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Cannabis Industry’s 401(k) Dreams Dashed by Tax Code, Legal Fears

Sept. 30, 2019, 8:46 AM

Helping employees save for the future is an unrealistic goal for cannabis companies hamstrung by tax law provisions and retirement industry fears that reach back to the federal government’s “war on drugs.”

Large 401(k) retirement plan providers are afraid to get involved with an industry engaging in activities still illegal under federal law, and a decades-old ban on most federal tax deductions can make providing plans expensive for the companies, tax and retirement professionals say.

“Cannabis companies want to provide a 401(k) benefit,” said Jewell Lim Esposito, a partner at FisherBroyles in Reston, Va., who specializes in cannabis, tax, compensation, and benefits. “Once the Fidelity-like company finds out the cannabis company is a cannabis company, they reject them.”

It doesn’t help that many human resources and payroll software providers take a similar tack, said Dan Walter, a managing consultant at FutureSense LLC, a consulting and professional services firm that serves the industry.

“There’s a stigma to it,” he said. “You have to build your own machine, so to speak.”

Closing the Gap

Enterprising vendors are working to fill the benefits void—although they are wary of sharing too many details.

Oregon-based Valentine Ventures, which declined to speak about the “Cannabis 401(k)” it markets online, addresses the legality of corporate tax breaks via a series of frequently asked questions on its website.

“There is nothing that prohibits a cannabis company from having a 401(k) plan. The only hard part is finding the service providers willing to work with the industry — which we have already done for you,” Valentine’s advisers write.

Charles Alovisetti, a partner at cannabis-friendly law firm Vicente Sederberg LLP, said he has seen instances of cannabis companies establishing 401(k)s via a non-license-holding subsidiary—states can require permits for different business functions like a cultivator or retailer—in order to work with mainstream retirement plan providers. The arrangements tend to implode once the administrator figures out what’s really going on.

“Anyone who is touching funds coming from a cannabis company is technically guilty of money laundering,” he said. “So it’s a real challenge.”

Practitioners applauded the House passage Sept. 25 of a cannabis-friendly bill (H.R. 1595) designed to inoculate depository institutions such as commercial banks and credit unions interested in dealing with state-legal enterprises. But they noted those changes do nothing to shield retirement plan administrators from government scrutiny.

Treading Carefully

Hurdles created by the Controlled Substances Act and the tax code strip cannabis companies of the ability to build toward the future—effectively penalizing them for growth, industry advocates say.

Tax code Section 280E, added in the 1980s, bars state-legal cannabis businesses from taking ordinary business deductions—including for 401(k) matching—and can drive their effective tax rates above 70%.

Section 280E works differently for producers and retailers, however, because the businesses are still permitted to reduce the amount of income subject to tax by the cost of their inventory. That can include the cost of the people making and distributing the product, and in turn, those employees’ benefits. Companies that do nothing but sell products they buy wholesale will for the most part be out of luck.

Katye Maxson-Landis, founder of cannabis-friendly Moxy Accounting firm in Portland, Ore., bemoaned that decades of inaction have forced companies to operate under a “Prohibition position.”

“Nine times out of 10, businesses are trying to stay alive. Tax positions be damned,” she said.

Esposito said a good accountant should be able to separate out the employee costs. Other tax professionals advise extreme caution in tracking what counts and doesn’t count as an inventory cost, because disputes over these categorizations have landed some companies in Tax Court and left them with large sums in back taxes.

“You need to be careful to make sure you are capitalizing those expenses correctly,” said Justin Hobson, counsel at Lane Powell in Portland and co-chair of the firm’s cannabis team. Some cannabis companies have structured their businesses so that the employment and human resources elements are placed in a separate entity, he said.

However, such companies have to tread carefully to avoid the appearance of abusive tax-structuring, as the Tax Court opinion in Alternative Health Care Advocates v. Commissioner showed.

Alternative Health set up a separate entity to provide itself with human resources and employment services. The Tax Court ruled the entity was still subject to the ban on deductions because it only served Alternative Health, and it decided the company owed a penalty.

Separate entity or not, what—and who—is part of the cost of inventory, often called cost of goods sold, isn’t always entirely clear.

“It’s not the same as buying a carton of dolls and moving it to the front of the story. There is no uniform field guidance,” said James Mann, a partner at Greenspoon Marder, who’s representing Harborside Inc. in an appeal of a Tax Court decision disputing that company’s cost of goods sold calculations.

“280E is so inconsistent with the rest of the code. It’s so discordant as cannabis is becoming a big business,” Mann said.

Growing Pains

As businesses grow and diversify, some more production-focused entities may be able to deduct contributions to their employee benefits plans, and other, more retail-focused entities may not be able to—even when they’re owned by the same parent company.

The 2018 farm bill legalized hemp—which can be used to make CBD, a non-psychoactive compound containing less than 0.3% THC, which is the psychoactive part of marijuana—in narrow circumstances. So if a large cannabis conglomerate has both federally legal hemp subsidiaries and marijuana subsidiaries whose activities are still banned under federal law, those two types of subsidiaries may be viewed differently by mainstream retirement plans.

But providing a plan to one entity and not the other could be a recipe for an Employee Retirement Income Security Act violation, tax and retirement professionals said.

Running afoul of ERISA’s nondiscrimination rules by offering employer-sponsored benefits only to select employees would likely jeopardize the tax-qualified status of the entire 401(k) program, putting every account holder’s retirement savings at risk.

“As companies grow, self-managing a 401(k) becomes super complex,” said Walter, adding that the bigger and more diverse a cannabis company gets, the more difficult it tends to be for it to provide a retirement plan to its employees.

“Most of these companies are growing through M&A and not organically,” Walter said. “The problem with that is it changes the profile of the company.”

Peter Hurley, principal at PCH Financial Consulting LLC in Denver, estimated that 70% to 80% of cannabis companies aren’t making much money. They’re just holding on in the hopes of being snapped up by a bigger fish.

Exploiting business tax breaks would be a stretch for many clients, Hurley said, particularly those that can’t even pay staff without spooking banks fearful of getting embroiled in a trafficking scandal.

“Never mind 401(k)s or sick leave,” he said. “They’re worried about, ‘How do we protect them so they can get a loan so they buy a home, so they can buy a car, so they can have a bank account?’”

To contact the reporters on this story: Warren Rojas in Washington at wrojas@bloomberglaw.com; Lydia O'Neal in Washington at loneal@bloombergtax.com

To contact the editors responsible for this story: Fawn Johnson at fjohnson@bloomberglaw.com; Patrick Ambrosio at pambrosio@bloombergtax.com