Cannabis Investor Guide 2023: Navigating Personal Tax & Liabilities

Whether launching a startup, collaborating with established industry players, or stepping into the shoes of an investor, knowledge is imperative when it comes to making sound investments; the Cannabis/CBD/Hemp industry is no exception. The potential profits in this booming market are undeniable yet the pitfalls of balancing accurate accounting, navigating intricate tax codes, and comprehending personal liabilities can quickly turn an investment dream into a financial nightmare. The mistakes of early Cannabis investors serve as stark reminders that success in this sector demands more than just passion or capital—it requires informed decisions backed by comprehensive knowledge and industry insight to ensure your investments are contributing to a strong financial future.

Learning from Early Cannabis Investors

The swift ascent of the Cannabis industry has captured the attention of investors worldwide, from average Joes to high-net-worth individuals. But as with any emerging market, the initial stages were riddled with lessons present-day Cannabis investors and CEOs need to learn from.

At the forefront of these teaching moments stands MedMen, a brand that epitomizes the allure of the budding Cannabis market. With its trendy appeal, MedMen attracted vast sums of investment. Yet, beneath its stylish, gimmicky facade were significant operational and financial issues. In 2018, even as MedMen boasted a revenue of $40 million, the company registered a net loss of $66 million. And MedMen was not alone; Tilray, another industry giant, with its $48 million in revenue, faced a staggering net loss of $67 million. Investors were soon confronted with a harsh reality: stellar revenues do not necessarily translate to profitability or long-term viability.

The setbacks these companies faced were not solely about their financial health. MedMen's journey was punctuated by a series of lawsuits, leading to the ousting of its founders in 2020. These incidents illuminated prevalent issues Cannabis companies need to prioritize: robust corporate governance, transparency, and sound accounting practices.

The downfall of such brands showcased the problems with prioritizing 'good ideas' and brand appeal over solid business fundamentals. For current and future Cannabis investors, it’s time to learn from the mistakes of the early green rush pioneers, so that the industry can continue to grow and thrive.

Investors Win with Accurate Accounting & Tax Compliance

Correct accounting, tax preparation, and reporting in the Cannabis industry require proper operational setup and processes, expertise, and tools. Maximizing tax benefits can be extremely challenging and nearly impossible if the right steps are not taken at the right time. As the industry grows throughout the nation, more accountants are attempting to serve these businesses. Unfortunately, mistakes made by well-intentioned accounting professionals are prevalent, costing Cannabis businesses majorly.

A Deep Dive into IRC 280E: At the core of many fiscal challenges for the Cannabis sector lies the IRC 280E. This stems from the Schedule I classification of Cannabis, which technically tags any sale of it as "trafficking" and legally bars businesses from claiming conventional deductions or credits like traditional businesses. The repercussions of overlooking or mishandling this code are severe, resulting in IRS penalties, audits, and other significant legal and financial repercussions. (Discover more ways Cannabis businesses differ from traditional startups.)

However, with informed tax strategies in place, Cannabis businesses can take advantage of legal pathways to diminish their tax burdens.

The Relief Offered by IRC 471: While 280E can seem restrictive, IRC 471 offers some relief to the stringent constraints of 280E, helping Cannabis businesses attain some deductions. This code allows businesses to allocate specific operational expenses to inventory, subsequently impacting the Cost of Goods Sold (COGS)—a crucial factor in ascertaining and trimming taxable income. But this reprieve isn't without its pitfalls; misinterpretation or incorrect application can also invite tax liabilities and fines.

A notable distinction within the 471 code also applies to different verticals within the industry:

• 471-11: Tailored for growers, processors, and manufacturers, it provides guidelines on how to allocate costs effectively.
• 471-3: Designed for retailers, it provides methods to slash taxable income. But such benefits demand an unwavering commitment to diligent documentation and transaction recording.

Broadening the Fiscal Horizon with Other Tax Codes: While the focus often hovers around 280E and 471, other tax codes can significantly influence a Cannabis business' financial strategy:

• IRC 263a: This addresses the capitalization and inclusion of certain costs in inventory. A nuanced understanding can drastically alter how Cannabis firms manage their expenses.
• IRC 199a: Often referred to as the Qualified Business Income Deduction, this provision, when employed correctly, can significantly enhance deductions, presenting Cannabis businesses with an edge in this competitive domain.

With the right expertise, businesses can navigate these tax challenges and maximize returns. Compliance with tax codes like 280E and 471 is multifaceted, demanding meticulous daily operations, a robust paper trail for each transaction, and a deep understanding of cost accounting specifically tailored for the Cannabis industry. Current accounting systems often don't fully address the unique needs of these businesses, particularly when they span multiple verticals. This gap underscores the importance of partnering with a specialized Cannabis accountant. Such a professional not only ensures regulatory compliance and bigger tax deductions but also attracts potential investors, paving the way for business growth and expansion.(Don’t make these crucial mistakes; check out these Lessons in Compliance from 4 Notorious Cannabis Cases).

Understanding Entity Structure Pros/Cons in the Cannabis Industry

Entity structure is incredibly important for Cannabis investors to understand. The structure of the company (or companies) can have major implications on personal tax and legal liability for those who are listed as owners. As a Cannabis accounting specialist, we encourage you to sit down with all investors and have an honest conversation about outside assets and how they could be affected so that the best structure can be determined. Rushing to throw together an LLC might not be the best option, and may expose investors with higher net worth or more assets to unnecessary liabilities. Having solid operating agreements and documenting how taxes will be paid so that owners aren’t on the hook for a surprise tax bill if they choose to be taxed as an S Corp. Those are just a few reasons why accountants in this industry need to really understand the pros and cons of choosing different entities, and need to be able to help their clients make an informed decision. Here’s more information to consider when choosing an entity structure.

C Corporations (C corps): The Cannabis Investor's Choice

Cannabis investors tend to favor C corps due to:

• Distinct Legal Structure: Shareholders and the corporation exist as separate legal entities. This shields shareholders from company liabilities and audits from extending to their personal assets, making investments more secure.
• Taxation Benefits: C corps are taxed at a current rate of 21% with limited financial exposure. An added advantage is the Internal Code Section 1202, allowing for a capital gains tax exclusion, as long as the stock is held for a minimum of five years. This section was created to inspire greater investment in small businesses. The limit on the amount of capital that can be excluded is $10 million, or ten times the adjusted basis of the stock.
• Capital Raising: C corps can raise capital more effectively and have a structured system for share issuance.

However, the C corp structure isn't without drawbacks. "Double taxation" is a major concern; the corporation pays taxes on its income, and shareholders pay taxes again on their dividends. Maintaining a C corp also involves extensive documentation, including Articles of Incorporation, by-laws, meeting minutes, cap tables, board resolutions, stock certificates, and more. Some argue that while the LLC structure might sometimes fall short of adequately mitigating risk for Cannabis investors, the C corp's tax implications and paperwork might be seen as overwhelming.

LLC Structure: Simplicity with Potential Risks

The LLC structure is appealing due to its simplicity and potential tax advantages. The top benefits include:

• No Double Taxation: Unlike C corps, LLCs avoid the issue of double taxation.
• Ease of Setup: Establishing an LLC can often be achieved within a few hours.
• Qualified Business Income Deduction: LLC members might qualify for a Quality Business Income (QBI) deduction, which can reach up to 20%, though specifics vary.

However, LLCs come with risks. The term "limited liability" can be misleading. In corporations with many investors, the risk of exposure to any one individual may be limited. Still, in those with relatively few, consequences can be severe. IRS audits can and have extended to personal assets. Hence, those who opt for an LLC should be fully aware of how it might impact the attractiveness of their business to investors.

The Multi-Entity Strategy:

An advanced approach for enhanced asset protection involves employing multiple entity structures. For instance, having a C corp hold several LLCs can offer the combined benefits of both structures. This strategy demands meticulous management across entities, from individual bookkeeping to exact intercompany transactions. Still, the high level of asset protection and potential for diverse investment channels can be worth the added complexities. (Learn more about using a multi-entity structure for a Cannabis business).

The Verdict: While C corps are generally more appealing to investors due to clearer legal distinctions and potential tax benefits, LLCs offer simplicity and can be more tax-efficient in certain scenarios. The primary aim should be to protect assets and ensure the business remains investor-friendly. Pursuing strategies solely to counteract 280E is not advisable, given the IRS's strong track record in such cases. The choice largely depends on the company's growth aspirations, investor profiles, and risk tolerance. It's crucial to consult professionals to align business goals with the right structure, ensuring both profitability and compliance.

Industry Expertise: The Key to Cannabis Business Success

The Cannabis CBD/Hemp sector isn't just about innovation and growth; it's also one of the most heavily regulated industries. With a myriad of compliance concerns ranging from human resources to OSHA, USDA, and the FDA, and extending to the local state and city ordinances, the journey for Cannabis entrepreneurs is intricate and demanding, requiring a thorough understanding of tax codes, compliance, and business entities.

The success of your business doesn't just rely on the quality of your product or service anymore but on your ability to successfully navigate the constantly evolving Cannabis landscape. Whether you're a budding investor, an eager entrepreneur, or an accounting professional targeting this sector, the importance of industry-specific knowledge cannot be overstated.

That's where nationally recognized specialists like DOPE CFO come into play; we not only provide the expertise required to traverse this challenging domain but also offer invaluable support. Knowledge is indeed power, and in the Cannabis industry, it's also the lifeline that ensures sustainability and growth. From proper accounting to deciphering tax codes and providing guidance on choosing the right business entity, DOPE CFO makes your Cannabis industry venture easy. Whether you're just starting out in the Cannabis realm or you’re looking to strengthen your foothold in the market, check out our webinar where we discuss this topic in great depth, and use our expertise as your roadmap to success.