Our Oregon office forms three or four cannabis companies per week. Our Washington office has formed hundreds of these businesses in the past four or five years, and our California office has seen a major uptick in company formation work since AUMA passed last fall. Though every state brings unique considerations for entity choice and structuring, most of these businesses (outside California) end up registering as either LLCs or C-corps. And most of them involve owners who bring different things to the table.
The most common example of differing contributions comes when one person brings skill and labor to the table, while another brings cash. The “sweat equity” partner may have expertise and relationships related to production or processing of cannabis, for example, while the traditional equity partner has the ability to immediately fund the marijuana business. In a classic scenario, these two individuals come to one of our cannabis business lawyers and say they would like to own the business “50/50”, or thereabouts. This raises some serious tax implications for the sweat equity partner.
The Internal Revenue Code values capital over labor, especially when that labor constitutes future services a person will contribute to a business in exchange for ownership. From the IRS’ perspective, if Party A contributes $100,000 in cash to an LLC or corporation, and gives a 50% interest to Party B (for a sweat equity contribution), the IRS will also value Party B’s interest at $100,000. Unfortunately, Party B will have to pay tax on that income, which is sometimes referred to as “phantom income.”
The following are a few of the more common ways to deal with phantom income in a situation where one member of a cannabis business provides the capital, and the other provides services:
Vesting. It is possible to have the sweat equity partner’s interest vest over time, through options allocated to that partner under a shareholder or operating agreement. The sweat equity partner will purchase and pay for his or her equity through distributions or dividends earned as an owner of the company. The vesting schedule here is very important. If the schedule is too long, the value of the membership (and the amount payable) may increase. If the schedule is too short, repayment may not be viable.
Company Loan. Often, the partner without cash at the onset will issue a promissory note to the company. Here, the sweat equity partner is acknowledging having received a valuable interest in the company, for which he or she owes a debt. The promissory note can be made with a commercially reasonable repayment period and interest rate, and the member can pay down the note with income received from the company. It is important to remember, though, that the note payments will be made from taxable income. This is simply a way to extend the tax hit over time.
Owner Loan. Sometimes, neither partner will contribute a sizable amount of cash up front. Instead, both partners will contribute a nominal amount, like $1,000, and the partner with cash will make a loan to the LLC. This option should be considered carefully, for a couple of reasons. First, from a tax liability perspective, the IRS may consider a company with a debt to equity ratio over 3:1 or 4:1 to be “thinly capitalized” and subject to scrutiny. From a legal liability perspective, an undercapitalized company may leave its owners open to vicarious liability on a “piercing the corporate veil” theory.
The above are simplified, high-level summaries of common methods lawyers and CPAs use to deal with phantom income in cannabis start-ups. It is important to note that each situation is unique and depends on a variety of factors. It is also important to note that sweat equity is not the only way phantom income is created in cannabis companies. Almost all pot companies have some amount of phantom income due to IRC 280, for example. That rule alone is a crucial business planning consideration for every marijuana entrepreneur.
Legal and tax structuring are critical decisions that can determine whether a marijuana venture succeeds or fails. Learning to look out for phantom income is key part of this analysis. That’s true for both sweat equity and cash investors — especially in this unique and highly dynamic industry.