280E and Proper Business Structures
Businesses subject to Internal Revenue Code Section 280E must choose their business structure carefully. In this article, I will describe the pros and cons of each structure, and provide recommendations for specific business types within the cannabis and psilocybin industry.
Limited Liability Company (LLC)
The Limited Liability Company (LLC) is now the most recommended legal structure. Many people automatically confuse LLCs with being synonymous with partnerships and, at one point, this was true. However, about 20 years ago, awareness started to change and now LLCs are considered for multiple tax treatments. For example, the LLC can be taxed as a sole proprietorship or disregarded entity, partnership, S corporation, or C corporation.
Partnerships should only be considered when holding assets for investment purposes or when the ownership structure necessitates it. Partnerships are the most flexible tax structure allowing diverse ownership types, capitalization, and distribution activities. However, it is a pass-through entity in which the business’s income is taxed at the partner level, the income can be subject to self-employment tax and, due to the relatively new Partnership Audit Regime enforced by the IRS, when partnerships are audited they can be charged tax at the partnership level at the highest individual income tax rates. For this reason, we don’t recommend partnerships unless it is necessary.
Most small businesses qualify to elect to be taxed as an S corporation if they choose. Like the partnership entity structure, the S corporation is a pass-through entity, meaning the business’s net income is taxed at the shareholder level. However, if appropriately managed, the S corporation can be more tax favorable than a partnership or C corporation. For example, the S corporation business entity must pay its officers a “reasonable wage,” subject to payroll taxes. But unlike partnership distributions, distributions paid from an S corporation are not subject to the 15.3% self-employment tax.
For this reason, the S corporation is the preferred entity structure for small businesses. For most companies in the cannabis and psilocybin supply chain, the S corporation is typically ideal. However, a pass-through entity is not recommended for companies with a significant 280E impact, specifically retailers or service centers.
C corporations should be considered before other entities operating in a federally illegal business, specifically those in which 280E applies. Tax is assessed at the business level, and business returns are prepared independently of the shareholders’ tax returns. In addition, due to its current Federal tax rate of 21%, it can be more tax favorable for business owners subject to higher individual tax rates. But most importantly, if a tax adjustment results in significant tax debt, the corporation is siloed from the shareholders. The corporation is responsible for the tax debts imposed by the taxing authorities, not the owners.
There is frequent pushback when suggesting the use of C corporations. There is a concern over double taxation in that C corporations pay tax on their earnings and then again when those earnings are paid out in the form of dividends. There is potential for double taxation, but those results are typically due to the mismanagement of the corporation funds or the lack of tax planning. The C corporation is only subject to the potential of double taxation when the ownership is attempting to extract value from it. Otherwise, the income of a C corporation will be taxed only once.
Most business owners intend to expand their operations and business holdings. The corporation’s earnings can be used to expand operations, purchase additional assets, or lend to other companies. Therefore, they are not likely to be subject to double taxation during the growth phase of their development. The risk of double taxation happens when the shareholders attempt to extract value from the company. Fortunately, with some planning, there are various ways that earnings can be paid out to avoid being taxed a second time. For example, value can be extracted as compensation through the payroll system or paid out as management or consulting fees; it is common for corporations to give bonuses to key employees that are also shareholders. Often the shareholders of a corporation will set up consulting or management companies that provide services to the corporation in return for fees; shareholders can be paid for simply being on the board. Finally, paying rent is a common way of extracting value without being double-taxed. The corporation leases real estate, human resources, or equipment from companies the shareholders may also own.
An ideal structure, we recommend, is to have your trafficking operations included as a C corporation and your real estate holding company structured as a partnership. Furthermore, I recommend that your real estate company do as little commingling of activities with your operating company as possible. For example, it is common practice for the real estate holding company to provide land and leasehold improvements to customize the property to address the operating company’s needs. This activity could cause the holding company to be considered “in the service of” trafficking. Therefore, to help reinforce the holding company’s position that it is simply a real estate investment company and not in the business of trafficking, we recommend that “build-outs” and other related activities be paid from the operating company and included in the operating company’s bookkeeping.
Selecting the proper business structure is vital for the success and growth of any company, especially for those operating in federally illegal businesses. While no one-size-fits-all solution exists, companies can optimize their structures with proper guidance and planning to balance their compliance, flexibility, tax, and risk mitigation needs.