Should Your Marijuana Business Be a Corporation or LLC?
Choosing Between an LLC or Corporation for Your Legalized Marijuana Businesses
For the most part, the factors that help you decide whether you should make your marijuana business a corporation or an LLC are the same as for any business. Both corporations and LLCs protect your personal assets, but if you want to have shareholders, you must form a corporation. LLCs have owners rather than shareholders and they have fewer formalities than corporations. For these reasons, LLCs have become a favorite among business owners. However, marijuana businesses that don’t really need to form a corporation should still give corporate status serious consideration before forming an LLC because of the unique challenges the legalized cannabis industry faces when it comes to federal income taxation.
State-Legalized Cannabis Operations and the IRS
Under Controlled Substances Act (Internal Revenue Code 21 U.S.C. § 801 et seq.), marijuana is classified as a Schedule I controlled substance, and Section 280E of the Internal Revenue Code says that businesses that traffic Schedule I and Schedule II controlled substances are not allowed to deduct any ordinary or necessary business expenses under Section 162(a), even in states where cannabis has been legalized medically and/or recreationally. The only thing that state-legalized cannabis businesses are allowed to do is subtract the cost of goods sold, or COGS, from gross receipts, although at this point, the IRS has given little guidance on exactly which costs are allowable and under what circumstances. The IRS does not classify the COGS as a deduction. Rather, it is subtracted from the gross receipts to determine the gross profit. For state-legalized marijuana businesses, the only way they can get any tax benefit from ordinary business expenses like rent, advertising, salaries and utilities, is if the IRS agrees that the “expense” is actually a “cost” to be subtracted from gross receipts.
The IRS decides what constitutes COGS on a case-by-case basis. If you have costs that were actually incurred in cultivating and/or procuring the goods sold and you deduct them as COGS, they may be allowed. On the other hand, if the IRS disallows the costs, any deficiency will need to be paid in a timely manner, and it's at this point that it might matter a lot whether your marijuana business is operating as a C-corporation, or as an S-Corporation or LLC.
Potentially Devastating Personal Tax Liability
Any corporation that has not filed form 2553 with the IRS to receive S-Corporation treatment is considered a C-Corporation. With C-Corporations, income is attributed to the corporation itself as is the income tax owed on that income. With S-Corporations, the income of the business passes to the individual shareholders, much like business income is attributed to the owners of LLCs. Because the income is considered to be that of the S-Corporation’s shareholder or the LLC’s owners, so, too, is the income tax liability. If the IRS determines that certain costs of the marijuana business are not actually costs of goods sold, they will disallow it. When a C-Corporation owes federal income tax that the business cannot pay, the corporation can be dissolved and the income tax debt goes along with it. For an LLC or an S-Corporation, however, the tax debt passes to the owners or shareholders pro rata to be reported on their personal tax returns and remains with them until paid, even if the business is dissolved.
The Bottom Line
LLCs have become extremely popular because they give protection from personal liability from creditors, except the IRS, of course, and they do not require the formalities of a corporation like a board of directors, stockholders and annual meetings. They’re so popular that often businesses don’t even consider a corporation if they do not have investors. However, until the federal government makes changes that allow all cannabis businesses to deduct ordinary or necessary business expenses under Section 162(a) just like any other business, operating as either an LLC or an S-Corporation could result in significant personal tax liability. Because of this, cannabis businesses should consider C-Corporation status because it protects against personal tax liability in a way that LLCs and S-Corporations cannot. You should consult with an accountant and/or tax attorney for advice on whether the IRS is likely to allow your expenses as COGS.
With TotalLegal, you can form your LLC or corporation in minutes. TotalLegal can either file for you or send you step-by-step guidelines for the right paperwork for your state on your own.