Recent Cannabis Cases - 280E and Bankruptcy

Friends!  Wanted to alert you to two very recent court cases – tax and bankruptcy – that impact the Cannabis industry and the way it does business.  Some fun reading for the short work week between holidays.

Management Companies and 280E

First, an opinion of the US Tax Court from December 20th that seems to put a fork in the 280E “management company” structures that many Cannabis companies have been using.  As I learned early on in my long, painful career as a deal lawyer, tax influences everything, and this opinion highlights that lesson.

For those not familiar, Section 280E of the Internal Revenue Code bars deductions of expenses for businesses trafficking in a controlled substance.  In short, the “management company” structure seeks to, well, structure around this limitation by having the license-holding entities (cultivation, production, distribution) contract with a management services entity that doesn’t hold a license or “touch the plant”, but instead only provides services to those licensed companies (e.g., holding the lease and providing employees).  The theory has been that, since the management company is only providing services, it’s not trafficking in Cannabis and therefore may take Federal tax deductions. 

TLDR: the US Tax Court rejected outright the defendants’ arguments that the management company wasn’t engaging in “trafficking in controlled substances”.  The Court noted that, among other things, the management company employees were directly involved in the purchase and sale of Cannabis, and the only difference was that the licensed entity held title to the Cannabis while the management entity didn’t.  The result of this is that the management company is fully-taxed, without the right to take deductions due to 280E, and its flowthru members were charged with the additional income (plus a penalty).  To make the point, the Court said that these “tax consequences are a direct result of the organizational structure petitioners employed”.

https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11855

Going forward, Cannabis companies should consider, among other things:

  • How does the apparent death of the “management company” structure change the economics of my business?

  • Should I continue to use flowthru (S corps and LLCs taxed as a partnership) entities at all?

  • What does this mean for my “management company” returns filed for prior years that claimed deductions?

  • Should I trust any structure that claims to avoid taxes?

  • Why does it seem like, every other day, there’s another roadblock to positive EBITDA?

My suggestion (not legal advice!) - make sure to discuss with your favorite lawyer and/or tax professional.   

Everything in business and law is about balancing risk (certainly something this industry knows well), but when it comes to specialized areas like tax, you want the most sophisticated advice you can get* to fully understand the nature of that risk and make a truly informed decision.  Ventures were set up by Cannabis business owners using the “management company” theory without appreciating that the structure itself hadn’t actually been tested or considered by the IRS.  To quote Homer Simpson: “I agree with you Marge .. in theory.  In theory, Communism works!”

Bankruptcy

Our second contestant today comes from the US Bankruptcy Court in Colorado (thanks to Jason Rosell, a bankruptcy lawyer at Pachulski Stang Ziehl & Jones LLP, for altering me to this**).  The case, In re Way to Grow, Inc., Case No. 18-14330 (MER) (Bankr. D. Colo. Dec. 14, 2018), involved an indoor hydroponic and gardening-related supplies company filing for bankruptcy protection (which is under Federal law).  Federal law makes it a crime to distribute “equipment, chemical, product or material which may be used to manufacture a controlled substance ... knowing, intending, or having reasonable cause to believe, that it will be used to manufacture a controlled substance”.  The Court rejected the debtors’ petition to file for bankruptcy because the debtors were selling, and would continue to sell while in bankruptcy, equipment directly to the Cannabis industry.  What’s notable about this case is that the debtor wasn’t a Cannabis company – it was an equipment manufacturer selling goods to Cannabis grower.

Although it had been clear in the past that a Cannabis company wouldn’t be able to take advantage of Federal bankruptcy protections, this decision broadly expands that limitation to companies servicing the Cannabis industry.  When the next recession hits, and companies touching the Cannabis industry are distressed, how will that play out?  My guess – it’ll be ugly and messy, and there will be many trade creditors to equipment companies taking haircuts and becoming owners.

Excelsior! (and happy new year)

*And, of course, it goes without saying, from your deal lawyer as well...

**See, above, my point about seeking out sophisticated advice in specialized, highly-regulated areas of law.

Written by: Marc Hauser