President Biden’s American Families Plan, as proposed, is a $1.8 trillion plan to overhaul and upgrade the nation’s infrastructure and includes a tax provision that could negatively affect the cannabis industry.
Included in this Plan is an increase in the corporate tax rate from 21% to 28%. Since a large number of “cannabusinesses” are C-Corporations, any increase in the corporate tax rate would negatively impact them.
What’s the Big Deal?
Although an increase in the corporate tax rate will negatively impact the profitability of businesses across the country, cannabusinesses would be disproportionately hurt because of Internal Revenue Code (“IRC”) Section 280E, which disallows defined deductions that are typically available to non-cannabis businesses. This effect on cash flow is exemplified as follows:
|Revenue||$ 12,000,000||$ 12,000,000||$ 12,000,000||$ 12,000,000|
|Cost of Goods Sold||6,000,000||6,000,000||6,000,000||6,000,000|
|Federal Tax Rate||21%||28%||21%||28%|
|Cash Flow||$ 2,370,000||$ 2,160,000||$ 1,740,000||$1,320,000|
In the above example, it is evident that under current regulations, the cannabis business pays an additional $630,000 ($3 Million in non-deductible expenses at 21%) in tax that the non-cannabis business would not. Further, if the tax rate is increased to 28%, the tax paid by the cannabis business increases an additional $210,000 to $840,000 in over what the non-cannabis business incurs.
If you also consider the impact of double taxation for C-Corporations, you can quickly see the obstacles that small businesses within the industry will face in an effort to get their business “off the ground”.
Is it Time to Reconsider The C-Corp Structure?
Although a corporate tax hike will make a C-Corp structure less appealing, there are several non-tax benefits to consider before ditching the C-Corp status.
C-Corps are More Attractive to Investors
Many startup businesses are structured as C-Corps because it is easier to raise capital and sell shares. Venture capitalists often prefer to invest in C-Corps and avoid other business structures due to inherent restrictions in ownership by non-corporate entities. Even S-Corporations pose difficulties to venture capitalists due to their restrictions on both the number of owners and on foreign ownership.
Qualified Small Business Stock IRC 1202
IRC Section 1202 excludes up to 100% of the gain recognized on the sale of qualified small business stock (“QSBS”) that is held for at least five years before the sale. Although the tax burden over the initial start-up phase of the business may create difficulties for small cannabusinesses, the eventual tax benefits on the sale of QSBS may be worth the temporary headache. If the goal is to grow the business as much as possible, and subsequently sell to new investors, then a C-Corp structure may still make sense.
Small Cannabusinesses May Benefit From a Change
Although the corporate tax rate is still 21%, many small businesses choose to become a pass-through entity, because individual graduated rates are less than or equal to the double taxation from a C-Corp structure. With an increase in the tax rate from 21% to 28%, and assuming no increase in personal rates, it is likely that many small businesses will keep their passthrough structure in place. Some businesses may consider switching from an existing C-Corp.
However, before switching to a C-Corp, owners should be aware that such a switch may create unintended tax consequences. For example, the conversion of a C-Corp into an LLC is treated as a complete liquidation of the corporation’s assets and any distribution of appreciated assets may be includable in income on the corporation’s tax return as well as the shareholder’s tax return resulting in double taxation.
Consult a Tax Advisor Before Making a Switch
Picking the right entity structure is important for any business, but it is especially important for cannabusinesses small and large. Partnering with a tax advisor who understands the nuances in the cannabis industry can save hundreds of thousands of dollars in tax. Before making the switch to or from a C-Corp, it’s important to understand all the pros and cons as well as understand recent legislative changes that can impact the entity selection process.