Written by: Abraham Finberg, CPA
For sometime now, cannabis businesses have formed various corporate entities to ease some of the challenges associated with operating in the legal gray area. Although there are legitimate and practical reasons for doing so, this practice is sometimes unnecessary and redundant. Further, you may actually be violating the law or in some cases laundering money. In order to avoid any unwanted taxes or criminal consequence, you should consult one of our legal and tax professionals right away.
Money Laundering: If you are misrepresenting your activities to your bank you may be charged.
Some cannabis business managers may form separate entities to facilitate opening a bank account. Unfortunately, US Code Title 18 Part I Chapter 95 § 1956 makes it a crime for “[w]hoever, knowing that the property involved in a financial transaction represents the proceeds of some form of unlawful activity… to conceal or disguise the nature, the location, the source, the ownership, or the control of the proceeds of specified unlawful activity.”
In other words, if you pretend you are one type of business but are actually another type of business you are probably laundering money.
Single Member LLCs: May mitigate the risk of money laundering charges.
One way to potentially mitigate the money laundering issue is to keep the management company a Single Member Limited Liability Company (LLC) wholly owned by the cannabis company. That means the cannabis company is listed as the 100% owner of the company in a statement of information with the Secretary of State and provides more transparency. Another potentially positive aspect of this type of “Single Member LLC” is that the IRS disregards such an entity and requires the activities to be listed in the cannabis company's income tax return. That means you save money since you don't have to pay to prepare an IRS income tax return for the LLC (California still requires a type of tax return, Form 568, however it is a much simpler return and unless the activities are more than $3,000,000 the return does not involve producing a profit and loss and balance sheet and it is much cheaper to prepare).
Although the single member LLC may allow you to be more truthful with your banking institution, cash deposits could still get you into trouble if the cash smells like marijuana. To quote FIN 2014-G001 guidance regarding marijuana-related businesses, “(eg. a “consulting,” “holding,” or “management” company) that purports to engage in commercial activity unrelated to marijuana, but is depositing cash that smells like marijuana” requires the filing of a primary suspicious activity report. Once a bank is filing these types of reports the account will probably be closed. Therefore, even if you are able to open an account, it may eventually be closed by the bank.
Taxation downfalls of the single member LLC
As most cannabis businesses are well aware, under IRS Tax Code 280E, a business trafficking in a controlled substance (e.g. Marijuana) cannot deduct its business expenses for tax purposes. However it can deduct from gross income its cost of goods sold (the costs of the product itself).
Thereunder, a problem with a single member LLC may arise. Specifically, because the cannabis company owns the LLC, it cannot charge various expenses since for tax purposes it doesn't exist (the cannabis company can't charge itself expenses). Therefore, while the single member LLC helps with the banking issue it does not solve the 280E problem and charge additional expenses (management fees).
Another way of approaching this issue is to charge cost of goods sold items to the cannabis company, which would lower gross income for tax purposes. (Anything creating the product would be cost of goods sold.) For example, the rent and utilities a grower pays for its grow warehouse would be deductible.
A separate company should have a business reason
Bottom line, to avoid tax and money laundering issues, a separate company needs a reason to exist as well as keep good separate accounting records.
For example, one potential separate business entity could be for a real estate company which rents the warehouse to the grower. Said Real Estate Company would justifiable be able to charge up to three times fair market value due to seizure risk and increase the cost of goods sold to the cultivator. The key here is the increase in rent price exists for a legitimate reason; a higher price due to the higher risk. A higher rate for utilities, would be harder to justify so anything more than about 18% more than the price incurred by the non cannabis company would not be a good idea.
What happens if the prices are unreasonable? The IRS can remove the excess pricing if it doesn't have a legitimate business purpose.
Another key to managing a separate company is the need for a true separate set of accounting records. The non cannabis company needs to produce justifiable invoices, issue the invoices to the cannabis company, and the cannabis company needs to account for the invoice as an amount owed to a vendor (accounts payable). If separate accounting records are not kept, two things may happen. The IRS would have reason to combine both companies into one entity since the non cannabis would not seem to have a business purpose and, even worse, the non cannabis company may seem to be a front for the cannabis company and create a money laundering problem.
It is essential that you strategize properly and invest in the proper professionals to avoid these pitfalls before it's too late.