by Jelena Grove

*When looking into any partnership, please speak to a professional and look into your rights reserved for equity partnerships in your state and municipality. This is not an exhaustive list of areas to consider and is not intended to be referred to as legal advice. Everyone mentioned in this article spoke from their own personal experiences, are not legal professionals, and are not offering legal advice.*

Social Equity Programs were the state’s way of giving impacted communities a lifeboat. Unfortunately, without offering support or resources to tackle Section 280E, the state left equity applicants drifting toward a waterfall without a paddle in sight. 

Contrary to the “green rush” narrative, for most non-VC-backed entrepreneurs, the cannabis industry is notorious for its high barriers to entry, particularly so for those most impacted by the war on drugs. Social Equity Programs (“SEP”s) are designed to lessen these barriers by providing priority licensing and compliance to fast-track individuals from disproportionately impacted communities into ownership and leadership positions within the cannabis space. 

But even with the establishment of SEPs across California, equity applicants in these programs continue to face hurdles that hold them back from full participation in the industry that promised opportunities to create generational wealth in impacted communities. 

Before equity applicants even obtain a license to operate, applicants are faced up against the structural flaws in the programs themselves, a lack of legal and financial guidance upfront, a tumultuous regulatory landscape, predatory investors, and credit unions, and now the economic havoc of COVID-19. 

The reward for making it through the process? A 70% taxation rate (or higher), thanks to the impossible burden of 280E. 

So how can social equity applicants (SEAs) hope to prosper in these programs if they’re expected to hand over all of their profits to Uncle Sam? 

One thing is clear: what SEAs need right now is reliable, unbiased resources and investment. The question is, from where? 

Cannabis Investors Want All of the Gain, None of the Pain (Social Equity is Left Out in the Cold… Again)

Founded in 2015 by Snoop Dogg himself, cannabis venture capital firm Casa Verde Capital invests in “scalable, capital-efficient businesses, led by world-class management teams, addressing long-term market needs.” 

Spoiler alert: they’re not talking about dispensaries. 

When you look at Casa Verde’s investment portfolio, or any other big-name venture capital cannabis firm (there are many), you’ll see lots of well-known cannabis-adjacent companies like Merry Jane, Green Bits, METRC, Dutchie, and more. 

What do these businesses have in common? 

Apart from their ubiquity within the cannabis industry, none of them actually touch the cannabis plant. That’s important because it means that they can write off their ordinary business deductions on federal tax returns, and therefore pay significantly less tax than their “plant-touching” counterparts – the businesses SEPs incentivize impacted individuals to start and operate. 

Needless to say, a software company with an effective tax rate of 30% (and often less with other tax planning strategies) will have a far easier time finding investors than a cannabis dispensary with an effective tax rate closer to 70% (more on that below). 

To further complicate investment prospects, cannabis operators still don’t even have access to banking services. For the most part, operators are still dealing in cash. The few credit unions that are willing to work with cannabis businesses aren’t making it easy: “Not only are we not getting write-offs, but the banks and credit unions that will deal with us aren’t even dealing with us as a normal company. They’re charging thousands of dollars more per deposit and transaction per month”  says Mike Davila, CEO of KGB Reserve, a Bay-area based brand, distributor, and pre-roll manufacturer. 

What is Federal Tax Code § 280E (and Where Does it Apply)?

“The intent of the law was to go after criminals, not law-abiding job creators.” – Grover Norquist, Americans for Tax Reform 

§ 280E is a federal tax code passed under Ronald Reagan to prevent people from claiming tax deductions for income stemming from “illegal business.”¹

In short, 280E is a reason why so many legitimate cannabis operators fail.

Since cannabis is still classified as Schedule I, cannabis operators are considered “illegal traffickers,” and are not allowed to write off virtually any business expenses at the federal level. Cannabis operators then end up being taxed based on their gross income, rather than on gross income minus business expenses, as illustrated in the simplified table below.²

Table 1: From National Cannabis Industry Association 280E White Paper

The result for SEAs: $60,000 at the end of the quarter that could have grown the business, hired a new BIPOC employee, or supported a charitable organization in the business’s back yard, are instead dumped into the federal tax system to be spent — who knows where. 

Speaking with OUR DREAM, Leanna Miller, a tax strategist, and accountant with BLUNT CFO explained that most cannabis businesses on average would have to pay closer to $250,000 in taxes to the federal government, each quarter. 

280E makes cost accounting for cannabis businesses extremely difficult. Not only are you stuck with more than double the effective tax rate, but if you deduct your expenses incorrectly, your chances of getting penalized by the IRS are significant. 

“If you’re a business owner, depending on what kind of legal entity you have, the IRS can audit your business, and you may or may not be protected,” says Miller. 

Errors in accounting are more common than not. In a recent audit conducted by the Treasury Inspector General For Tax Administration (March 30, 2020),³ TIGTA found that nearly 60% of tax returns for cannabis businesses in 2016 were filed incorrectly. 

“It’s surprising to me how many (tax) professionals don’t understand the requirements of 280E and the adjustments imposed on cannabis businesses, particularly retail,” says Ani Galyan, attorney and tax specialist at Galyan Law. 

Getting Around § 280E (With a Professional’s Help)

Business Structure and Shared Service Agreements 

The most common strategy to offset the tax burden is by creating a shared service agreement with the other subsidiary entities in a corporation. In general, partners of social equity applicants know this very well. 

In plain English, because very few of us can remain focused when it comes to tax strategy of any kind… plant-touching cannabis businesses should discuss with their tax, accounting, and legal advisors whether it makes sense to start a new, secondary company that pays as much of the overhead expenses as possible. In this structure, the management company charges the license-holding (280E-liable) company a management fee to cover the costs. This preserves as many tax deductions as possible and can significantly reduce the total overall taxes a business is required to pay due to 280E rules.

Can I Get Out of 280E by Using Tax Code 471(c)?

IRC § 471(c) is a section of the tax code that allows small businesses with annual revenue of under $25M the option of restructuring their accounting methods to determine inventory costs (COGS) on their own. In theory, this would allow people to claim deductions on otherwise 280E-prohibited inventory. 

While some folks are getting excited about 471(c),⁴ a potential loophole in 280E, the IRS still hasn’t issued any form of guidance for 471(c) and tax specialists OUR DREAM spoke to for this article urged folks to use extreme caution.⁵ 

According to Leanna Miller, the 471(c) strategy is largely still half-baked. “Until either the guidance comes out from the IRS or somebody wins a fight in the US tax court, we follow the procedures that we follow. Until then, the most important thing for you to take advantage of in 280E is making sure you understand your cost of goods sold.” 

If your accountant thinks it’s a great idea and files a 471(c) claim too early, you run the risk of the IRS issuing guidance later on that could jeopardize your entire business. Even with the help of a seasoned cannabis CPA to file for a change in accounting methods, the likelihood of you getting audited is high. 

How to Use COGS to Avoid 280E

While they can’t avoid it entirely, cannabis operators do have legal ways to maximize deductions despite 280E because they can still write off their cost of goods sold (“COGS”) at the state level (see Table 1 above). These are things that are directly tied to the products sold, like soil and fertilizer for growers, or inventory costs, pre-roll tubes, bags, and other supplies for manufacturers.

There are options to cover your ass as a cannabis operator staring down the barrel of 280E, but don’t expect clear guidance and hand-holding to understand the rules and regulations unless you seek out a professional.

“For the most part you’re on your own when it comes to figuring out 280E,” Degi Simmons, CEO of social equity brand Cloud9, told OUR DREAM. “If I was doing it for myself, there would be a lot of things I’d miss and not be able to take advantage of.”

This is why it’s so important for equity applicants to get tax and legal advice from CPAs and lawyers with proven experience navigating the complexities of the cannabis space before any operating agreements are signed. 

“Expect CPA fees to be part of your business expenses. Do whatever you can to write it off on the entity that is not plant-touching” – says Nina Parks, CEO of Nina Parks Consulting, and a co-founder Original Equity Group and founder of Gift of Doja. 

By Not Addressing 280E, Social Equity Programs Have Let Down the Communities They Pledged to Support

Social equity partners typically only hold a license for one entity within a corporation’s web of subsidiaries. Before they become partners in these companies, social equity programs support SEAs’ involvement with plant-touching businesses (i.e. retail, distribution, delivery, and cultivation). As we’ve seen, these types of businesses are all directly impacted by 280E. 

Ultimately, SEAs are being set up to fail before they even finish the program. Before they have to worry about taxes, they have to worry about getting their business operational in the first place. 

To further complicate matters, LA’s Social Equity program has come under fire in the past year and is facing allegations of corruption, system failure, and negligence.⁶ In response, the City of LA recently passed several amendments to its Municipal Code attempting to better define ownership and equity in these companies and to prevent non-equity applicants from exploiting loopholes in the system.⁷  

The program was designed to fast-track highly-impacted individuals into positions of ownership but falls short when it comes to protecting the longevity of their businesses. LA’s Social Equity program fails to provide the resources and tools necessary to help SEAs navigate the complexities of business structures and taxes – issues well-capitalized businesses can simply buy their way out of.

“Not only are we starting from behind where we can’t write off a lot of things, but we also can’t even get the help we need to file correctly,” says Mike Davila at KGB Reserve. 

Hiring accountants, lawyers, and CPAs are as expensive up front as they are helpful in the long-term. 

By definition, an equity license holder is already a highly impacted individual – and comes from either a low-income background or has a past cannabis conviction on their record. They typically don’t have access to financial services like tax planners and lawyers to implement the appropriate infrastructure and protections, and the social equity program as it exists today isn’t helping them figure it out. 

How does 280E impact equity applicants who are passive equity partners? 

Roughly speaking, social equity licenses can take one of two forms:

1. Where a qualifying entrepreneur applies for a license and operates the business themselves; and
2. Where a business not qualified for a social equity license instead partners with a qualifying individual, leveraging their eligibility to obtain the license. In this case, the equity partner (“SEP”) may have varying degrees of control and economic interests, solely depending on the deal they negotiate.

Particularly in the latter, there is an enormous opportunity for the SEP to be taken advantage of – one of which is when it comes to paying taxes.

Unfortunately, SEAs are often sold an opportunity to enter these partnerships and “make a bit of cash for signing a few papers” without being warned about the 280E implications that could directly impact them. 

Passive equity applicants and partners listed on a license as a “majority owner”, but not directly participating in the revenue or cash flow created from the business, should speak with a lawyer or consultant about tax implications before signing an operating agreement. 

OUR DREAM spoke with an LA equity license holder who is a silent partner, and asked to remain anonymous, “I signed my operating agreement a couple of years ago before I knew what 280E was and it was a predatory deal. My partners use my license to package millions of dollars worth of product, but I don’t see a dime. My operating agreement does not state that they will be covering all of the taxes and it’s been a conversation that they are now trying to avoid having with me. So what happens if they don’t have the right amount of money to keep operating and paying taxes? I could be liable for anything outstanding.” 

“I signed my operating agreement a couple of years ago before I knew what 280E was and it was a predatory deal. My partners use my license to package millions of dollars worth of product, but I don’t see a dime. My operating agreement does not state that they will be covering all of the taxes and it’s been a conversation that they are now trying to avoid having with me. So what happens if they don’t have the right amount of money to keep operating and paying taxes? I could be liable for anything outstanding.” 

Luckily, the new LA ordinance does allow for renegotiating social equity operating agreements; however, this is not the case for many other equity partners across the country.

Possible Solutions: What To Keep An Eye Out For

280E will continue to overwhelm cannabis operators – especially social equity license holders – until cannabis is de-scheduled or 280E is amended (it’s not likely to be repealed because it still covers all other scheduled drugs like cocaine and heroin). There is legislation both at the state and federal levels that aim to alleviate this burden on cannabis operators, but the likelihood of significant federal de-scheduling is slim. 

Tax Credits

Since venture capital largely isn’t an option for equity businesses in need of funds, many groups are hopeful that investment in equity businesses will come in the form of government subsidies in the future. 

These subsidies could involve special tax credits, either as a percentage of tax revenue from the cannabis industry or as an allocation of funds being rerouted from divestment in the police.⁸ The idea is to funnel money away from entities who have historically perpetuated the cycle of violence against these communities, back into these communities. 

Federal Legislation 

The Small Business Tax Equity Act (HR 1118) was introduced in Congress last year.⁹ The proposed federal bill would amend IRS code 280E and exempt state-compliant cannabis businesses from the tenants of 280E tax law and allow them to claim ordinary deductions on their taxes like any other business. According to GovTrack, the bill has only a 2% chance of passing – but it’s a start. 

State Legislation 

AB 1525 is one bill currently on the table for the State of California, which would eliminate penalties for banking institutions that do business with cannabis companies.¹⁰ Mike Rosenblum of Thompson Coburn says the bill “could provide a meaningful boost to California’s cannabis industry by easing access to financial services for cannabis businesses, and by protecting ancillary companies that serve the industry.” 

“If banking were allowed for cannabis businesses, that would also bring gun-shy investors into businesses that touch cannabis,” says Derrick at KGB Reserve. 

Finally, SB 595 is a bill that would waive application fees and license renewal fees and may offer a reprieve for equity businesses.¹¹ 

Is There Any Hope for Social Equity Businesses? 

Social equity businesses are not only up against the structural barriers wrought by systematic racism and drug war-era legislation, but also against the extremely well-financed competition (both in regulated and unregulated markets), the complexities of a rapidly evolving market, the financial burdens to remain compliant, listless bureaucrats, predatory investors, Section 280E, and the shortcomings of a program that was supposed to make all of this easier. 

In the meantime, grassroots advocacy groups are taking it upon themselves to fill in the blanks. 

Oakland-based Original Equity Group (“OEG”) features individuals who have successfully navigated equity programs and represent verified social equity applicants attempting to do the same. OEG is currently working on a grant program to help equity applicants get the technical support they need to succeed. 

Nonprofits like OUR ACADEMY connect SEAs and BIPOC entrepreneurs in the cannabis industry with experienced mentors, pro bono services, and a network where they can strategize, share experiences, and focus on community reinvestment.

While the future for social equity is hazy, these programs and others like them offer a lighthouse of hope for those brave enough to jump into the industry. 

“There are major success stories [in this space]. Whether or not those businesses survive depends on what we do now, whether or not they thrive depends on how unified we are, to be able to provide the necessary resources to make this happen across the board,” says Ramon Garcia, co-founder of OEG. “With this equity program we knew it wasn’t gonna be perfect, but we knew that it could be an example to show people how this really can work.” 

OUR DREAM and it’s affiliated parties do not provide tax, legal, or accounting advice, nor are we professionals in these areas. This article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Always consult your tax, legal, and accounting advisors before implementing complex business strategies, especially when operating in the cannabis industry.

¹ Office of Chief Counsel Internal Revenue Service Memorandum. 23 Jan. 2015, https://www.irs.gov/pub/irs-wd/201504011.pdf

² National Cannabis Industry Association. Internal Revenue Code Section 280E: Creating an Impossible Situation for Legitimate Business. Apr. 2015, https://thecannabisindustry.org/uploads/2015-280E-White-Paper.pdf

³ Treasury Inspector General For Tax Administration. Office of Audit Highlights. 30, Mar. 2020, www.treasury.gov/tigta/auditreports/2020reports/202030017_oa_highlights.html?fbclid=IwAR0p2ms6mab2tGFTSTDYGJfHkyvvkWWt0q65KkGfSBuk0jbkcHoFDxTKWqs

⁴ Shannon, Calvin, et al. Member Blog: IRC Section 471(c) of the TCJA May Mitigate the Curse of 280E for the Cannabis Industry |. 13 May 2020, https://thecannabisindustry.org/member-blog-irc-section-471c-of-the-tcja-may-mitigate-the-curse-of-280e-for-the-cannabis-industry/

⁵ Hardwick, Sean. “Internal Revenue Code § 471(c) Is the New Tax Burden of the Marijuana Industry.” Mr. Cannabis Law, Https://Mrcannabislaw.com/Wp-Content/Uploads/2019/09/Header-Logo-1.Png, 10 Apr. 2020, https://mrcannabislaw.com/blog/internal-revenue-code-§-471c-is-the-new-tax-burden-of-the-marijuana-industry/

⁶ Schroyer, John. Turmoil Abounds over Los Angeles’ Latest Marijuana Business Licensing and Its Social Equity Program. 15 June 2020, https://mjbizdaily.com/turmoil-abounds-over-los-angeles-social-equity-program-latest-marijuana-business-licensing-round/

⁷ “Social Equity Changes to Los Angeles Cannabis Licensing Will Impact Industry.” MMLG, 26 July 2020, https://mmlg.com/los-angeles-social-equity-cannabis-licensing-2020/

⁸ Denkmann, Libby. “City Council Votes To Slash LAPD Budget By $150 Million.” LAist, 1 July 2020, https://laist.com/2020/07/01/los-angeles-city-council-votes-lapd-budget-cuts-150-million.php

⁹ Blumenauer, Earl. “H.R.1118 – 116th Congress (2019-2020): Small Business Tax Equity Act of 2019.” Congress.gov, 8 Feb. 2019, www.congress.gov/bill/116th-congress/house-bill/1118

¹⁰ Rosenblum, Michael, and Monica Roth. “Proposed Bill May Ease Access to Financial Services for California Cannabis Businesses.” Thompson Coburn LLP, 6 Aug. 2020, www.thompsoncoburn.com/insights/blogs/tracking-cannabis/post/2020-08-06/proposed-bill-may-ease-access-to-financial-services-for-california-cannabis-businesses?utm_source=Concep

¹¹ United States, Congress, California. “SB-595 Cannabis: State Licensing Fee Waivers: Needs-Based Applicants and Licensees: Local Equity Applicants and Licensees.” California Legislative Information, 14 Oct. 2019, https://leginfo.legislature.ca.gov/faces/billTextClient.xhtml?bill_id=201920200SB595