By Mary Amato, CPA, Partner
We have not seen a reform to the tax code as sweeping as the TCJA (Tax Cuts and Jobs Act of 2017) since 1986. As with the reform then, there are sure to be technical corrections to the new law and interpretive guidance to be issued by the Internal Revenue Service in administering the new law. Nevertheless, it behooves taxpayers to understand even now which provisions may affect them and how. It has been hard to miss the great amounts of discussion that are even still taking place regarding the new limitations on state income and real estate tax deductions for individual taxpayers, but relatively little discussion has addressed the possible benefits (whether intended by the new law or not) for the cannabis industry.
One such possible benefit is the new “20% deduction.”
The new law creates a 20% deduction from taxable income for “qualified business income.” This is an “extra” deduction; no expenditure on the part of the business is required to benefit from this deduction, when it is applicable to a taxpayer. The deduction applies to a “qualified business” operating either as a sole proprietorship or as a flow through entity (S corporation or partnership) and has the effect of lowering the federal tax rate on the qualified business income flowing from such sole proprietorships/flow-through entities to individual taxpayers. For example, an individual who would otherwise pay taxes at the highest marginal income tax rate of 37% on such income would see a drop in the effective tax rate on such income from 37% to 29%. Mechanically, the deduction is computed on each individual partner’s or shareholder’s personal return, and this computation is separate from the computation of the net taxable income of the business. In that regard, there are multiple hurdles in computing the deduction as there are possible limitations that apply, and therefore results may vary based on each taxpayer’s tax situation.
To what extent might this deduction benefit the cannabis industry?
To begin, the term “qualified business” excludes certain specified industries from benefitting from the 20% deduction, but the cannabis industry is not one of those specified industries. Accordingly, it is clear that ancillary (non-plant touching) cannabis businesses may avail themselves of this deduction (unless they are one of the specified excluded industries).
What about 280E impacted cannabis businesses?
For that question, there is a dearth of guidance available as of the date of this article, as the law is still too new, but a literal reading of the new law suggests that the deduction might not be prohibited from reducing income flowing from a pass-through entity that is subject to 280E limitations. Although 280E prohibits any deduction, except for cost of goods sold, from the income of a 280E business, it nevertheless remains unclear as to whether 280E impacted cannabis businesses may benefit from this deduction. The reason for this is (1) this deduction is different from other deductions since other deductions represent amounts actually expended by a business whereas this deduction is “a freebie” – effectively simply a mechanic that results in a reduced tax rate on a business’s income; and (2) the tax reform’s legislative history is completely silent as to whether this deduction is not available to 280E-impacted businesses.
If the deduction would be applicable to 280E impacted businesses, which generally have effective tax rates much higher than 37%, the benefit of the deduction to such business could be much more dramatic than the aforementioned drop from 37% to 29%. Cannabis businesses should therefore consult with their tax advisors to determine how best to proceed in this regard.
The new deduction, applicable to business income flowing from sole proprietorships and flow through entities only, also prompts the question of whether the entity form choice for your business is really the optimal choice. Said another way, for those businesses operating as C corporations, the 20% deduction is not available. On the other hand, the new law reduces the federal corporate tax rate to a flat 21%, and eliminates the corporate alternative minimum tax, changes in and of themselves that may generally result in a reduced cash outlay for federal taxes. Other considerations in this regard include what the plan is for eventually exiting the business and how soon such an exit might occur. These considerations can be discussed with a tax advisor as well.
With the vast changes made to the tax law, it is not business as usual. Proactive planning should be done to forecast what effect the new 20% deduction –and the other myriad of changes to the tax code --- may have on you and your business for 2018.