Tax Considerations For Investors In Financially Distressed Cannabis Companies

Thanks to maturing markets, limited access to capital, and disproportionate tax burdens, many companies in the cannabis industry are facing major challenges in managing their debt. Creditors and investors are increasingly negotiating restructuring and refinancing agreements that allow distressed companies to continue operating and preserve a future return on investment.

Without careful consideration of the tax consequences of these options, creditors and investors may find that the ultimate cost of restructuring is more than they bargained for. Here are several factors to consider to avoid tax traps for the unwary from Tax Partner Barbara Webb.  

High Cost Of Debt + High Effective Tax Rate = Cash Crunch And Tough Decisions 

How did even well-funded, operationally successful cannabis companies arrive at this decision point: service debt, or pay taxes? The current cash crunch in the industry has been building for years, precipitated in part, by banking regulatory constraints and an abnormally high effective federal tax rate. 

As the below chart illustrates, cannabis companies have lacked access to traditional banking and market rate loans, which has created a unique opportunity for lenders willing to invest in the space. Debt financing vehicles bearing effective interest rates as high as 20% have become standard in the industry. In addition, Internal Revenue Code Section 280E essentially taxes the industry on gross margins, such that even a company that would otherwise be in an overall tax loss position may still owe taxes. 

Caught in this double bind, even an operationally successful cannabis company may face a difficult choice: service debt timely at the expense of keeping current with taxes, risking tax liens that threaten the license, or pay taxes when due at the price of defaulting on debt and risking the viability of the business overall.  

The Tax Impact Of Debt Restructuring

Restructuring debt is one route for creditors of cannabis companies in distress to preserve the license and keep the business operational. However, debt modification carries potential tax traps for the unwary – both borrower and lender. Depending on the relative value of the debt exchanged, the borrower can realize cancellation of debt income and incur additional tax liability. The insolvency exception to recognizing and paying current tax on this income may not be available to a cannabis company, as the fair value of its assets – including intangibles – may still exceed its liabilities. A lender may also experience a taxable event on the refinancing, either in the form of interest income, or gain due to the valuation of equity received in the exchange.  

In any debt refinancing situation, both the borrower and the lender should anticipate and plan for complex tax calculations involving debt discounts (I.e., original issue discount, or OID) and the fair value of company equity in order to determine correct tax treatment. To avoid any last-minute surprises or deal delays, the borrower and the lender should model the tax impact on both sides. 

Sales Of Distressed Assets And The Tax Impact

A lender may consider compelling the sale of standalone assets to provide the borrower with an influx of cash to maintain operations and service restructured debt. When considering this option, it is important to have a thorough understanding of the borrower’s tax structure, which may include multiple separate tax filing entities.

First, the tax impact of a sale should be factored into the borrower’s post-sale cash flow projections. Key questions include:

• Where do the assets reside within the borrower’s structure and what is the tax filing entity’s tax basis in the asset?
• What will be the effective tax rate on a sale, taking into consideration federal, state, municipal and even transfer taxes?
• Will there be a tax cost to moving cash from the sale  between the asset-holding entity to an operating or debt-holding entity?

Second, a creditor must understand whether cannabis business assets can be sold in the jurisdiction’s regulatory environment. If a sale of licensed assets is restricted to equity, the borrower’s tax filing structure will determine the character of the equity being sold and which entity will ultimately pay tax on gain from the sale. 

Assignment Of Income Receipt Of Equity

A default that results in a creditor becoming an owner or part of management presents several potential tax traps for the creditor to avoid.

Depending on how the agreement is structured, the assignment of operating income and participation in management may turn the lender, or the lender’s entity, into a “trafficker” subject to 280E.

The lender should also be cognizant of the borrower's standing with the taxing authorities The retention of the cannabis or reseller license is tied to staying current with state and local taxes. If the borrower has delayed remittance of sales and excise taxes to state and local governments, the lender may find that it must first settle such liabilities so that the business may continue to operate.  

"Workouts" With Taxing Authorities

If income taxes are past due, it is important that the tax filing entity continues to make payments toward the balance on a regular basis. A taxpayer cannot apply for a formal IRS payment plan until a revenue officer is assigned to the case. Also, a taxpayer must usually pay all outstanding taxes that are not overdue and remain “current” on all future taxes in order to establish and remain on an installment agreement. Federal and state revenue officers are generally willing to work with taxpayers in financial distress who act in good faith throughout the process.

Engaging a professional representative who understands tax controversy practice and procedure and how to work with revenue officers can make all the difference between establishing a payment plan and facing a tax lien.

How MGO Can Help

Creditors and cannabis companies navigating financial distress in the industry should engage a tax professional with both industry experience and a high level of technical skill to navigate the complex tax impact of a workout or restructuring. MGO’s Cannabis Tax team has both the industry experience and the technical skill to assist creditors and companies of all sizes during this challenging time.