Budding Companies Part 2: Audits, Investments and Other Administrative Headaches
By Charles S. Alovisetti, Partner
Sep 6, 2019
This is the second post in Vicente Sederberg’s “Budding Companies: Forming Cannabis Startups” series, which explores different issues involved in the formation of new marijuana and hemp companies. Read Part 1 here.
Entity choice, governance and taxation were covered in our first post. Now, let’s talk more about taxation and the importance of good governance for cannabis entities.
No surprise: Cannabis companies are at a far higher risk of audit by the IRS. There are a number of high-profile cases where the IRS has audited a cannabis company and determined the entity took disallowed deductions. Under 280E a company cannot avail itself of normal business deductions, but many cannabis companies push the envelope to reduce their significant tax burden.
If a cannabis business is taxed as a pass-through entity, the IRS may follow the money in its audit and go after the owners individually for back taxes, holding them personally liable for the taxes that should have been paid. A corporation, on the other hand, can help avoid this situation, provided there is no malfeasance on the part of the ownership group. Back taxes typically remain the liability of the entity itself and are not individual liabilities of the owners.
Most startups reinvest their revenue in operations, and it is rare for a high growth company to have excess cash that can be distributed to owners outside of an exit event. It may be easier for a corporation to retain cash to reinvest in operations than it is for an LLC. A corporation currently pays a 21% tax on its earnings, while LLC owners are taxed on their distributive share of the LLCs income at their personal tax rates (which may be in excess of 21%), regardless of whether any cash is distributed. After distributing cash to allow its owners to make their personal tax payments, an LLC may be left with less cash than a similarly situated corporation, leaving less capital available to reinvest in operations.
Taxation can also impact administrative functions and create additional costs. Partnership tax accounting is complex and tracking the capital accounts of each member of an LLC can be time-intensive. (Roughly speaking, a capital account is the running total of a member’s contributions, profits and losses, and investment.) An LLC must also send out a K-1 form to each of its owners at the end of every tax year. This form states the profit and loss allocated to each owner. Each owner must include this K-1 in their respective filings and pay taxes, or take a deduction for, any allocation of profit or loss. If a startup has a wide shareholder base, sending out K-1s can add to its accounting burden. LLC owners also face additional administrative burdens, and each may be required to file a tax return in multiple states. As an example, if an LLC has income originating in Colorado, the owners have an obligation to file a Colorado tax return and pay applicable state taxes regardless of which state they reside in.
Foreign investments and taxation
Foreign investors may prefer to invest in corporations rather than LLCs since a corporation investment can allow them to avoid the obligation to file U.S. income tax returns. Similar issues can apply to tax-exempt organizations who may be subject to taxation on Unrelated Business Taxable Income (UBTI), a concept similar to ECI, though with key differences.
Pass-through taxation can result in foreign investors facing unique downsides to investing in an LLC. First, foreign investors are generally not subject to tax in the U.S., but they would have U.S. tax obligations for income effectively connected to the U.S. trade or business (called Effectively Connected Income or ECI) which can occur if they directly hold an interest in an entity subject to pass-through taxation. This would obligate foreign investors to make a federal income tax filing in the United States.
Second, countries that treat LLCs as corporations, such as Canada, do not attribute the taxes paid by LLCs to their owners. A Canadian investor may not benefit from foreign tax credits for taxes paid to the IRS and can end up facing double taxation. This is why Canadian companies making investments in the US often opt for limited partnerships (LPs). However, the LP entity form is generally not appropriate for startup companies. In addition to the burden on the investors themselves, an LLC also has withholding obligations on certain types of income allotted to foreign owners, even in the absence of distributions.
The issues related to foreign investors are often resolved by setting up a blocker corporation – a U.S. or foreign entity classified as a corporation for U.S. income tax purposes – between the startup LLC and the foreign or non-profit investor. This is common practice in the investment fund context, but it adds a layer of complexity and expense that could be a deal-breaker, especially for a small investment in a startup.
It is also possible for an LLC to “check the box” and elect to be taxed as a corporation, which would resolve issues related to foreign investors. This allows a startup to take advantage of the greater flexibility of the LLC form (discussed below) while not having to worry about the complications of pass-through taxation. (Unless specifically mentioned, this series of posts assumes LLCs are taxed as partnerships and not as corporations or disregard entities.)
In addition to the fundamental differences in how corporations and LLCs are taxed, three other tax features bear consideration. Please note these are extremely simplified descriptions of tax differences between corporations and LLCs:
- A corporation, but not an LLC, can take advantage of the Qualified Small Business Stock (QSBS) benefit set forth in Section 1202 of the tax code. Subject to certain qualifications, if a person holds QSBS for a five-year period, they may be able to exclude up to $10 million of capital gains on an exit.
- An LLC can distribute appreciated property tax-free to its members, which can enable spin-off transactions. If a corporation distributed property to its shareholders, the property would be a taxable dividend.
- If the owners of an LLC or corporation are also employees of the startup, entity choice can significantly affect employment taxes. An LLC’s members are generally subject to self-employment tax on their share of income, but a corporation’s shareholders are not. However, if a corporation is profitable and does not make any dividends while paying above-market salaries to its owner and employees, this can create issues.
Read the next post in Vicente Sederberg’s Budding Companies Series, where we look at different rules regarding governances between corporations and LLCs, explore how different structures affect exits, and what types of business investors are looking for.