Unexpected 280E Dangers in Farm Service Management Arrangements- Part I

By Rachel Wright, Simon Menkes, & Abraham Finberg- CPAs licensed in California of AB FinWright LLP & 420CPA, and Andrew Gradman, Esq of Andrew Gradman Tax

This is Part I of II of our series entitled “Unexpected 280E Dangers in Farm Service Management Arrangements.” This series is intended to educated cannabis business owners, professionals, and their advisors on Federal income tax issues surrounding this emerging area of the cannabis industry.

What is a Farm Service Management Arrangement?

As cannabis becomes mainstream, we are seeing growth in what we call Farm Service Management Arrangements—that is, contracts by which a licensed entity pays for the services of an unlicensed entity to help them, in one form or another, assist in running their cannabis cultivation operation.  Often these management consultants have experience in the industry – from setting up, to maintaining, and ultimately harvesting the plants.

Over the past year or longer, more of our clients have presented us with these farm service agreements- whether they know they have or not.  In some cases, the contractual relationship has been thoroughly thought through- and even memorialized in a contract- yet in others it is as is typical in cannabis, a handshake deal.

When approached with this type of arrangement, we recognize that it is essential to ensure that legal counsel, educated in cannabis licensing and business transactions should also be involved, in coordination with a CPA, also seasoned in the industry.  As professionals serving the industry, and as a team, it is our job is to ensure both the legal and tax sides have been properly navigated and also to educate the business owners on the importance of setting up the arrangement properly.  The best outcome happens when we have an open conversation with both sides of this arrangement in order to discuss the topic that has plagued this industry- and that is, the federal tax implications and the unexpected 280E danger of these farm arrangements.

Why are these Outsourced Arrangements Helpful?

Let’s say you’ve taken the plunge and gotten into cannabis. You’re a savvy investor: you’ve purchased prime agricultural land and gotten it licensed and zoned for cultivation. Not an easy proposition. There’s only one problem: you don’t have a clue how to cultivate it. So, you reach out to an experienced third party to help you.

Or perhaps you have tons of experience in cannabis (some possibly from before California’s Prop 64) and have found an investor with land and license who is risk averse. They want to go into business with you and have you managed the employees and the payroll taxes, as well as run the farming aspects of the business.

What do you both do? You create outsourcing arrangements with your new partners, such as a farm services management agreement, with one company as the license-holder (referred to here as “LicenseCo”) and the other company as the outsourced expert (referred to here as “OutsourceCo.”).

Farming Arrangements Go Way Back but Have Special Modern-Day Concerns

Farm service management arrangements such as farm service agreements are as old as Medieval Europe and can even be traced back to ancient Greece, if not earlier. However, today’s “Big Brother” government has special requirements connected with cannabis that an outsourcing arrangement can run afoul of.  Every business owner and advisor concerned with Internal Revenue Code 280E should also be concerned here- at least for OutsourceCo charging a management or service fee of any kind to the LicenseCo.  Certainly, the farmers of days gone-by had similar tax concerns as they ultimately had to pay a part of their profits to landowner and government official.  However, they did not likely have tax law as complicated as the many voluminous sections in what is the Internal Revenue Code in the United States today.

Hidden 280E Pitfall for OutsourceCo

Fees paid to OutsourceCo by LicenseCo may come in many types of arrangements.  At times, OutsourceCo may be the only inhabitant on the land and may actually act as agent for collection of funds for the licensee and purchases of supplies, nutrients, and improvements to run the cultivation.  They also may supply their own labor by having employees on payroll.  Their fees earned may contain a consulting fee for the management of these functions as well as a fee for the labor, and often, a reimbursement for the supplies they have paid for.  We’ve seen quite a number of these arrangements.  The structure may vary slightly, but in the end, the 280E pitfall is that OutsourceCo now has cannabis-touching employees and is therefore considered a drug trafficker.

The OutsourceCos of the world need to understand the special risk posed by Internal Revenue Code Section 280E and the Controlled Substances Act, which treats legitimate cannabis businesses like drug dealers.  As such, they would only be able to deduct items that would reduce gross income- commonly known as cost of goods sold.   However, for those providing a service, who do not capitalize inventory costs and therefore are not entitled to cost of goods sold, tax implications can be dangerous.  Strict reading of the code implies that all of the cash that OutsourceCo receives would be subject to federal taxation without any deductions.  This means that if OutsourceCo charges has a cost plus approach on labor they employ and provide to LicenseCo, that they would not be able to deduct their payroll costs.  In other words, labor service fees that they charge to LicenseCo would be subject to 21% federal tax (for C Corporations) with no deductions.   Potentially all other fees they charge have some danger also having disallowed deductions.  Again, because service companies do not sell inventory, service-based companies, by definition, do not have costs of goods sold.

At this point in our conversation with OutsourceCo, we hear an audible sense of disbelief in their voice.  “What are we to do?” they say.   We have basically just undermined their whole business model.  We have both the Internal Revenue Code 280E and the classification of cannabis under the Controlled Substance act as a Schedule I drug to blame.   There is light at the end of the tunnel, and we promise that it is not that of a train.  Stay tuned for Part II of our series entitled “Unexpected 280E Dangers in Farm Service Management Arrangements” where we discuss some of the dangers in debt further as well as some possible solutions to effectively structure these deals.

About The Author

Abraham Finberg

Managing Partner

420 CPA AB FinWright

Abraham Finberg MBA, CPA, managing partner at AB FinWright, has been a leader in the cannabis sphere since 2009, counseling clients in all phases of business advisory and tax, from start-up through M&A and IPO.

About The Author

Rachel Wright

Managing Partner

420 CPA AB FinWright

Rachel Wright, MST, CPA, managing partner at AB FinWright, specializes in cannabis accounting and taxation for multi-state and multinational entities, advising clients on everything from internal controls to the bottom-line implications of mixed local, state, federal and international statutes of taxation.

For all your taxation challenges in cannabis, feel free to reach out to me or any of the other team members at 420CPA and share with us your business challenges. We have been helping cannabis companies since 2009.