10 top tax issues in cannabis operating agreements
In our experience, most new cannabis operators face a number of common issues concerning entity structure and operating agreements. Read on for a summary of the top ones to consider.
This article was first developed based on questions received during a January 2021 webinar with New Frontier Data and NFP titled “Industry Outlook: The Cannabis Commercial Landscape in 2021 and Beyond.”
- Plant-touching vs. ancillary businesses
- We generally recommend that clients set up separate legal entities for plant-touching and non-plant-touching operations. These should be separate businesses in form and substance. Commingling of funds, intercompany transactions, or interdependence could lead to IRS challenges if the taxpayer argues that the ancillary business is not subject to Internal Revenue Code (IRC) Section 280E.
- Most operators utilize an LLC for their initial legal structure. A multi-owner LLC is by default generally treated as a partnership but can elect to be treated as a corporation for federal income tax reporting purposes.
- We generally recommend to stay treated as a partnership for income tax purposes, and as such the remainder of this summary focuses on partnership tax issues. However, there are some situations in which electing to be taxed as a corporation is beneficial for tax purposes. Therefore, it is critical that operators consider both the federal and state tax impact of entity selection.
- Being a partnership for income tax purposes is generally more flexible than being a corporation, in that starting as a partnership for income tax purposes and later converting to a corporation for income tax purposes (“C corp conversion”) can often be accomplished without tax consequences. The same cannot be said for starting as a corporation and then later converting to partnership tax status. The most common problem we see related to C Corp conversions is taxable gain triggered by outstanding member debt. It is therefore critical from this aspect that operators are adequately capitalized with equity and avoid having any members loan money to the company.
- Sometimes we see operating agreements that specifically prohibit members from personally guaranteeing debt. From a business standpoint, this makes sense, since allowing members to guarantee debt in a sense runs counter to the liability protection the LLC is supposed to provide. However, traditional bank financing is still the exception in the industry, and nontraditional financing often requires personal guarantees. Investors with experience in real estate may be under an erroneous assumption that partnership debt, that is not guaranteed, provides at-risk basis for loss utilization in the cannabis space as well. However, most likely, the nontraditional financing common in the industry would not meet the requirements of qualified nonrecourse financing that usually provide such at-risk basis in the real estate space. It is therefore critical that operators understand the terms of any debt agreements and their impact on members.
- It is common for a typical operating agreement template to include a provision providing for a targeted capital account allocation method. This is not as straightforward as the template might cause some to think. In short, under a targeted capital account allocation method provision, the partnership allocates income or losses to get the capital accounts as close as possible to the amount that would be distributed to each investor if the company were to liquidate as of whatever date the calculation is being calculated for (typically, the last day of the year). Investors that have a preferred return would be allocated more income because their preference gives them more right to cash at liquidation, and so a member with a straight 10% equity investment will not automatically be allocated 10% of taxable income or loss in any given year. If investors do not understand the details of preferred returns, waterfalls, and how they impact the target capital account calculation, they could be surprised when they receive their Schedule K-1, leading to unnecessary investor relations issues.
- Most often, withholding requirements are related to nonresident state taxes. However, partnerships with foreign investors could be a subject to federal withholding of up to 37% of taxable income. This is further complicated in cannabis operations because taxable income often does not match cash flow due to 280E deduction limitations. For companies with foreign investors, it is critical that they understand their tax structure and any withholding requirements. Unanticipated withholding requirements can create significant cash flow problems. Foreign investment has been relatively rare in the industry, but we are seeing more foreign investment and hence potentially more foreign withholding issues. It is also critical that operators seek appropriate legal counsel to confirm whether foreign investors, or even out-of-state investors, are permissible based on their state regulations.
- There are strategies, structures, and elections that could help reduce state and foreign withholding obligations in certain cases. Typically, those elections or structures need to be in place prior to the end of the tax year at issue to be effective for that tax year.
- Recently we have seen operating agreements that require quarterly or annual payment of preferred returns. It is critical to consider building in some flexibility to these provisions. Otherwise, operators could find themselves paying distributions on preferred returns before they are cash-flow positive. For example, this flexibility might be accomplished by allowing preferred return payments to accrue until two years from the date of the first sale of product or any other reasonable metric. Virtually every cannabis project we have seen has taken longer than it expected to start cash flowing. That means that operators could still be licensing or constructing a facility one year after the initial capital contribution, and at the same time be required to make distribution payments, which would conceivably cause significant harm to the company.
- A typical operating agreement template might not include a provision to require tax distributions (i.e., distributions of cash to assist partners in their payment of taxes arising from being allocated shares of taxable income). To help timely cover such partners’ tax payments, operators should consider adding a provision requiring a minimum distribution of approximately 40% of the taxable income allocated to the member (i.e., as reported on the member K-1), to be paid by April 15 following the tax year-end, or on some other appropriate schedule to assist the partners in their tax payments. This provision can be drafted to only kick in if the existing preference payments did not already exceed 40% of taxable income. This provision can also be drafted to be at the manager’s discretion and subject to available cash flow. Tax distributions, more than the preference payments or any other required distributions, can be structured as an advance on the preference payments (which would reduce future preference payments). Being able to receive tax distributions has been a common request of investors in an effort to protect themselves from unfunded tax obligations generated by nondeductible 280E expenses.
- It is advisable to consider avoiding using partnership equity awards because of the numerous tax complications for the company and the employee. A suitable alternative might be having a deferred compensation bonus plan that is tied to the financial performance of the company. Still, there is a concern in the cannabis space. Namely, such bonus plans often include a sale or change of control as a triggering event. Typically, these triggers result in a bonus being paid the day before the closing of such a transaction, as compensation income on a W-2 creating a large salary expense in the tax period paid. If Section 280E is still in place at that time, any portion of this bonus expense not related to direct cost of goods sold (COGS) labor would be nondeductible. It is therefore critical that operators understand the tax impact of these bonuses when considering a potential liquidating event.
Section 280E, a lack of access to traditional financing, banking restrictions, and state regulatory requirements are unique to the cannabis industry. Therefore, in determining the extent of modifications advisable to “standard” operating agreements in the industry, it is critical that cannabis operators consider working with advisors who understand that unique complexity.
