A recent court ruling in Alternative Health Care Advocates et al. v. Commissioner of Internal Revenue offers some significant tax implications for cannabis operators and management companies. The case, which was filed at the end of December 2018, is a cautionary tale for any cannabis operators who partner with a management company to help run their business while staying compliant with the 280E. Management companies are a common strategy that cannabis business operators deploy to save on taxes, but is it really that helpful?
Here’s what you need to know.
What happened in the case?
Alternative Health Care Advocates is a nonprofit mutual benefit corporation based in California. For tax purposes, the business was classified as a C-Corporation.
Wellness Management Group provided management services to Alternative Health Care advocates – management services such as managing HR, paying for advertising expenses, hiring and payroll. Wellness Management Group was taxed as an S-Corporation.
In this arrangement, Wellness was paid by Alternative Health Care Advocates through fees for its services.
Again, this arrangement of a management company is not unusual. Many cannabis operators set up management companies to mitigate the impact of the 280E.
As a refresher, the tax code 280E bans any business that “trafficks” Schedule 1 and Schedule 2 controlled substances from deducting business expenses on their federal taxes.
Cannabis is still considered a Schedule 1 substance at the Federal level. Therefore, in most instances, state-licensed and legal cannabis businesses cannot claim normal business deductions like payroll, marketing expenses, or rent.
Cannabis companies may partner with management companies to avoid tax responsibilities under the 280E, but there are other reasons for setting up this arrangement. The biggest benefit to the management company model is access to banking and regular payroll services. Management companies offer cannabis operators an avenue for running a semi-regular business operation while still staying compliant with the 280E.
Where the arrangement can backfire, however, is if the management company is seen as trafficking cannabis. This happens when the management company “introduces new transactions to the system involving the same pot of money,” according to CannaLawBlog.
In the case, the court ruled that Wellness’s business activities were essentially inseparable from Alternative Health Care Advocates:
“Wellness employees were directly involved in the provision of medical marijuana to the patient-members of Alternative's dispensary. While Wellness and Alternative were legally separate, Wellness employees were engaged in the purchase and sale of marijuana (albeit on behalf of Alternative); that was Wellness' primary business. We do not read the term “trafficking” to require Wellness to have had title to the marijuana its employees were purchasing and selling.”
In short, it made no difference to the court that Wellness and Alternative were two different business entities in a contractual agreement; Wellness, the management company, was still claiming tax deductions that violated the 280E regulation, and therefore had committed tax fraud.
One last important nuance to this case is that Mr. Duncan, one of the Wellness shareholders, only offered his ‘management’ services to his one cannabis dispensary (Alternative Health Care Advocates), even though he had ‘anticipated’ that Wellness (management company) would help other dispensaries out. Without providing these management services to another dispensary in the five years it was operational, Wellness sent a nearly clear signal that this management arrangement was simply for tax purposes only.
The main thing our experts want you to know about this ruling is that cannabis management companies may be subject to the 280E. Structuring your company as an S-Corp or a C-Corp doesn’t seem to have a measurable impact on the court’s opinion. If you are trafficking or managing a company that is trafficking, that entity is likely subject to the 280E and all its restrictions.
In the Alternative Health Care Advocates case, the S-Corp “Management” company (Wellness) filed taxes on March 15 and wrongly assumed that 280E doesn’t apply to them. In their tax filing, Wellness deducted a ton of expenses that they ultimately were not allowed to under tax code 280E. What this did was reduce the taxable base of the shareholders and created an underreporting of their flow-through income.
Let’s illustrate this through a simple example.
If the business made $1,000 and there are three equal owners, but 90% expenses, then each owner would get $33.33 in earnings ($100/3). But since all of those 90% of expenses were disallowed, their taxable base went up 10x to $333.33 each ($1000/3).
This illustrates that Individual shareholders, in particular, will be hit hard for under-reporting their income. The management company model hurts individual shareholders of the management company more than the cannabis company itself.
Lessons learned from Alternative Health Care Advocates
How can you mitigate this risk?
First and foremost, get professional tax advice that is backed by experience and tax court rulings. Do not try to bypass or bend the laws in your favor by trying some new, creative tax strategy. It may work for one or two years, but if it backfires, it can be extremely painful and costly. A CPA that has experience in cannabis is recommended over your local generalist CPA since there are so many nuances that the local CPA may not be aware of.
As you saw, when the IRS goes back to calculate your tax liability it can add up quickly and in this tax court ruling, it was over $1MM for one of the owners. If you do get a judgment against you or your company, payback the deficiency, additional taxes, and penalties as soon as you can. If you don’t know, the deficiency is how much more taxes an individual should have paid, as well as additional penalties.
The second lesson from this case is that you need to create and save detailed documentation for your business from day one. This is because there is something called the statute of limitations for auditing. Typical audits are three years. But since this was a large understatement in income, the IRS had six years to “start” this audit. This timeline is not set in stone by any means; in the Alternative case, the IRS showed that it can trigger the audit within the six-year window, and then take another three-four years to conduct and complete the audit and corresponding court cases. The risk is that this accrues more interest and penalties for you the longer a case such as this drags out. And with little to no documentation, your audit will drag on longer than necessary.
If you’re worried about your management company and tax responsibilities, get in touch with our experts for advice.