also have had a tax bill of $30,000 on this gain due almost immediately. The tax payment would have also reduced the amount of funds available to invest in the new business.
Now, instead this entire $200,000 gain is invested in a qualified opportunity fund in order to purchase and renovate a building in an opportunity zone. With other qualifications met, the taxes on the gain now qualify for deferral until 2026. This results in the investor deferring for up to 7 years the $30,000 tax liability. If the investor waits the full 7 years the taxes due will be reduced by another 15%, an additional $4,500 savings.
If the investor also holds the investment in the opportunity fund for at least 10 years they may be eligible to eliminate or substantially reduce the taxable gain on the sale of the investment at the time of the sale.
Adding to the previous example, let’s also assume the $200,000 invested into the building now contains all new build-outs and improvements. After 10 years, the entrepreneur investor then decides to sell the business investment and the building now has a fair market value of $600,000. With all qualifications met and the taxable gain reduced entirely, the investor will realize a $60,000 tax savings or more.
Hundreds of communities in Michigan made the list of approved Opportunity Zones. Check it out here.
Of the 19 social equity zones identified by the state, 18 of these also qualify as federal opportunity zone areas.
There are numerous requirements and elections that are necessary for a qualified opportunity fund and tax savings to be allowable. Specific rules for leasing activities also exist in order for the business to remain eligible. A CPA can help you determine the appropriate steps to take advantage of this program.
Business owners and investors should consider their eligibility under the social equity program and other incentives available to maximize tax savings and reductions in regulatory fees. Long term tax and strategic planning can help business owners and investors maximize cost savings many years into the future.
We can help!
At LC Solutions Michigan PLLC our team of CPAs and accounting professionals can help your business explore participating Michigan’s Social Equity Program, as well as consider the benefits and risks of investing in a federal opportunity fund. We take the time to thoroughly understand our client’s business goals and develop tax planning strategies customized to their objectives. Having the right tools in place to make strategic tax and cost planning decisions is also critical to business success. Our team can help you understand which cost and tax savings options are available and the steps necessary to achieve them.
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, also check out our Facebook page here.
August 31, 2019
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