Unlocking Potential with 280E Assets for Cannabis Business Exits

Cannabis businesses are inordinately tax-disadvantaged compared to other organizations. Because they are precluded from deducting typical business expenses, like rent, insurance, utilities, and advertising, maintaining a healthy bottom line is challenging.

 Such is the state of the industry at the moment, in whole, because of Section 280E of the tax code, which prevents any business engaged in the sale or production of an “illegal” substance regardless of compliance with state codes.

 Though 39 states permit the legal sale of cannabis for medical and recreational use, the federal tax code has not evolved in kind. Until such time as cannabis is rescheduled, companies must use every accounting tool at their disposal to gain ground.

 Section 471(c) allows for some (albeit risky) deductions based on capitalizing inventory. If using this accounting method, costs can be recovered when the business is sold and applied to the final capital gain. However, this is not a complete snapshot of what’s possible, as 280E assets may also be leveraged at exit as the law states that such expenses cannot be permanently disallowed.

Understanding 280E and Its Impact

Section 280E is a massive thorn in the side of the cannabis industry. Essentially, this federal tax code limits business expense deductions for any company involved in the “trafficking” of illegal substances, of which cannabis is currently one.

 While other organizations can write off rent, advertising, payroll, accounting and legal fees, insurance, and other business-related expenses, cannabis companies must absorb these costs as the cost of doing business.

 Because most business expenses are disallowed, cannabis companies pay 70% of their gross income in taxes vs. non-cannabis companies, which pay about 30%.

 This immediately puts all cannabis companies at a disadvantage, driving retail costs higher, limiting investment potential, and, in some cases, forcing cannabis businesses to fold as they cannot maintain any meaningful profitability.

 Many CPA firms specializing in the cannabis industry have applied creative interpretations of the tax code to mitigate the impacts of 280E, which are arguably most effective when preparing for a business exit. Capitalized business expenses can, on exit, be applied to reduce capital gains, thus helping to make exits more tax-friendly so owners and investors can move on with grace.

280E Assets: What Are They and How Can They Help?

While cannabis companies may be restricted in many ways, leveraging certain assets can help to recover costs and potentially reduce tax liability.

 Tax attorney Nick Richards cites a historical case, CBS Corp. & Subsidiaries vs. the United States, in which disallowed non-personal expenses should be recognized as basis and allowed on exit, thus reducing capital gains and associated taxes.

 In the case of cannabis businesses, such assets would be separate from those reclassified under 471(c). Though there are few precedents to support whether this tactic would work, language contained in 280E indicating that some expenses cannot be permanently disallowed leads us to assume it’s worth a try.

 Simply put, while not all expenses can be applied to COGS, they can still be viewed as an asset and applied as basis. Expenses or depreciation that can’t be deducted in the year incurred, therefore, may be used to reduce capital gains when the business is sold.

Exit Strategy Planning and the Role of 280E Assets

We’re all hoping that rescheduling efforts succeed and cannabis businesses can start to focus more on building their business and less on finding ways to stay in it—or get out entirely.

 If you’re leaning toward the latter at this point, a combination of 471(c) and 280E assets might bring a bit of sparkle to the occasion for you, as the owner, and prospective buyers.

 Buyers typically prefer acquiring assets, as opposed to equity. Such would be the case when purchasing a cannabis business, as the equity may not be sufficiently valued compared to the assets.

 When the adjusted basis of the assets is valued at market rates, it allows the purchaser to monetize their acquisition cost through depreciation and amortization deductions.

 Ergo, by classifying certain expenses as 280E assets, there is good potential for tax savings and a more attractive prospect for prospective buyers. Until reclassification is a done deal, structuring deals with 280E in mind is recommended. As always, meticulous recordkeeping and due diligence are essential to mitigate undue IRS scrutiny.

Capitalizing Disallowed Costs: Takeaways from Rick’s Latest Article

Going back to Nick’s article outlining 280E assets and how they can help cannabis companies recoup millions on exit, we must underscore his urge for caution. While an aggressive tax posture could help owners recover costs previously ineligible as deductions, there may well be pushback.

 Because the IRS disallows certain deductions (i.e., costs they deem personal, meals, etc.), they may decide to disallow portions of the asset permanently. In the CBS case Nick cited, all deductions were allowed, and 30% of the related income was summarily excluded from taxation.

 Conversely, cannabis companies must continue to pay tax on 280E costs through to exit. This is where 471(c) and 280E asset theory comes into play; as if the former rule allows an expense to be attributed to COGS, 280E cannot permanently disallow it.

 Granted, these are complex concepts requiring the advice of a qualified tax attorney and CPA experienced in such matters. However, it should provide a glimmer of hope for any cannabis entrepreneurs looking to move on.

Final Thoughts

If the challenges of the cannabis business outweigh the effort or rewards, perhaps it’s time to start planning your exit strategy. Speak to your tax specialist today to learn more about 280E assets and how they can support exit and tax planning. GroWise is committed to pushing the boundaries of what’s possible to maximize the value of your company now and reap the highest returns possible on exit.

 Set up a call today; we’d love to learn more about your plans and show you how we can help you get there.