• Companies face tax burden challenges related the classification of cannabis as a Schedule I controlled substance and IRC 280E.
• To navigate this, companies may be able to utilize vertical integration strategies and incorporate transfer pricing best practices to minimize tax exposure.
• A transfer pricing study will help identify and risks or opportunities for improvement.

As the cannabis market continues to grow, in the United States cannabis operators continue to face difficulties related to an excessive tax burden due to IRC 280E. One of the most effective strategies for mitigating tax exposure under 280E has been to leverage the benefits of vertical integration.

Since IRC 280E affects the various verticals differently, some cannabis companies are able to isolate activities within distinct business units and maximize Cost of Goods Sold (COGS) calculation to mitigate the impact of IRC 280E.

The potential downside is two-fold. First, IRS tax court cases have made it clear that isolating business units is not a universal solution. And secondly, if not optimally established and documented, transactions between the business units can be problematic and create issues with the IRS.

This article breaks down the impact of IRC 280E, demonstrates the potential benefits of vertical integration, and describes how a proactive transfer pricing strategy can help you maneuver the specific tax and regulatory considerations that affect the industry.

What IRC 280E means for your tax liability

Section 280E penalizes traffickers of Schedule I or II drugs by prohibiting the deduction of “ordinary and necessary” business expenses after reducing gross receipts by COGS, essentially resulting in your federal income tax liability being calculated based on gross income, not net income. For a cannabis operator, COGS typically consist of the cost of acquiring inventory by purchase or production.

Not only are these cannabis companies facing high federal taxes, but there is now an intense level of scrutiny in both federal and state tax audits on intercompany arrangements.  

Impact of vertical integration on IRC 280E calculations

Many cannabis companies have become vertically integrated, i.e., combining production function (i.e., cultivation and manufacturing) of cannabis with retail or resale (i.e., distribution) or sometimes all three. Since Section 280E is directly related to selling or the “trafficking” of cannabis-related products, it has the biggest potential impact on retail operations. This means that if a producer can support a higher selling price to its retailer, the retailer will have more COGS from the producer, and the producer will have more costs to deduct because of the allowance of indirect costs.

The business motivation for vertical integration is to better control the supply chain and the end user’s experience. From a tax perspective,  cannabis taxpayers want to dis-integrate  activities subject to 280E from those for which a position can be argued that they are non-280E activities, such as management services. The Internal Revenue Service (IRS) uses transfer pricing to challenge such segregation and to make allocations between or among the members of a controlled group.

How a transfer pricing study can help your cannabis business

Whether its receives the recent budget infusion or not, the IRS is likely to conduct more transfer pricing audits of the cannabis industry, compared to other industries.  These audits frequently result in much higher tax adjustments and significant penalties. In addition, since several states have had budgetary shortfalls due to COVID-19 and other factors, multistate businesses are more frequently being audited by individual states’ tax authorities.  If your business has international or domestic intercompany transactions, you’re facing a difficult and uphill battle amid current local, state, and federal tax regulations. The best defense against an IRS transfer pricing audit is a comprehensive transfer pricing study.

A robust transfer pricing study provides the basis with which a company can refute and push back against federal and state claims that their intercompany transactions have no economic or operational substance.  As part of a transfer pricing study we will work with you to identify key classes of intercompany transactions, document the pricing of such transactions and reference comparable benchmark data sets to support qualifying transactions.  Where transactions fall outside norms, we will work with you to identify differentiating characteristics and seek other data if available, or recommend policy and pricing changes, along with an assessment of the potential exposure.

Taxpayers with inadequate or out of date transfer pricing policies risk an increased likelihood of controversy and transfer pricing adjustments. Thus, even if you have had a transfer pricing study performed in the past, it is important to have it reviewed and updated. 

While a transfer pricing study directly reduces a company’s risk of tax assessments and liabilities resulting from tax audits, they also indirectly reduce execution risk when a company is considering an M&A transaction, a capital raise, or go public transaction.

How MGO can help you integrate transfer pricing for the cannabis industry

MGO’s transfer pricing practice has significant experience with the various transfer pricing concerns of the cannabis industry. We also work closely with our federal and state tax practices to assist many cannabis companies with their specific tax and regulatory considerations, which include:

• Section 280E disallowance of ordinary business expense deductions;
• Common supply chain concerns for operators, like state restrictions on inventory and separation of cannabis and industrial hemp;
• Non-plant-touching structures that operate independently from the 280E-affected business lines; and
• Sales and excise taxes specific to the cannabis industry.

To learn more about how we can help support establishing, optimizing, and documenting transfer pricing policies so your business can grow in this dynamic industry, contact us.

Understanding IRS overpayment and underpayment rates

The overpayment rate is the sum of the federal short-term rate plus 3 percentage points. For corporations it is the federal short-term rate plus 2 percentage points. For the portion of a corporate overpayment of tax exceeding $10,000, it is the federal short-term rate plus 0.5%.

The underpayment rate is the sum of the federal short-term rate plus 3 percentage points, except underpayments for large corporations is the sum of the federal short-term rate plus 5 percentage points.

Starting April 1, the new increased rates will be:
• 4% for overpayments (3% for corporations),
• 1.5% for the portion of corporate overpayment exceeding $10,000,
• 4% for underpayments, and
• 6% for large corporate underpayments.

How is interest calculated on unpaid taxes?

Interest accrues on any unpaid tax from the due date of the return until the date of payment in full. The interest rate is determined quarterly. Interest compounds daily and is charged on the sum of all outstanding taxes and penalties.

What are the most common penalties?

Failure to Pay Penalty: If a return is filed but the tax owed was not paid on time, a late payment penalty will be imposed at .5% of the unpaid taxes for each month, or the part of the month the taxes remained unpaid. The penalty will not exceed 25% of the unpaid tax amount. Full monthly charges are applied even if taxes are paid in full before the end of the month.

Failure to File Penalty: Based on how late the tax return is filed and the amount of unpaid tax as of the original payment due date, this penalty is 5% of the unpaid taxes for each month, or the part of the month that a tax return is late. The penalty will not exceed 25% of the unpaid tax amount.

Combined Failure to Pay and Failure to File Penalty: If both penalties are applied in the same month, the Failure to File Penalty will be reduced by the amount of the Failure to Pay Penalty applied in that month. Based on the current penalty percentages, the late payment penalty would remain at .5%, and the late filing penalty would be reduced to 4.5%.

Substantial Underpayment Penalty: This penalty applies to (1) individuals if the tax liability is understated by 10% of the tax required to be shown on the return or $5,000, whichever is greater or (2) to corporations, if the tax liability is understated by 10% (or, if greater, $10,000) or $10,000,000. The penalty is 20% of the portion of the underpayment of tax that was understated on the return.

Negligence or Disregard of Rules or Regulations Penalty: At 20% of the portion of the underpayment of tax, this occurs due to negligence (lack of a reasonable attempt to follow the tax laws) or a disregard for the tax rules, meaning the taxpayer carelessly, recklessly, or intentionally ignores the tax laws.

Underpayment of Estimated Tax Penalty: This penalty applies to corporations or individuals that do not make enough estimated tax payments or are late in paying them when required. The penalty is based on (1) the amount of the underpayment, (2) the period when the underpayment was due and underpaid, and (3) the interest rate for underpayments published quarterly by the IRS. To avoid it, corporations can make quarterly estimated tax payments if they expect to owe $500 or more in estimated tax when they file their return. Individual taxpayers can avoid it if they owe less than $1,000 in tax after subtracting withholding and refundable credits, or if they paid withholding and estimated tax of the lesser of at least 90% of the tax for the current year or 100% of tax shown on the prior year’s return.

Can an IRS penalty or interest be removed or abated?

The IRS can remove or reduce some penalties if the taxpayer acted in good faith and can show reasonable cause for the failure to meet their tax obligations. However, by law, the IRS cannot reduce or remove interest unless the penalty is removed or reduced.

Reasonable cause is based on all the facts and circumstances of each situation, and the IRS will consider any reason establishing that a taxpayer used all ordinary business care and prudence to meet their federal tax obligations but were unable to do so. It is important to note that lack of funds is not reasonable cause for failing to file or pay on time — but it could be considered reasonable cause for the failure-to-pay penalty.

The IRS’s First Time Penalty Abatement Policy (FTA) can provide relief from a penalty if a taxpayer has not incurred penalties previously. To qualify under this policy, the taxpayer (1) did not previously need to file a return or had no penalties for the last 3 years prior to the tax year in which the penalty was received, (2) is current on all required returns or extensions of time to file, and (3) has paid or arranged to pay any tax due.

What options are available if a taxpayer cannot pay the taxes due?

• Short Term Payment Plan: This plan is not available for businesses unless it is a sole proprietor or an independent contractor. There is no setup fee, and the balance must be paid within 180 days. A short-term payment plan is available for individuals if less than $100,00 in combined tax, penalties and interest is due. Penalties and interest accrue until the balance is paid in full.
• Long Term Payment Plan (Installment Agreements): An installment agreement is available for individuals if less than $50,000 is owed or for a business if less than $25,000 is due in combined tax, penalties and interest and all required returns are filed. Penalties and interest accrue until the balance is paid in full. The maximum term for most installment plans is 72 months.

If a taxpayer pays less than the full amount due, how is the partial payment applied?

If a taxpayer makes a partial payment accepted by the IRS, and the taxpayer provides specific written directions as to the application of the payment, then the IRS will apply the payment as instructed by the taxpayer. If the taxpayer does not provide instructions with the partial payment, then the partial payment is applied to periods in order of priority that the IRS determines is in its best interest. The payment will be applied to satisfy the liability in successive periods in descending order of priority until the payment is absorbed. If the partial payment applied to a period is less than the liability for the period then the payment will be applied to the tax, then penalty and finally interest, until the amount is exhausted (Rev. Proc. 2002-26).

Example: The taxpayer incurs the following tax deficiency, penalties and interest:

Year 1: Tax: 6,000, Penalty: $1,800, Interest: $1,200
Year 2: Tax: 7,000, Penalty: $ 0, Interest: $ 1,500

The IRS agrees that the taxpayer can satisfy the total liability of $17,500 for a payment of $15,000. There is no agreement as to the allocation of the payment and the taxpayer does not provide any directions for application of the partial payment. The payment is first applied to the Year 1 tax, penalty, and interest (a total of $9,000), leaving $6,000 to be applied to Year 2. The remaining amount is completely absorbed by the tax due for Year 2, which results in the payment of interest in Year 1, but not for Year 2.

However, if the partial payment accepted by the IRS is less than the total of tax and penalties due in both years and there is no agreement regarding the application of the partial payment, then nothing is allocated to the interest in either year. For example: following the amounts listed above, if the partial payment was $12,000 instead, then the entire amount is applied to the tax and penalty in Year 1 (a total of $7,800) and the remaining amount of $4,200 is applied to the Year 2 tax due. None of the partial payment would be applied to the interest in either year.

Final thoughts

This year, failing to file your tax payments by the April 18 deadline will cost you more. If you are flirting with the deadline, remember that you will owe interest on any unpaid tax from the return’s due date until the day you actually make the payment — and interest will compound daily.

If you have questions and want to ensure you avoid being hit with tax penalties and interest, please reach out to MGO’s Tax team for assistance. You can rely on us to help you mitigate the impact of the interest rate increase.