The Tax Cuts and Jobs Act (“the Act”) is effective beginning January 1, 2018. The Act made dramatic changes to prior federal tax law. The most significant changes were: 1) the reduction of the corporate tax rate, and 2) a new 20% deduction for individuals and other non-corporate taxpayer’s operating a business. Previously, we have outlined the income tax consequences of operating as C corporation vs. operating as a partnership. (See our posts HERE and HERE). Because the law is effective in 2018, all cannabis businesses should review the tax consequences of being classified as a C corporation vs a partnership at this time. Fortunately, a business has an opportunity to change how their business is taxed by making an “Entity Classification Election.” This post outlines some of the opportunities and pitfalls in making this election.
The New Landscape on Choice of Entity
The Act lowered the corporate tax rate to 21%. However, a corporation and its shareholders are still subject to double taxation. Dividends paid are taxable; and the highest marginal rate on dividend income is 23.8% (capital gain rate of 20% plus net investment income tax rate of 3.8%). Accordingly, the top rate for operating in corporate form is 44.8%.
In contrast, the marginal tax rate for a partner in a cannabis related business is as high as 45.1% (highest marginal individual rate of 37% plus non-deductible portion of self-employment rate of 8.1%). Although the new law allows partners to deduct up to 20% of income from operations, it is unclear if a partner of a cannabis business is allowed this deduction, per I.R.C. 280E. Furthermore, the self-employment tax computation is capped each year so the effective self-employment tax rate may be less than 8.1%.
The Need for Analysis
Merely comparing the highest marginal rates between a corporation and a partnership would lead to the conclusion that it is slightly better to operate as a C corporation (i.e., a 44.8% rate vs a 45.1% rate). In the right circumstances, that analysis is very effective. However, a raw comparison of rates is usually only the first chapter of the story. Under the new law, factors such as: 1) the individual tax bracket of each owner, and 2) whether cash distributions are planned, significantly impact the analysis. A business may, or may not, qualify for the favorable 20% deduction which further complicates the analysis. For these reasons, a business is strongly encouraged to run numbers before choosing to file as a C corporation.
Electing to be a C Corporation
If, after running the appropriate analysis, taxation as a C corporation is best, what are the next steps?
The next step is to File Form 8832, an Entity Classification Election (“C Election”). The following entities may elect to be taxed as a C corporation:
- Single Member Limited Liability Companies; and,
- Multiple Member Limited Liability Companies.
Filing a C Election for tax purposes has no impact on how your entity is operated under state law. A State of Washington LLC that makes a C Election continues to operate as a LLC under Washington state law. Although it is recommended to amend any current operating agreement to reflect the C Election, the governance, management and sale provisions of the LLC will not materially change. It is further recommended that the managers formally document that all members approve of making a C Election. Finally, it should be noted that partnerships and LLC’s may also make an election to be treated as an S Corporation. A different set of rules apply to S Corporation elections and are not addressed in this post.
When to Make the Election
A C Election may apply prospectively or retroactively. The easiest approach is to elect on a prospective basis. A properly completed prospective election is always considered timely by the IRS. If a LLC wants to immediately be taxed as a C Corporation at formation, the C Election must be filed 75 days from the date of formation. An LLC that has been taxed in prior years as a partnership can also make a C election for the current tax year. For example, a LLC that wants to be treated as a C Corporation for 2018, should make an election by March 15, 2018.
A business that misses the opportunity to file a prospective election may nonetheless make a retroactive election under very specific circumstances. A business that wants to elect to be treated as a C Corporation must file a request for late election relief no later than 3 years and 75 days from the effective date of the election. For example, an LLC that wants to be taxed as a C corporation beginning on January 1, 2016, must file a request for late election relief on or before March 15, 2019.
The most common situation, as discussed in further detail below, is to make a C Election on or before the due date of your tax return.
For example, a business currently categorized as a partnership that wants to elect to be treated as a C corporation for 2018, can file an election on March 15, 2019. The election must meet all the criteria for late election relief:
- The entity failed to file Form 8832;
- The entity has not yet filed the tax return for the desired election year;
- The entity has acted as a C Corporation;
- The entity has reasonable cause for the failure to file Form 8832.
Although the IRS is not required to grant late election relief to a taxpayer, the IRS has traditionally been very fair in granting relief and most taxpayers will meet this criterion. Once a business elect’s C corporation status, it must continue to file as a C Corporation for 5 years. Finally, a business must examine how a C Election will be treated for state income tax purposes. Some states may require an independent election to be treated as a C corporation, for example.
The new tax law presents opportunities for businesses to reduce its federal income tax liability. All business should examine their current tax filing profile and act as quickly as possible to take advantage of the lower tax rates imposed on C corporations.