Are Delayed Tax Payments a Viable Capital Allocation Strategy?

August 8, 2023 · MG Magazine

Notorious Mafia kingpin Al Capone never filed a federal income tax return, claiming he had no taxable income. Before he was convicted of tax evasion in 1931, he boasted, “They can’t collect legal taxes from illegal money.”

The rationale might resonate with cannabis companies in the United States, which manufacture and sell a federally illegal product but are expected to pay federal, state, and local taxes anyway. In fact, companies nationwide have been racking up tax debt at an alarming rate. The hope is they will be able to negotiate payment plans when the Internal Revenue Service and other taxing agencies come calling, but that strategy is fraught with risk and has the potential to decimate any operations so tempted.

SFGate.com recently reported more than 13 percent of California’s legal cannabis retailers, or about 265 storefronts, missed a state tax payment deadline of May 1. Those businesses now face penalties of up to 50 percent on delinquent taxes. The California Department of Tax and Fee Administration reported a total of $250 million in delinquent cannabis taxes for 2022; some estimates put the figure as high as $600 million now.

And California companies aren’t the only ones who’ve been delaying tax payments.

An analysis of financial filings by Green Market Report in 2022 found ten publicly traded multistate operators (MSOs) were carrying a combined total of more than half a billion dollars in federal tax debt. At that time, Acreage Holdings, Ascend Wellness, Ayr Wellness, Cresco Labs, Columbia Care, Curaleaf, Green Thumb Industries, TerrAscend, Trulieve, and Verano Holdings owed the IRS $507.2 million, according to their second-quarter 2022 financial reports. Had the companies been forced to pay in full, only one of them—Green Thumb Industries (GTI)—would have had enough operating capital to last for more than ten months.

Companies have rationalized the kick-the-can-down-the-road strategy for tax payments by saying it’s cheaper to pay the interest and penalties to the IRS and state tax authorities than it would be to borrow the money they need to pay off their tax bills.

“Part of our capital allocation strategy is to lengthen our tax payment cadence,” Verano Chief Executive Officer George Archos explained to shareholders during an earnings call in 2022. “The strategy is not unique to Verano and has been utilized amongst other large U.S. companies. The cost of penalties and interest for this are significantly below the available cost of debt.”

Cannabis companies with good credit ratings that seek loans from private lenders currently face rates ranging from 12–14 percent. Those with less-than-stellar credit can expect interest to add about 16–20 percent to the note. So is paying penalties and interest on delinquent federal taxes a smart approach?

“That’s actually a misconception,” said GreenWave Advisors founder Matt Karnes. “The IRS could charge up to a 25-percent rate per annum. But the formula varies depending on circumstances, and that’s just the interest. Then they’re going to tack on penalties. So it is actually more expensive to rely on the IRS for financing.”

Karnes said companies can negotiate payment terms with the IRS, but they can’t avoid penalties and interest, which continue to accrue until the balance is paid even after a deal is reached.

Using the formula “cash taxes paid/(CFO + taxes paid),” Karnes broke down the taxes paid as a percentage of cash flow from operations (CFO) for all the major MSOs for fiscal 2022 and found the majority of them do not have sufficient cash to meet their federal tax obligations.

As for state tax debts, “not every state is created equal, and it would stand to reason California would crack down because they’ve been disadvantaged by the illicit market for so long,” Karnes said. “But it’s not surprising that a lot of the retailers are holding back, because I think there was an issue with the retailers remitting the excise taxes that was pretty widespread in California. Now the question is how aggressive the state will be.”

More state governments are following California’s and Colorado’s lead and allowing business expense deductions to offset the effect of Internal Revenue Code Section 280E, which may provide some minor tax relief. “If [states are] going to legalize [cannabis], why the hell should they not allow normal operating expenses as deductions?” Karnes asked.

And, some companies might argue, until the federal government legalizes cannabis, why should they pay federal taxes at all? (Full Story)

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