Like most things, the buying and selling of businesses has taken a pause as the nation works its way through the COVID-19 crisis. M&A activity has slowed largely as a result of the considerable difficulty the experts are experiencing in arriving at valuation calculations that both buyers and sellers can agree on. In most cases, owners have put their intentions to sell on the back burner, and are focused on getting their companies through the crisis and coming out on the other end intact. So how are the professionals who advise business owners on M&A activities looking at the issue and what are they recommending to their clients, especially those clients who before the onset of the pandemic were looking to sell as their exit strategy? We asked Keith Veres, a Principal at HBK CPAs & Consultants, who, as Director of the firm’s Corporate Finance division and a Certified Exit Planning Advisor helps clients looking to raise capital, acquire businesses or sell their business, and Robert Zahner, a Senior Manager with the HBK Valuation Group who executes valuations and related technical services for businesses looking to acquire or sell.

Q. How has COVID-19 slowed the pace of M&A?
Veres: The questions at the center of any M&A transaction revolve around the value attributed to the companies involved in the proposed transaction. How do you value a business in this climate, especially when companies are not yet certain just how much revenue they may be losing—or gaining, as is the case with some companies? A buyer will always look at historical information but is more interested in forward-looking projections, because anyone buying a business wants to know what’s it going to do when they own it. They’d want to determine how all facets of that business are going to be affected by the pandemic, including what has happened to suppliers and customers and the collectability of accounts receivable. To determine a price, you need to know what it’s worth now, what are the value drivers and detractors? Is the business transferable and attractive? Getting to the bottom of these critical questions required considerable effort under normal circumstances. What we are all dealing with now has added new levels of complexity to the business valuation process.

Zahner: There’s no question that the current crisis has put sellers at a disadvantage, even if some industries have been well positioned to react to COVID-19, including certain retailers, household staples manufacturers, and technology companies. But for the most part, it’s advantage buyers. Many buyers, though, have also been forced to put their M&A activity on hold. Cash is short, and they likely have their own problems to tend to. However, companies with strong balance sheets and private equity groups with “dry powder” could be out in search of deals at a discount. Sellers are wary of this; if they aren’t, they should be. Many are taking a wait-and-see approach. Not many want to buy an enterprise that isn’t sure how to forecast its cash flows through the end of this year, let alone two to three years into the future. And as Keith said, the uncertainty can lead to widely disparate valuations between buyers and sellers, which makes deal-making difficult.

Veres: Many buyers of small businesses use SBA lenders, and most M&A activity through those channels has been put on pause for at least the next 30 to 60 days. Each business is unique—not only their business type and historical financial performance, but their ownership group, their employees, their community, their market. It’s why we say, “If you’ve seen one M&A transaction, you’ve seen one M&A transaction.” We’ve been talking with our strategic partners—attorneys, investment bankers and business brokers—and it’s unclear how the crisis will ultimately affect each business. Relationships, as they exist between suppliers and customers, will change. So many unknowns are having an impact on the valuation process right now.

It is a very difficult time for business owners who have been contemplating their exit strategy because buyers understand that revenue is down, unemployment applications are what they are. What’s the fallout of all that? How do you value a company that for three decades has been performing in a fairly consistent and predictable manner? How will that valuation look in two to three years? It’s why you see the equities markets fluctuating like they are. They’re having difficulty following the value implication for companies all the way through to the end. Most buyers are pausing unless they think they can get a bargain. For business owners preparing to exit, it’s going to be very difficult, except under certain circumstances, to command the value they could have commanded three months ago.

Q. What should sellers do now during the crisis period?
Zahner: Unfortunately for many business owners contemplating an exit, current market dynamics have likely eroded value and put sellers at a disadvantage compared to just months ago. Therefore, a practical strategy for sellers may be to weather this storm the best they can, then look at it again on the other side. If your company has certain strengths that allow it to do so more effectively, like a nimble supply chain or easy scalability in either direction, now is the time to build on those strengths and tell the story once the crisis is through.

Veres: One thing we’re telling business owners is that it is important to go through the valuation process, if only to determine what it is that drives the value of their business and look at their business from a buyer’s perspective. They might not have done that level of analysis at least in the recent past, that is, put on a buyer’s glasses and see what things make the business valuable and what things might detract from the perceived value. A buyer will do their due diligence on your business and look for reasons to re-price what their initial letter of intent indicated as their offering price. That’s now standard operating procedure. So when we’re going through the process of looking at their business from the buyer’s perspective and uncovering real value drivers, it allows us to determine where business owners should be spending their time. Their time should be spent making their business as attractive and easily transferable as possible. Most things that will help a business get prepared for a sale are things that will also help them weather storms like the one we are in right now.

When a buyer is looking at a business, they’re looking at a risk-return proposition. Typically the lower the risk, the higher the value they will place on your business. If you can come out on the other side of this pandemic and prove that you survived a historic attack on your business, that might prove a significant differentiator for you when it comes time to market your business to potential buyers.

There’s a wave of baby boomers contemplating their exit strategies. Some of them might use the crisis to take the steps to improve their business that they were dragging their feet on before.

Zahner: The two things that have arguably impacted value the most are supply chain disruption and the demand shock with everyone staying home. A lot of businesses will be looking at their supply chains with the idea of tweaking them to make their companies more attractive. Do they have the proper contingencies in place? Should they be looking at different geographic regions or keeping things closer to home? What is the best strategy to maximize responsiveness? Also, it’s important to think about how business activity will be forever changed on the other side of the COVID-19 pandemic. Strong, flexible IT environments will be more important than ever, as will changing customer preferences. I believe that the current crisis has accelerated shifts that were already in motion; telemedicine, grocery delivery/pickup, how we get our hands on essential household products.

Veres: Also, a lot of businesses will reconsider how much they spend on brick and mortar given that remote work is proving to be an option. Business owners will learn that they didn’t miss too many beats having 80 or 90 percent of their people working from home. So maybe 30 or 40 percent of their workforce could continue working at home, thus reducing the square footage required to house their employees.

Q. What do you see on the other side of this crisis for M&A activity?
Veres: Sellers are going to have to be creative. In deal making that’s going to be a necessity because there are so many unknowns moving forward. There will likely be more deals with an earn-out attached to them. Getting a buyer and seller to come together over a value is going to be more difficult; there’s plenty of ammunition on both sides to dispute attaching a definitive value to a business that is in transition. We will see concessions being made that allow for a valuation to play itself out in terms of future revenues and profits. Sellers might also be asked to take on larger notes receivable from buyers instead of having the buyer come up with 90 percent at closing. Sellers might need to take on some additional risk. There’s going to be more consternation on both sides, but when you have a willing buyer and seller, you should be able to work it out. Deals are still going to happen.

Zahner: I think there will be fewer buyers and sellers for a period of time. How long that goes is anyone’s guess. No one is sure when the recovery will start, or if values will rebound to pre-crisis levels, but once the virus has been controlled and self-isolation mandates are lifted, business and consumer confidence will rise, and possibly quickly. But for now, everything’s against the seller. Any influx of capital will be more for operations and working capital than deal making. Earn-outs and “holding the paper” on deals might get the buyer to pay more in the long run, but the deck is stacked against the seller at this time. So if you don’t have to sell, you’ll likely want to wait.

Q. Do you have deals in the making for any of your clients now?
Veres: Yes. There are some deals in the due diligence process where legal documents have been signed. Contracts may include a force majeure clause that allows the buyer to step away from the deal under extraordinary circumstances. A deal without that clause could still be enforceable. There are other contractual issues that can cause the sale to be delayed, like deals that were scheduled to be SBA financed that are now on hold. Some businesses are more protected from societal and economic turmoil and may see their deals still go through. Again, every deal is unique, but most are taking a deep breath and pausing.

There was a lot of money out here looking for a market correction, but who would have thought of a pandemic and a Saudi-Russian oil war happening at the same time? We had expected a pullback from such a long period of increasing business values, and there was a lot of money on the sidelines waiting for that. I believe activity will ramp up when there’s a recovery—there is a lot of dry powder looking for an opportunity.

Zahner: From a valuation perspective, there are a lot of things we’re dealing with now that don’t have much to do with transactions. What we’re doing as a valuation group is addressing cash flow issues and market conditions and working with our clients to try to quantify the impact as accurately as possible. The valuation date plays an important role in this. Was the crisis known or knowable as of a certain date in time? Once it was knowable, what were the cash flow impacts? How long will they persist, and how quickly will things return to normal? These are all very difficult questions, some of which are unanswerable. When we don’t know those things we have to incorporate the impact of the crisis in other ways. We can adjust our selected rates of return and apply lower value multiples based on revised market capitalizations. We just have to be careful not to double-count certain factors. For example, it’s probably inappropriate to apply depressed earnings multiples to recast projections that have already incorporated negative performance. But in general, the transaction process won’t re-start until we get back to some normalcy.

Q. What are your recommendations to owners planning their exit strategies?
Veres: We’re recommending to anyone contemplating what is likely the most significant transaction of their lives, the sale of their business, to assemble their team of advisors who will help them through the process. Business owners had become a little complacent about having accurate valuations for their businesses. They were getting comfortable applying vague “rule of thumb” calculations to estimate value. Moving forward, the valuation process is going to be much more complicated than that. You need a qualified professional advisory team—investment banker or business broker, attorney, CPA, financial advisor and a valuation expert. We’re all here to help you get the best price and terms whenever it is that you want to execute a transaction. It has never been more necessary to have people like us to help you down that path.

Whether it’s an internal or external exit strategy, you want to understand all your options. A vast majority of business owners are not aware of all of their options. They think it’s either sell or close the doors. It will be important to talk about other options. Are there opportunities for joint ventures? Might you consider making some of your own acquisitions? There are thoughtful conversations to be had with buyers and sellers to consider their options.

Zahner: If you don’t look at it from a selling perspective, you might consider passing the business on to the next generation. Strategies like gifting are very attractive now, especially with a taxable estate. With market conditions as they are and uncertainty swirling, fair market value has dropped, and transfers can be made at supportably lower values. I want to be clear that we aren’t suggesting that values are artificially low. Risk profiles are growing. Cash flow is plummeting. These are real concerns for our business owners, and value will be impacted accordingly. Therefore, it could be a good time to get with your estate planning professionals to see if the timing might be right.

Veres: Many of our clients had originally anticipated that their kids would take over the business when Mom and Dad were ready to retire. Many of those same business owners later became aware of the fact that their kids had other plans for themselves. Those other plans may no longer be available and it might be time to reconsider keeping the business in the family. Maybe some of the togetherness during this crisis will percolate that thinking. Mom and Dad’s original intent for the business might happen after all. If this is an option, get the valuation experts to work and have the tax and financial planners help you craft the best plan to keep the business in the family.

Owners are optimistic people. They are entrepreneurs and have shouldered risk and responsibility for many years. Their expectations are that they’re going to come out on the other side better for it and still execute their exit plan at some point. We can help them see that they may now have more time for a thoughtful approach to the process. Most business owners have a passionate relationship with their business. They have probably invested the vast majority of their time and money into their businesses and they will do everything they can to get through this. We can do our part by helping them execute a successful exit strategy when they are ready to do so.

Note: For more on exit strategy options, read Leaving Your Business on Your Terms at HBKSwealth.com.

Internal Revenue Code section 280E prevents businesses engaged in the trafficking of a Schedule I or II controlled substance* from taking federal income tax deductions for ordinary and necessary business expenses—allowing deductions only for costs of goods sold. However, in certain situations, S corporation shareholders may receive a tax benefit from these otherwise non-deductible expenses due to stock basis ordering rules.

Generally, losses may be deducted by a taxpayer only to the extent of their basis, that is, the amount invested. Basis is adjusted in the following order: (1) income, (2) non-dividend distributions, (3) non-deductible expenses, and (4) losses.

When a shareholder’s loss or deduction items are disallowed due to basis limitations, they are suspended and carried over to the succeeding taxable year. The suspended losses and deductions are treated as incurred in that succeeding year, are added to the shareholder’s loss and deduction items actually incurred during that year. Under Treas. Reg. 1.1367-1(g), however, a shareholder can elect to have basis adjusted in a different order: (1) income, (2) non-dividend distributions, (3) losses, and (4) non-deductible expenses. The effect of the election is that any unused non-deductible expenses are carried forward until they are used to reduce stock or debt basis. Once the election is made, the shareholder must continue to use that ordering rule unless the IRS approves a change back to the standard rule. The election may be made on an original return or an amended return.

Consider the following illustration:

George is the sole shareholder in an S corporation. At the beginning of the year, he has $100,000 in basis. The company has a taxable loss of $250,000 for the year, plus $600,000 of non-deductible expenses.

If the shareholder makes—or has previously established—a 1.1367-1(g) election, they can apply $100,000 of taxable loss to their basis first. The loss will be taken on their individual return and the remainder—$150,000 of losses and $600,000 of non-deductible expenses—carries forward to the next year.

If the shareholder has not made the election, the $100,000 of beginning basis will be reduced by $100,000 of the non-deductible expenses. The entire $250,000 loss is then carried forward to the next year. However, the $500,000 of non-deductible expenses exceeding the basis are not deductible and do not carry forward. By making the election, the shareholder receives a tax benefit even though the expenses are in theory non-deductible.

	Election under 1.1367-1(g)	Stock Basis Ordering Rules
Basis:
Beginning basis	100,000	100,000
Non-deductible expenses		(600,000)
Non-deductible expenses in excess of basis – not carried forward		500,000
Stock basis before losses	100,000	0
Losses incurred	(250,000)	(250,000)
Suspended losses carried forward	150,000	250,000
Stock basis before non-deductible expenses	0
Non-deductible expenses	(600,000)
Suspended non-deductible expenses carried forward	600,000
Ending stock basis	0	0
Suspended losses carried forward	150,000	250,000
Suspended non-deductible expenses carried forward	600,000

On the surface, the 1.1367-1(g) election seems like a good idea. It allows the use of a tax-deductible loss now instead of a future year. However, making the election could have negative consequences for S corporation shareholders, as any deductions for non-deductible expenses that aren’t used up due to basis limitations are lost.

These rules affect all S corporation shareholders, but it’s particularly important for cannabis companies because under the limitations of the Controlled Substances Act they tend to have large amounts of non-deductible expenses. Taking advantage of the stock basis ordering rules is an involved process requiring many considerations; it is critical to use a tax preparer familiar with these rules. Making a 1.1367-1(g) election without considering the consequences, or being unaware of the carryover rules and tracking non-deductibles incorrectly, could be extremely costly. Make sure you have a CPA who knows the rules and can apply them to your benefit.

* The Controlled Substances Act (CSA) is the statute establishing federal U.S. drug policy under which the manufacture, importation, possession, use, and distribution of certain substances is regulated. It was passed by the 91st United States Congress as Title II of the Comprehensive Drug Abuse Prevention and Control Act of 1970 and signed into law by President Richard Nixon.[1] The Act also served as the national implementing legislation for the Single Convention on Narcotic Drugs.

While the legalization of adult use of marijuana is currently off the table in New Jersey, New Jersey and other states will have to contemplate taxation in anticipation of future legalization. Determining a “right” sales tax that balances revenue receipts as it serves to eliminate a black market is not an easy task.  The following article sheds light on various marijuana taxation methodologies. (For purposes of this article, local taxes are not being considered.) There are two primary ways states tax the sale of adult use marijuana products: as a percentage of the selling price, similar to sales tax, or by weight. Taxing based on sales is easier to calculate. However, prices will likely decline once the market matures (see FIGURE 1), so tax revenue will decrease as well. As well, vertically integrated businesses could manipulate markups to reduce the tax burden. The Colorado Department of Revenue’s Marijuana Enforcement Division reported pounds of flower and bud sold in 2018 as of the date of the writing of this article. They had not reported revenue.  The Average Market Rate per pound of has been reported and, as shown in FIGURE  1, decreased significantly in 2018, then started to rebound in 2019.  
Weight-based taxes are more complicated in that it requires determining the amount of the tax and when the tax is assessed.  For example, a weight-based tax could be assessed at the cultivator, processing or retail level.  At the retail level, taxes would need to be set at different rates for different types of products: flower, concentrates, edibles. When taxing edibles, how would the non-cannabis ingredients be accounted for?  When taxing tinctures, would the potency and quantity be considered? There are significantly more factors to consider when ‘weighing’ the options of a weight-based tax. History indicates that prices tend to be higher immediately following legalization; lower tax rates can encourage the legal purchase of cannabis.  When prices decline, tax rates could be increased, keeping out-of-pocket costs to consumers the same or almost the same.  If taxes are too high, whether weight-based or assessed as a percent of sales, many customers will continue to purchase through the black market.  States must also consider that when the United States de-schedules or legalizes marijuana, it is highly likely a federal excise tax will be placed on sales of the product.  This will replace the burden of Internal Revenue Code Section 280E currently burdening business taxpayers. What is the effect in dollars of taxing based on a percent of sales versus weight? To illustrate, we analyzed Colorado’s reported sales and the wholesale weight of flowers/buds sold from January 1, 2014, to December 31, 2018.  As Colorado has not yet reported weight data for 2018 yet, we used the 2017 monthly data adjusted for the year-over-year sales increase. These computations are for illustrative purposes only and are subject to the following assumptions:

• includes only the weight of sales of flowers/buds;
• assumes no markup no profit made by the cultivator, distributor, or retailer; and
• ignores local taxes.

FIGURE 2 reflects a computation of tax revenue (medical and adult use) for the first four years of legal adult use in a state with a population of 8.908 million (specifically New Jersey).  
Based on this analysis, total sales tax collected for the five years was $52.8 million greater using a weight-based tax structure of $42 per ounce compared to the 12% percent of sales tax.  Obviously, the 25% tax rate would generate more revenue – but it would likely be a less effective means of eliminating the black market.   Examples of Sales Tax on Marijuana  
As FIGURE 3 shows, the process of taxing marijuana can range from simple to complex and the amounts of tax collected can vary significantly.   Nine states (and Washington DC) do not impose their general sales tax on medical marijuana while four states (Alaska, Delaware, Minnesota, and New Hampshire) do not levy sales taxes. FIGURE 4 illustrates a sample transaction ($250 per ounce based on no markup of product and all taxes being passed through to the consumer) in both medical and adult use markets and the different amounts that would be charged to the ultimate consumer and the taxes collected.  On the medical side, the purchase of an ounce of marijuana results in a purchase price ranging from $250 to $342.50, depending on the state.  For adult use, the price paid would range from $282.50 to $360.75.  
Under the weight-based tax structure ($42 per oz), the consumer’s cost for medical marijuana would be $266.63 (the fourth lowest, with two states levying no taxes).  For adult use, the $42 per ounce tax would result in being at the halfway point compared to other states.  It is very important to realize that the price will not be the same in all states and that this example is presented for comparison purposes only. Sources: Colorado Marijuana Enforcement Division’s Market Size and State Demand for Marijuana in 2017 – Market Update (Aug. 2018) https://www.colorado.gov/pacific/sites/default/files/MED%20Demand%20and%20Market%20%20Study%20%20082018.pdf Colorado Marijuana Enforcement Division: 2016 Annual Report https://www.colorado.gov/pacific/sites/default/files/2016%20MED%20Annual%20Report_Final.pdf Colorado Marijuana Enforcement Division’s Market Demand and Size Study, July 2014 https://www.colorado.gov/pacific/sites/default/files/Market%20Size%20and%20Demand%20Study%2C%20July%209%2C%202014%5B1%5D_3.pdf https://www.colorado.gov/pacific/revenue/colorado-marijuana-tax-data https://www.colorado.gov/pacific/revenue/colorado-marijuana-sales-reports https://www.colorado.gov/Tax/marijuana-taxes-file Economic Impact of Tourism in New Jersey, 2017 – January 2018) https://www.visitnj.org/sites/default/files/2017-nj-economic-impact.pdf

In a United States Tax Court case¹ decided November 29, 2018, the court reaffirmed the Internal Revenue Service’s disallowance of certain deductions for companies operating in the cannabis industry. Background Patients Mutual Assistance Collective Corporation d/b/a Harborside Health Center (HHC) is a California medical marijuana dispensary, operating four industry-related activities. HHC believed each of its activities was a unique trade or business. The activities are: Brand Development, Therapeutic Services, Sales of Products Containing No Marijuana, Sales of Marijuana and Products Containing Marijuana. Internal Revenue Code (“Code”) Section 280E (“280E”) states:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedule I and Schedule II of the Controlled Substances Act) which is prohibited by Federal Law or the law of any state in which the trade or business is conducted.

Resolutions 1) 280E The Code allows a business to deduct all its “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” However, as stated previously, Code Section 280E contains an exception disallowing expenses related to … “carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” HHC argued that “consists of” means an exhaustive list or in other words “Section 280E only applies to business that exclusively or solely traffic in controlled substances and not to those that also engage in other activities.” The IRS argued that a single business can have multiple activities and that 280E applies to an entire trade or business if any one of its activities is trafficking in a controlled substance.² The Tax Court ruled “Following the most common usage of ‘consists of’, as HHC suggests, would indeed make Section 280E ineffective. If this section denies deductions only to businesses that exclusively traffic in controlled substances, then any street-level drug dealer could circumvent it by selling a single item that was not a controlled substance … This reading would edge us close to absurdity, which is another result our reading of a statute should avoid if possible.” 2) More Than One Trade or Business “An activity is a trade or business if the taxpayer does it continuously and regularly with the intent of making a profit… A single taxpayer can have more than one trade or business.”³ Also, taxpayers may have multiple activities that nevertheless are only a single trade or business. HHC stated that if 280E applies to its marijuana sales, the business should be entitled to deduct expenses for any separate, non-trafficking trades or businesses. HHC argued it had four activities. The IRS argued HHC operated only as one trade or business, whose business was “trafficking in a controlled substance” and therefore subject to 280E. The Tax Court analyzed the sales volume, floor space, and employee time spent on the four different operations and ultimately determined that HHC’s primary operation was selling marijuana and marijuana-related products and its other activities were “neither economically separate nor substantially different.” 3) Cost of Goods Sold All taxpayers, even drug traffickers pay tax only on gross income, which is defined as gross receipts less the cost of goods sold. This means HHC is not limited to owing taxes based on its gross receipts. However, the definition of cost of goods sold came into question. The Code has three sections that address cost of goods sold – Section 263, Section 263A and Section 471. Since there are multiple sections the question becomes which section applies to HHC? The IRS argued the applicability of Section 471, enacted in 1954 which was in place when Congress enacted Section 280E in 1982. Section 471 has separate regulations for resellers and producers. The regulations state “resellers” use as their cost of goods sold, the price they pay for inventory plus any “transportation or other necessary charges incurred in acquiring possession of the goods.” The regulations for “producers” are more complex. Producers must include in cost of goods sold both direct and indirect costs of creating their inventory. The regulations state to inventory: “cost of raw materials”, “expenditures for direct labor” and “indirect production costs incident to and necessary for production of the particular article”. HHC argued that limiting its cost of goods sold to “only the actual cost used to purchase inventory” violates the Sixteenth Amendment and that “section 263A represented the most accurate tax-accounting method for calculating cost of goods sold.” The Constitution does limit Congress to taxing only gross income,⁴ and HHC argued that not letting marijuana dispensaries use 263A forces them to pay tax on more than their gross income.” The Tax Court ultimately ruled “Section 263A capitalization rules don’t apply to drug traffickers. Unlike most businesses, drug traffickers can’t capitalize indirect expenses beyond what’s listed in the section 471 regulations. Section 263A expressly prohibits capitalizing expenses that wouldn’t otherwise be deductible and drug traffickers don’t get deductions. Because federal law labels HHC a drug trafficker, it must calculate its cost of goods sold according to Section 471”. Next the Tax Court had to determine whether HHC is a “producer” or a “reseller” in accordance with Section 471 since there are different rules for producers versus resellers as far as how to calculate its cost of goods sold. The IRS argued that under Section 471 “production” means “manufacturing” while the Tax Court added that “producers” retain title to the items throughout the production process. The question became did HHC own what its growers grew? HHC argued that “it exercised a high degree of control over the growers it purchased marijuana from. HHC only purchased marijuana from its members and even then, only if the members used HHC clones (which they purchase or received for free), took HHC growing class, followed HHC’s best practices and met HHC quality control standards”. The IRS stated HHC “didn’t create the clones, maintain tight control over them, order specific quantities, prevent sales to third parties or take possession of everything produced. HHC bought clones from nurseries and either sold them to growers with no strings attached or gave clones to growers expecting that they’d sell the bud back to HHC. Nothing prevented either type of grower from selling to another collective and [HHC’s owner] Steve DeAngelo thought it would be futile to try to use the courts to stop them. HHC had complete discretion over whether to purchase what bud the growers brought in, paid growers only if it purchased their bud, and at times rejected the ‘vast majority’ of its growers’ bud. And HHC thought growers could do whatever they wanted with the rejected bud.” The Tax Court ruled “HHC merely sold or gave members clones that it had purchased from nurseries and bought back bud if and when it wanted. In between these two steps it had no ownership interest in the marijuana plants. HHC is therefore a reseller for the purposes of Section 471 and must adjust for its cost of goods sold according to Section 1.471-3(b).” This is the most restrictive calculation regarding the costs of goods sold and thereby the lowest calculation for the cost of goods sold. Thus, HHC could only include its purchase of the products and related transportation costs. Conclusion The Patients Mutual Assistance Collective Corp. case further denies ordinary and necessary business expenses for entities they operate in the cannabis industry. The case also defines the criteria to determine cost of goods sold. If you have questions about the case, its impact on the cannabis industry, or any related matter, please contact a member of the HBK Cannabis Industry group at Cannabis Industry Inquiry. Our team will walk you through the options and help you decide what strategies may be best for your cannabis-based business.   Footnotes

1. PATIENTS MUTUAL ASSISTANCE COLLECTIVE CORPORATION d.b.a.HARBORSIDE HEALTH CENTER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Docket Nos. 29212-11, 30851-12, 14776-14, Filed November 29, 2018.
2. PATIENTS MUTUAL ASSISTANCE COLLECTIVE CORPORATION d.b.a.HARBORSIDE HEALTH CENTER v. COMMISSIONER, 2018, p25.
3. Ibid, p37.
4. Gross income is defined as gross receipts minus direct costs.

During his campaign, New Jersey Gov. Phil Murphy (D) made his intentions to fast track the expansion of New Jersey’s medical marijuana program clear. This is the first step towards legalization of recreational marijuana in the state. While legal on a state level in some jurisdictions, cannabis remains a Schedule I controlled substance at the Federal level. This disparity between governmental bodies will leave many business owners wondering: what goes on my tax return? Because of Internal Revenue Code Section 280E, no deductions for ordinary and necessary business expenses are allowed in calculating taxable income for businesses trafficking in controlled substances. The courts have clarified that only deductions for expenses considered to be “cost of goods sold” are allowed. So what does that mean? Typically, cost of goods sold (COGS) includes direct expenses related to the production of marijuana, such as seeds, soil, and fertilizer. It may also include the cost of electricity used to power plant-growing lights and the labor costs paid to workers harvesting crops. The problem is that Section 280E disallows deductions for indirect expenses like taxes and licenses, insurance, and legal fees. Because of this, business owners in the industry are being taxed at much higher rates than non-cannabis business owners. This can result in a considerably increased effective tax rate because the business owners pay taxes on their “gross income” instead of their “taxable income.” The determination of permissible expenses should be made on a case-by-case basis in consultation with a tax advisor who is familiar with the unique issues of the cannabis industry. The most important takeaway from this article should be that taxation of the cannabis industry is very complicated and it’s extremely important that business owners consult a reputable tax advisor before filing any tax returns related to this matter. Please contact Stacey Udell at (856) 486-2299 or Tyler Tomalavage at (609) 883-9000 with questions.

Do you know what your business is worth right now? Practically speaking, it is worth what the highest bidder is willing to pay for it — no more or no less. Nevertheless, by taking all the relevant factors into account, you can position yourself for the best possible deal.

The first step is to have a business valuation prepared for your company. Our firm can provide a comprehensive report, which can be a starting point for negotiations.

Typically, potential buyers conduct their own due diligence of businesses they are interested in. They may rely on professional appraisers who use different measuring sticks and come up with another valuation. For example, a buyer may seek a valuation based on fair market value, intrinsic value or a different standard might be applied. Internal factors that are unique to the business are taken into account, such as the company’s financial position.

At this juncture, other external factors can also come into play. Some of these issues reflect the economy, market demand for the company’s products or services, and the health of the industry as a whole. If demand is low, it could suggest reduced profitability. Therefore, it might be advantageous to postpone your plans to sell the business until demand increases or stabilizes.

Interest rates can also affect the value of a business. When interest rates are rising, it can have an adverse effect on cash flow, since outstanding debts can result in higher charges. Therefore, you might want to sell a business when interest rates are relatively low.

Our firm provides a comprehensive set of services relating to business valuations. We can walk you through every step of the process so you understand it completely. Our services include an analysis of:

• The relative strengths and weakness of your business.
• Steps you can take to enhance the value.
• How to keep taxes to a minimum.
• Where to find potential buyers.
• The optimal time to sell.
• The value of tangible assets, such as real estate and equipment, as well as intangible assets, such as
• patents, trademarks and non-compete agreements.

Contact our office to arrange a meeting. Our business valuation professionals understand the complex internal and external factors involved in valuing a business.

On August 4, 2016 Proposed Regulations were issued by the Treasury Department which may have a significant impact on your estate plan. If the Proposed Regulations are enacted as currently drafted, it may result in the loss of both the lack of control and lack of marketability valuation discounts for transfers of interests in family-owned entities to other family members. For wealthy families who utilize valuation discounts as a means of minimizing future estate taxes, it is essential that they understand the impact of these regulations and the immediate planning options that may be available.

Background
IRC Section 2704 was enacted in 1990 as part of an initiative by Congress to limit valuation discounts taken when interests in family-owned entities were transferred to family members. Over time the ability of the IRS to use Section 2704 as a means of limiting discounts has effectively been eliminated due to various state laws and taxpayer-friendly court cases. The Proposed Regulations effectively negate the effect of these state laws and court cases and provide the IRS with additional means by which to limit valuation discounts.

What are discounts?
Discounts are a reduction in the value of an interest in an entity due to the lack of control the owner of a minority interest may have, the difficulty of the owner to find a willing buyer of a minority interest, and other factors that may play in to a third party’s desire to own that interest. The effect of these discounts may be illustrated as follows:

Sam has a gross estate worth $20 million, which includes a family business valued at $10 million. He gifts 40% of the business to a trust in order to remove any appreciation on the business from his estate. The gross value of the interest transferred to the trust is $4 million ($10 million multiplied by 40%). However, since a minority owner of the interest cannot force a sale or redemption of the interest, the value of the interest transferred to the trust is worth less than the gross value. The value is therefore reduced by up to 40% or more to reflect the difficulty of marketing the non-controlling interest. If Sam is successful in arguing a 40% discount, the gross value of the interest will be reduced to $2.4 million and Sam would have reduced his estate by $1.6 million simply by making the transfer.

What may the impact of the election be?
As with most things, the impact of these Proposed Regulations combined with the results from the upcoming election is uncertain. If the Democratic Party maintains control of the White House and is able to take control of the Senate, then it is possible will be successful in enacting their current estate tax proposals. These proposals currently include a reduction of the estate tax exemption to $3.5 million without adjustments for inflation, a reduction of the gift tax exemption to $1 million, and a high tax rate of 45%. In addition, the new president may continue to push for other changes that President Obama has sought, including the restriction or elimination of Grantor Retained Annuity Trusts (GRATs) and the sale of assets to grantor trusts via an installment note.

What should you do?
The regulations will be effective 30 days after the regulations are finalized. The IRS is holding a hearing on December 1, 2016 and many expect the final regulations will be issued before President Obama leaves office on January 20, 2017. If so, then these regulations may be effective in mid February. Time is of the essence in determining what planning options you may have. Once the Proposed Regulations are effect, which may be as early as the end of the year, the ability to claim these valuation discounts may be substantially reduced or eliminated. This will have a significant impact on your tax and asset protection planning flexibility.

Many of you may remember the mad rush in late 2012 with the fear that the estate, gift, and generation skipping transfer tax exemptions were going to be reduced to $1 million in 2013. Many of our clients incurred significant costs and hassles in implementing planning quickly, and were frustrated when the reduction never occurred. The current situation is vastly different. While the Proposed Regulations could be changed before them become effective, the more likely scenario is that they will be finalized in their current format and the ability to claim valuation discounts will be severely curtailed.

We encourage you to contact us as soon as possible to discuss the impact these Proposed Regulations may have on you and your estate plan.