The budding cannabis industry, despite its rapid growth and gradual acceptance in recent years, still faces a major sustainability challenge: Cannabis businesses cannot deduct most ordinary business expenses. Under Internal Revenue Code Section 280E, no tax deduction or credit is allowed for amounts paid or incurred in carrying on a business if the business consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act) that are prohibited by federal law or the law of any state in which such trade or business is conducted. Since marijuana is a controlled substance, cannabis businesses face a particularly high tax burden. In this context, employee stock ownership plans (ESOPs) emerge as a strategic solution, offering a pathway for cannabis businesses to enhance their cash flows while also retaining and motivating their workforce.
ESOPs are a type of tax-qualified retirement plan with assets held in a tax-exempt trust. If an ESOP is established for an S corporation and acquires all of the stock of the corporation, the ESOP will not be subject to federal income tax (or state income taxes in most states). With an S corporation, any income tax obligation passes through to the shareholder, and, in this case, the shareholder is a tax-exempt entity. ESOPs also provide a way for the owners to obtain liquidity, and they enable employees to become beneficial owners of the company. This is ordinarily achieved through the allocation of company shares to participants over the course of the repayment of a loan that finances the sale.
The Taxing Reality of Code Section 280E
Code Section 280E was initially introduced in the 1980s to prohibit businesses engaged in illegal drug trafficking from deducting ordinary business expenses. Despite the changing legal landscape of cannabis, with numerous states legalizing its use for medical and recreational purposes, Section 280E continues to prohibit federal tax deductions and credits for the business expenses of cannabis companies, including items such as rent and salaries. However, such businesses are generally permitted to deduct the cost of goods sold.
Mitigating Tax Liability
A 100% ESOP-owned S corporation in the cannabis industry holds a unique advantage in mitigating tax liability. Unlike traditional corporate structures, an ESOP-owned S corporation does not pay federal income tax, does not pay state income tax (in most states), and, perhaps most significantly, is not affected by the Code Section 280E restrictions on deductions and credits. Accordingly, the ESOP structure eliminates a significant expense for many cannabis companies and increases cash flow, allowing the company to reinvest its earnings into the business. This increase in resources can be used for any number of expenses, from growth and development of the business to repayment of its debts.
Although the cannabis industry is subject to a significant disadvantage under Code Section 280E with respect to tax deductions and credits, an ESOP offers an alternative that entirely mitigates this disadvantage. Furthermore, the ESOP provides liquidity for the selling shareholders and the opportunity to create an ownership culture among employees who will benefit from participating in a tax-qualified retirement plan.
If you have questions about transitioning to an ESOP or about ESOPs in general, please contact one of the attorneys in the Employee Benefits and Executive Compensation Practice Group at Bradley.