In the world of cannabis, management companies have gained notoriety, and unfortunately, the reputation hasn't always been positive. A landmark tax court case, Alternative Health Care Advocates vs. the Commissioner of Internal Revenue, shed light on the potential pitfalls of misaligned cannabis management company structures in the industry. Let's delve into the case and explore its implications for cannabis businesses.
In this influential tax court case, the judge ruled that an S Corporation functioning as a management company for a dispensary was deemed to be involved in the business of cannabis trafficking, making it subject to regulation 280E. While the management company, Wellness Management Group, primarily provided HR services, advertising expenses, and payroll, the court's decision highlighted the risks associated with employees engaged in activities related to cannabis procurement or patient interactions.
The Ownership Connection
Another crucial aspect of the case was the ownership relationship between the management company and the retail store. Despite the presence of a separate legal entity and a contractual agreement, the court disregarded the distinction and considered the management company as merely existing to serve its retail store. As the management company claimed deductions that violated regulation 280E, it was accused of committing tax fraud.
Consequences and Lessons
Following the court ruling, the tax liability of the business was recalculated, resulting in a staggering amount of over $1 million for one owner alone. The case also highlighted that the IRS has a six-year lookback period for audits in cases involving large understatement of income. The implications are clear: businesses, even if not directly handling cannabis, can still be subjected to regulation 280E and denied deductions. Courts are likely to view cannabis management companies similarly to actual cannabis businesses.
Appropriate Use of Cannabis Management Company Structures
While cautionary tales abound, it's important to note that management companies can still serve a purpose in the cannabis industry. However, their establishment must be grounded in reason and necessity. Solid separation of accounting records and a legitimate business purpose are vital to avoid potential tax and money laundering issues.
Alternatives: Real Estate Entities
One viable example of a separate entity within the cannabis industry is a real estate company that leases its physical space to retailers or growers. Such a company can charge fair market rent, justified by the nature of the lease. However, it is crucial to ensure that the pricing remains reasonable, as the IRS can intervene if excess pricing lacks a legitimate business purpose.
The tax court case underscores the need for careful consideration when structuring management companies within the cannabis industry. Deductions cannot be indiscriminately claimed through these entities. As the cannabis industry continues to mature, access to banking and regular payroll services is improving, reducing the reliance on management companies.
For more guidance with your cannabis business reach out to Redbud Advisors, we are cannabis tax experts always guiding you in the right direction.
Remember, it is essential to seek professional advice from attorneys for legal matters and qualified cannabis accountants for tax and accounting concerns.