By Selvan Boominathan, JD, LLM
In a prior post, we discussed how federal income tax applies to cannabis businesses and the huge burden imposed by Section 280E. You may have read about the major tax cuts being proposed in Congress recently which are meant to spur economic and industrial growth across America. Surely Congress would encourage the super-fast growing, multi-billion-dollar cannabis industry by reforming Section 280E, one of the biggest drags on growth, right?
Well, not exactly. As of this writing, the House of Representatives and the Senate have each proposed a tax cut bill, and neither one would make any change to Section 280E. Some members of Congress introduced propose amendments, but nothing made it into the bills.
All is not lost, however. The tax cuts that would benefit non-cannabis businesses would also benefit cannabis businesses, reducing some of the tax bite which could make it easier to conduct business. But there is still a tricky interplay with Section 280E and the tax reform proposals, and understanding how that could affect your business could be key to your business’ future growth.
Below is an explanation of the major changes that could impact cannabis businesses. Note that there are, in some cases, significant differences between the House and Senate versions of the bill. Furthermore, the bills are subject to change as they continue to move through the legislative process. (In fact, it is possible that no tax bill is passed at all).
TAX RATE REDUCTIONS
Both the House and Senate bills would lower business tax rates from 35% to 20%, effective in either 2018 (House bill) or 2019 (Senate bill). Pass-through businesses (such as partnerships, LLCs, Subchapter S corporations) would be capped at a top rate of either 25% (House) or 31.8% (Senate, after taking into account the 17.4% deduction). Cannabis businesses, which have higher-than-average effective tax rates because of 280E, would see those rates tumble from the current 60-70% to ~45-55% for corporations and ~40-60% for pass-throughs.
CAPITAL ASSET INCENTIVES
Both the House and Senate bills would allow a 100% immediate write-off of certain capital expenditures (“bonus depreciation”). This would be a boon to non-plant-touching/non-280E cannabis businesses that have fixed asset expenditures. In contrast, plant-touching cannabis businesses can only recover depreciation through “cost of goods sold” because of 280E. It is not clear whether the relevant inventory tax regulations require depreciation to be computed in accordance with GAAP principles (which may not allow bonus depreciation).
MORE CASH METHOD
Both bills would significantly expand the number of taxpayers that can use the cash method of accounting in calculating taxable income. Under the cash method, a taxpayer would include as income money actually or constructively received and would deduct money actually paid. Currently, a C-corporation or a partnership with C-corporation owners cannot use the cash method if its average annual gross receipts exceed $5 million. A farming C-corporation cannot use that method if its average annual gross receipts exceeds $1 million. The House bill would raise these limits for all companies to $25 million; and the Senate Bill would peg $15 million as the new threshold.
Expanding use of the cash method is meant to be a business simplification proposal. It is far easier for small businesses to track cash, rather than tracking payables and receivables. Plant-touching cannabis businesses can use this simplification, with an important caveat: they would still need to keep careful track of inventory cost of goods sold, since that is the only permitted business deduction under 280E.
OTHER PROPOSED CHANGES
Some other positive proposals: both bills would repeal the corporate and individual alternative minimum tax (AMT). This is a secondary tax regime that sometimes unexpectedly imposes additional tax on taxpayers. Also, both bills would retain the research and development (R&D) tax credit, so ancillary non-plant touching businesses in the industry would continue to benefit if they research or develop a new product or process unrelated to the controlled substance. 280E would continue to disallow the R&D credit for plant-touching cannabis businesses, however.
Both bills would negatively affect the cannabis industry by repealing the domestic production activities deduction (Section 199). Section 199 currently allows a deduction equal to 9% of qualified profit (from the sale of items produced, grown, extracted, etc. – in the U.S.). The deduction is currently available to ancillary businesses that do not traffic in controlled substances (280E prevents plant-touching business from taking this deduction).
So, while neither the proposed House nor Senate bills would impact Section 280E, both could significantly impact cannabis businesses and the growth of the industry at large. We expect positive changes to result from business tax rate reductions, capital expenditure incentives, repealing the AMT, and simplicity from increased cash method users. Repealing Section 199 is a definite step back, though.