Taxes a big factor behind the financial woes of California marijuana companies

The tax man is not popular in business circles, but that’s even more true in the cannabis industry. Particularly in California.

Federal and state tax bills have become a major factor in the widening cash crunch that’s been developing in the California marijuana market for months, a trend that’s gotten so dire that many in the state predict more business failures this year.

While many know the much-despised 280E section of the federal tax code – which bars standard business deductions for any company trafficking in a controlled substance – California’s state tax agency has also been compounding the financial burden with hefty penalties for late payments, industry insiders said.

“A lot of companies underestimated the impact of 280E, which means that their tax burden is way higher than they ever thought,” said Katy Young, a San Francisco-based attorney and president of the International Cannabis Bar Association’s board of directors.

“What business activity you did on Jan. 1, 2018, became a taxable event on Sept. 15, 2019, and now everyone is scrambling to figure out what the (expletive) to do,” she said, referring to an extension deadline last year for federal business tax returns.

State taxes can be even worse to deal with, in part because the California Department of Tax and Fee Administration (CDTFA) is quicker to levy penalties for late payments, according to San Francisco Bay Area tax attorney Regina Unegovsky.

“280E is the big bright line … but, from my perspective, it’s not nearly the nastiest thing that can happen,” Unegovsky said, noting that the CDTFA can levy a whopping 50% penalty for late tax payments.

“I have clients that owe $1 million in tax and another $1 million in penalties (to the state of California),” she said.

Tax burdens compiling

All the various tax bills are adding up, Young and Unegovsky said, and the composite picture is bleak for many small businesses that can’t afford a big legal and financial team to handle the complexities.

“It combines to be huge,” Unegovsky said. “The chickens came home to roost really quickly. A lot of people have racked up a lot of tax in a short period of time.”

Unegovsky said her client base, about 18 companies, ranges from those with zero tax liability – because they can afford professionals such as her team – to a legacy operator that now owes the IRS $14 million in taxes and penalties.

The $14 million IRS bill stemmed from an audit that encapsulated four years of operations, Unegovsky said. It remains an ongoing fight with the federal government because, she contends, the audit wasn’t conducted fairly.

During the audit, Unegovsky said, the IRS threw out all the proof and receipts her client offered to back up the tax returns while declaring the company had “nothing but income,” she said.

The IRS determined that the company owed the federal government $12 million in back taxes, then added on $2 million in fees.

“We’re now taking the next steps to try to get them a barely fair exam,” she said. The IRS declined to comment.

There can also be surprising tax bills from across the state, depending on the type of business, California CPA Dana Borys said.

She cited San Diego as an example of a municipality that’s decided all distributors and delivery services that ship marijuana products into the jurisdiction are liable for part of the local MJ tax.

“It’s $20,000 here, $30,000 there” for many operators dealing with a range of tax bills from around the state, Borys said.

The IRS doesn’t transfer business-tax liabilities to company executives the way California can, Unegovsky said, which means state tax bills can follow entrepreneurs for years even if a business closes down.

“People have got to figure out what their state and local taxes are going to look like, because the CDTFA has a much greater ability to make personal assessments after a business goes broke and shutters,” Unegovsky said.

The CDTFA confirmed in an email to MJBizDaily, “The cannabis tax law imposes a mandatory 50% penalty for failure to pay the cannabis taxes when due.”

The agency also wrote that businesses “may be relieved of the penalty if the taxpayer can demonstrate the failure to pay the tax was due to reasonable cause and circumstances beyond the taxpayers control.”

Legacy operators still transitioning

Part of the problem is that many longtime cannabis companies didn’t keep solid records for years, according to Ed Gines, a contract chief financial officer who works with several California MJ companies.

That results in an even bigger lift for those companies to file error-free tax returns to both the state and federal governments, and it makes it more likely a mistake will trigger a costly audit.

Gines has one client, for instance, who’s been trying to acquire a California retailer. But the deal hit a snag when it came to light during the due diligence phase that the retailer hadn’t been charging the 15% excise tax mandated by the state.

While the retailer’s products were cheaper for consumers, the oversight left the business in a huge financial hole – all because of a misunderstanding of how state regulations work.

Of the 10 marijuana companies Gines has worked with to date, none of them had “any books whatsoever,” he said.

“They’re just throwing darts with a CPA to create tax returns: ‘I think our sales is this, our cost of goods is that,'” Gines said.

“If you don’t have books, how would you know what your tax bill is? That’s why the CFO that comes in and organizes all the spaghetti … (has) a need for my services. That’s not a sales pitch, it’s a reality check.”

Gines works mostly with smaller companies that produce $5 million in sales or less. In that sector, he estimated, about a third of the financial problems can be chalked up to 280E, another third to the state’s 15% excise tax and the rest to “financial management inferiority.”

More audits on the way

That lack of recordkeeping and the fact that many marijuana businesses still operate on a cash-only basis make the industry a ripe target for state and federal audits, Unegovsky said.

“When you have a public listing of licensed activity, on the fed side, it’s like shooting fish in a barrel. Why wouldn’t they audit?” Unegovsky said. “I do think it will happen. It’s just a matter of when.”

She and Borys said that payment plans are typically an option with the IRS, because the feds are looking to collect, not to put companies out of business.

The IRS also moves much more slowly than local and state government entities, they said, so more often than not it’s local and state taxes that need to be prioritized.

Regardless, the marijuana industry’s tax future is “going to be messy,” Borys predicted.

John Schroyer can be reached at [email protected]

3 comments on “Taxes a big factor behind the financial woes of California marijuana companies
  1. Rod Gass on

    The truth will painful.

    Yes, it’s believable and was forecasted prior to the vote on $64.

    Tax fraud was part of the transition from cash to “legal”. Why did so many decide to go “legal”? I don’t know why.

    When voters installed the state into the middleman position between cultivators/consumers, excess taxation and punishment where explained in great detail by the NO on $64. Maybe the excess taxation will now be understood by the greedy.

    Reply
  2. Jeff Freeman Jr on

    This sucks, but, to be honest, this already happened in Washington State and Oregon. Still, for different reasons, California is just at the beginning of what I see as an enormous shift where they go from being known as the biggest and most influential market to being the highest risk in terms of cannabis business failure.

    California has always lead the nation in cannabis; however, this is an entirely new industry and is overwhelmingly run by traditional business. Both the customer and traditional entrepreneurs’ lack of commercial cannabis experience has resulted in very little value attributed to product quality and disproportionately places enormous value on brand recognition and marketing. Due to this, we have seen a marketing war, whereas some good friends of mine have spent $500k a month just on digital ads to gain awareness, which in many cases reinforces the value of brand recognition over tangible quality. When both the customer and the provider lack knowledge on products, it quickly becomes all about brand positioning, which is artificially created by marketing and branding. Most of the largest companies in California do not make any products. They are purely marketing and distribution companies, most customers are unaware of this and see the overwhelming amount of sexy marketing and will overpay for these products in relation to the quality, which again reinforces lower standards and hurts quality producers.

    In terms of the taxes causing issues for current cannabis companies, it’s clear as day these companies should have looked into other states that were dealing with similar or, in my case, the EXACT same bill 280e. Ignorance is no excuse when examples are all around you.

    Overall, the way they have rolled out the recreational cannabis industry in Wa, Or, & Ca is catastrophic to the industry as a whole. I bet 70% of the current companies go out of business in the next 2-5 years, similar to the failure rate in both Oregon and Washington State. I imagine most new markets will likely cap licenses to ensure only the largest players can participate, thus removing the gold rush idea. The good news is that it will be easier to regulate fewer groups, and they will be such a large size they should have the capital to sustain this rocky start.

    Taxes and lack of cannabis professionals killed the cannabis “Free-Market” idea.

    Jeff Freeman Jr

    Reply

Leave a Reply

Your email address will not be published. Required fields are marked *