Despite the unique challenges for cannabis business owners, you can minimize your tax burden by properly structuring your business. We discuss how using a C Corporation or LLC can help you reduce your taxes.
The Unique Tax Challenges for Cannabis Businesses
Cannabis businesses face unique challenges, because cannabis is considered an illegal substance on a federal level. As a result, your business has to adhere to Section 280E. This means you’re only allowed to deduct expenses related to the cost of goods sold.
Other businesses that don’t fall under Section 280E may deduct ordinary expenses related to running the company. This allows companies to only pay taxes on their net income, which is often significantly lower than gross income.
With a cannabis business, there’s a possibility for you to owe more in taxes than you receive in net income, because you can’t deduct most expenses for tax purposes. That makes it difficult to build a viable, sustainable business.
How to Structure Your Cannabis Business
Before we talk about how to structure your business, we want to emphasize that you have to follow Section 280E, no matter how you set up your company. You can only deduct expenses related to the cost of goods sold for your cannabis business.
There is no perfect business structure for your cannabis company. However, we can help you run the numbers to decide which option is more beneficial to you. For example, you can create a Limited Liability Company (LLC) or a C Corporation to offer legal liability protection.
How Taxes Work with a C Corporation
You’ve probably heard of the double taxation with C Corporations. A C Corporation is required to pay taxes on its earnings because the IRS considers it a legal entity. As a shareholder, you may also pay taxes on the dividends you receive. This is where the double taxation comes in.
The benefit of paying taxes at the corporate level for a cannabis business may be that corporate tax rates are lower than your individual tax rate. For example, if your personal tax bracket is 30% and the C Corporation pays 21%, you can significantly reduce your tax burden by incorporating your cannabis business.
How Does an LLC Pay Taxes?
If you create an LLC for your cannabis business, you can elect to be treated like a C Corporation. In that scenario, you pay taxes on the company level. But with an LLC, you can use it as a flow-through entity instead, by electing to be treated as a partnership.
Partnership income flows through to the individual partners. You will receive a Schedule K-1 with your portion of the company earnings. Remember these earnings include all the expenses the IRS won’t let you deduct, which means you report higher earnings than you actually receive from the company.
Then you include the K-1 income on your individual tax return. Depending on your tax bracket, this could be better or worse than using a C Corporation. If you fall into a low individual tax bracket, you can save money on taxes. If your tax bracket is high, using C Corporation tax status for your LLC is more beneficial.
Unfortunately, you can’t go back and forth between partnership and C Corporation, as benefits you. Once you make the election, you generally have to wait 5 years before you can change it.
The Basis Rule & How It Affects Your Cannabis Business
One thing you should think about is your basis in the company. With an LLC, each partner’s share is reduced by their share of nondeductible partnership expenses. This lowers the partner’s adjusted basis and forces you to recognize a larger taxable gain when you sell the partnership interest.
Even if your business operates at a loss because you can’t deduct certain expenses for tax purposes, you may benefit when selling the company because of your lowered adjusted basis, avoiding capital gains taxes.
How this plays out is different for partnerships and C Corporations. It all depends on your personal tax bracket and tax credits when you sell the company.
Let Us Help You Structure Your Business
We can help you do the math to figure out which business structure would be more beneficial to you. Reach out to us and let us help you minimize your taxes.