Recognition of Internal Revenue Code (“I.R.C.”) § 280E and its potential to limit deductions can have a material impact on the ongoing operation of a cannabusiness.  While operational concerns require attention, improper tax classification of an entity can result in unnecessary additional tax being owed.  In Loughman v. Commissioner, T.C. Memo 2018-85, the United States Tax Court explained why owners of S corporations may be subject to higher aggregate tax liabilities than their partnership counterparts.

Choice of entity for state law purposes is not the same as an entity’s classification for tax purposes.  While state law may permit entities such as corporations, limited liability companies, and limited liability partnerships, amongst many others, these classifications do not ultimately dictate the tax treatment that an entity may elect.  For instance, a limited liability company may be taxed as a partnership, a C corporation, an S corporation, or as a disregarded entity.  A number of rules dictate how and when entities may elect their tax classification.  Importantly, to avoid a corporate (or second) level of income tax, many businesses choose to operate as pass-through entities, generally either an S corporation or partnership for tax purposes.  This generally results in only an owner level of tax.  Although income taxation of an S corporation or a partnership is similar, there are a few important differences.  One of these key differences, particularly for cannabusinesses, is the requirement for S corporations to pay shareholder-employees “reasonable compensation.[1]” 

In Loughman v. Commissioner, T.C. Memo 2018-85, the Tax Court held that wages paid by a cannabis dispensary to its shareholder-employees were not deductible.  While this may seem predictable given the Court’s past interpretations of I.R.C. § 280E, since the business was taxed as an S corporation, it had the effect of double taxing the income of an S corporation to its owners.  That is, wages paid were not only not deductible at the corporate level, but they were also taxed as income to the shareholders.  In so holding, the Tax Court stated that wages were a below-the-line deduction and are not properly included within cost of goods sold.  Furthermore, the Tax Court emphasized that disallowance of the deduction for wages paid by the business (and inclusion of wages in the taxable income of the shareholder-employees) did not result in impermissibly disparate treatment when compared to other taxpayers.  The Court observed that the same treatment would exist if the wages were paid to a third party and not to the shareholder-employees.

As a result of Loughman, proper entity selection is important for cannabusinesses.  If an owner will be performing significant services for the business, taxation as an S corporation may result in a potentially significant double tax.  To avoid this, cannabusinesses requiring significant services from their owners, which are otherwise not deductible as a result of I.R.C. § 280E, should seek treatment as a partnership for tax purposes.  In addition, if the owner is performing wages for separate businesses, proper accounting for the allocations must exist.  If taxation as an S corporation is required for other reasons, owners should minimize payments to shareholder-employees as wages, subject to existing “reasonable compensation” requirements. Whether or not a given cannabusiness chooses to be structured as one of these types of entities also requires a review of business – the same tax considerations may not impact a producer as they would a retailer – and careful consideration of non-tax aspects. Cannabusinesses must keep abreast of developments in tax law that are unique to their industry.  These businesses must plan to minimize the effects of disparate tax treatment.  Rosenberg Martin Greenberg is experienced in all aspects of federal and state tax laws, including developments germane to the legalization of marijuana in Maryland.  For a free consultation, please contact Brandon N. Mourges at or 410.951.1149.

[1] In some contexts, choice of an S corporation over a partnership may be beneficial in order to reduce employment taxes.  That is, whereas S corporations must bifurcate wages and profits for shareholder-employees (and employment tax is only due with respect to wages), partnerships do not recognize a concept of wages for owners.  Accordingly, all partnership income is generally subject to self-employment taxes.