Did you know that finding a location and going through the permitting process is one of the first things that Cannabis licensing authorities are asking for from applicants? One of the greatest challenges that Cannabis business owners face is finding a place to operate. Just because Cannabis is legal doesn’t mean that local authorities will allow operators in their jurisdiction. Then there’s zoning and dealing with the community at large to approve an incoming Cannabis business.
Keep in mind, finding an approved location happens before there is any guarantee of a license, so there is a huge amount of liability and financial entanglement involved early on. And since the licensing process can be a huge game of hurry-up-and-wait, having a strategy and utilizing an accountant that understands how 280E effects real estate, how to prepare and maintain your financials for the licensing process, and how to properly account for all of the expenditures and investments that are incurred before the doors open will be vital.
As accounting professionals, we often advise our clients on two things as they pertain to real estate: tax and liability. In addition, there are now licensing considerations to take into account.
Licensing authorities ask for very detailed information about the property (how it was obtained, financed, encumbrances on the deed, etc), so having a sound strategy for how you intend to hold the real estate is incredibly important. For the purposes of this article, we’re going to deep dive into tax and liability aspects of things, as business owners may not realize that their real estate holdings may be subject to 280E if they aren’t structured properly.
Not understanding how 280E relates to leasing or buying real estate for Cannabis use could lead to some explosive penalties and consequences. This blog will give you a better understanding of how leasing property affects a business’ relationship with 280E, and the pros and cons of leasing in this industry.
So let’s dive in.
The first question to ask yourself when a client buys land and wants to lease acreage out to Cannabis growers is, “are they subject to 280E?”
So, right off the bat, we know that 280E focuses on business, not just a legal entity.
The tax code doesn’t mention anything about no deduction for a legal entity if that legal entity sells pot or heroin, it says a business, – that's a critical point.
Another essential question to answer before you begin is, “what is trafficking?”
Typically, we view trafficking as someone growing or selling Cannabis. However, it also could be defined as transporting Cannabis, which can apply to distribution and delivery companies if they take possession and are making a markup on the product.
But when you're looking at this from a tax perspective when you take a position on your tax return, you might be right and you might be wrong.
You may not know the answer until the IRS shows up and audits your client.
So you can explore more aggressive or conservative positions, but there's not always a right or wrong answer.
So why is trafficking relevant to real estate transactions?
Aside from its important distinction for tax purposes, it’s essential for landowners who are leasing to Cannabis companies to know where they stand in terms of liability.
Let’s say you own a piece of land and a Cannabis company comes to you to lease your estate, are you liable for trafficking at this point? It appears at this basic level, there is minimal legal risk for landowners.
But what if you already own land and decide to open a dispensary?
Well, that’s where things can get tricky, as often seen in Cannabis court cases.
So, what's the problem?
The problem is that some Cannabis business owners are trying to set up multiple entities to own the land, then lease it back to the dispensary, which they also own, and then get out of tax liability that way. That's generally not going to work.
Previously one of the largest dispensaries in California, Harborside found trouble with the IRS when they tried to bypass 280E by claiming tax deductions through another non-Cannabis entity that allegedly sold various other products and services.
Harborside argued that even though 280E applies to its marijuana sales, it can still deduct its expenses for any separate non-trafficking trade or business.
The tax court says that is correct.
So now the court says we need to determine which, if any, of Harborside's activities are separate trades or business.
But what if you own two LLCs? Is that one business or two businesses?
Well, to the courts, under 280E, it could be considered a single business or it could be two depending on the circumstances.
But some lawyers may say, “Let's just set up two legal entities. It doesn't matter that it's just one business. We're going to save on tax that way.”
Bad news: that advice will lead you into the same legal trouble Harborside and many other dispensaries who have gone to court have faced
The tax courts have stated that “a single taxpayer can have more than one trade or business or multiple activities that nevertheless are only a single trade or business. Even separate entities' activities can be a single trade or business if they're part of a unified business enterprise with a single profit motive.”
Adding to that, “Consider the degree of organizational and economic interrelationship of various undertakings. The business purpose, which may be taken separately or together.”
What does all this mean? Well, the court is clearly saying that even if you have 12 different entities, some C-Corps and LLCs, own pieces of real estate, branding, leasing company, and a dispensary, it could still be considered one economic enterprise.
Let’s circle back to the fundamental question of leasing real estate.
If someone is leasing real estate to a Cannabis dispensary owner, the organizations will not be considered one economic entity if there are different owners (between lessor and lessee).
But, if the landowner is the same owner as the dispensary, both businesses will likely be subject to 280E. If the non-canna businesses are not compliant due to lack of correct accounting treatment, or are not substantial or profitable, you’re going to run into problems with the IRS, as they will not pass the test to be considered separate entities, regardless of how the business is structured.
Lawyers that are not experienced in Cannabis matters tend to misinform their clients, so don’t be surprised if your client is receiving conflicting advice between you and their counsel.
There are plenty of cautionary tales that will prove that having separate entities is not enough, and that the business still may need to comply with 280E.
In fact, your business could get hit with double taxation, because if you have two entities, you could create phantom income and expenses (that are subject to tax). It's not real, in other words, to the owner, and you’re just booking income and expenses in areas to get a tax benefit, which could cost you more in the long run had you just applied the right treatment to the income.
While it may not make sense to try to get around 280E using separate entities to hold real estate, there may be benefits with regard to protecting assets. It’s important to really assess what’s more important, or even feasible: protecting assets or minimizing taxes? And do the goals of various investors conflict with each other? Often, trying to achieve both goals can result in conflicting outcomes, so in the case of Cannabis companies, utilizing separate entities may not be the best strategy to minimize taxes. Do not forget that protecting assets can be just as important and valuable.
The trouble we’re finding is that people think that they are saving money on taxes by using separate entities, but they are not. Inadvertently, by prioritizing tax savings, they are exposing themselves to more liability.
As far as entity structures go, we need to look at the goals and tax positions of all the owner/investor groups and each answer will depend on their unique situations. It is often wise to consider forming a C-Corp structure because it reduces the audit risk for investors, taxation can be fairly neutral or beneficial compared to an LLC at exit, among other reasons. For example, in the event of bankruptcy, the C-corp can file, and it wouldn’t flow through to the owner and affect the real estate holdings since they’d be separated.
There is no one size fits all answer on the lease versus buy decision. You are going to actually have to put a calculator to it and figure out what is going on, and which is the best way to go for each particular situation.
When it comes to leases, you're going to have to think about accounting, and so for GAAP accounting, there are new lease standards that have been released from the FASB. The new lease standards indicate that most leases are going to end up on the balance sheet. So in the old days if you're a small company and you lease a piece of equipment, you just debited lease expenses and credited cash every month when the new standard comes into effect. The good news for small companies is it's not going into effect until effective for fiscal years beginning on December 15th, 2021. That gives quite a good chunk of time for smaller companies to worry about that. But, eventually you'll need to be thinking about that as well on the accounting side.
With the new leasing standard, this brings up multi-entity issues, cash flow issues, and finally we have to address GAAP accounting issues. So there's quite a lot to think about, and if you don't have the knowledge or tools in your toolkit to consider all these things for your client, consider looking into our program at DOPE CFO. We do provide education about all of these issues in our program, along with the tools, training, workpapers, guidance, an expert community, and more.
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