One of the most important decisions a new cannabis business can make is the form of entity it will use. In fact, one of the first questions businesses ask is whether the right entity for a cannabis business is a limited liability company (LLC), corporation, or something else. Like basically every other legal analysis, the answer depends on a lot of business-specific factors. In this series, I break down some of the key points for consideration of the right entity type for a cannabis business. In my last two posts in this series, I looked at corporations and LLCs. In this third and final post in this series, I’ll look at some of the alternative business types we’ve seen or heard about.
A note on limited liability
For those of you who didn’t read my other two posts in this series, I want to define the concept of limited liability. Limited liability is one of the fundamental features of certain business types. If a person owns a company with limited liability protections, the person is generally not personally responsible for the debts, liabilities, etc. of the company. Except in a few limited scenarios, if the company is sued and loses, the owner won’t lose anything– except, at most, their investment in the business. But as alluded to, not all businesses have limited liability by definition. I’ll discuss those below.
A note on taxation
In my prior posts I covered general tax principles applicable to corporations and LLCs. A corporation is taxed on its income. Then, if the corporation issues dividends to shareholders (after paying taxes on its income), the shareholders are taxed individually. This is commonly called “double taxation” and the corporate structure is called a C-corporation. LLCs and partnerships, on the other hand, have pass-through taxation, where the corporate form is essentially ignored (I’m oversimplifying) and profits and losses of the business are passed directly onto its owners for tax purposes. There are benefits and drawbacks to each structure, which I went over before. But taxation is another key area for selecting the right entity for a cannabis business.
A sole proprietorship is a business owned by a single person that is not incorporated. There is no legal distinction between the owner and business. Even if a jurisdiction allows sole proprietors to obtain cannabis licenses, this is never the right entity for a cannabis business. It’s a poor option for any business, really, because there is no limited liability. Limited liability is absolutely critical and is something you get by default in a corporation, LLC, or other limited liability entity. While forming a company takes some expenses (filing fees, drafting legal docs, company taxes), that generally pales in comparison to liabilities that could accrue personally when someone’s house, cars, or other personal property would be at stake.
Broadly speaking, a partnership exists whenever two or more people team up to carry out a business for profit. If people associate to form a partnership without forming an entity, it’s what is called a “general partnership.” Like a sole proprietorship, general partnerships have no limited liability and are therefore never the right entity for a cannabis business.
Most states allow partners to form limited liability partnerships by making certain filings with the state and adhering to certain governance formalities. Like I said above, this is really a minute ask when considering the downfalls of not having limited liability. There are also entities called limited partnerships with limited and general partners. I may address limited partnerships in a different post, as they can get fairly complicated.
Partnerships are, like LLCs, taxed on a pass-through basis. People looking for C-corporation taxation in partnership type model generally opt instead for LLCs. With a few exceptions (LLPs for law or accounting firms and limited partnerships for funds) partnerships of any kind are pretty rare for cannabis businesses.
DAO is short for Decentralized Autonomous Organizations. These are a new entity type that’s begun to crop up in the Web3, NFT, and blockchain technology spaces. We wrote about them at length here and here so I won’t repeat everything, but here’s a blurb that may help explain:
DAOs allow for creating organizations on a cooperative and decentralized basis that can then achieve the common goals of their members. Smart contracts underlie a DAO’s operations by executing transactions between counterparties that automatically handle the administrative duties and related decision-making traditionally performed by humans in management roles. Governance is then decentralized when control of the smart contracts is transferred from the DAO’s developers to the DAO’s members.
For now, I’m not aware of any licensed cannabis business organized as a DAO though it would likely be allowed under state laws that expansively allow almost any entity type to apply for a license. The problem with DAOs is that they are based in large part on smart contracts. This may help in simple organizations, but cannabis businesses are often much more complex to govern. So for the time being, a DAO is probably not the right entity for a cannabis business.
Trusts and REITs
A trust is a legal relationship where one party (knowns as a “trustor” or “grantor” or “settlor”) entrusts another party (“trustee”) to hold property for the benefit of a third party (beneficiary). Trusts are creatures of state law. State law for trusts varies significantly – in terms of types of trusts, whether a trustor can also be a beneficiary, and if the trust is treated as a separate legal entity.
I’ve personally never seen a trust own a cannabis license. Instead, individuals often own cannabis businesses via trusts. This can get thorny for family trusts with beneficiaries under 21, as most states have age requirements for ownership of a cannabis business. But nevertheless, a trust owning equity in a cannabis business is very common.
REIT is short for Real Estate Investment Trust. REITs are generally created to raise money from third parties, and often in public markets (yes, even in the cannabis space). Their plans run the gamut of investment– from development through operation and sale of cannabis related properties.
REITs are not subject to federal income tax. They are instead permitted to deduct dividends they distribute to investors. They must have at least 100 shareholders and are suitable only for large scale real estate investments. So again, they aren’t the type of entity you’d see owning a cannabis license although we see them invested in cannabis real estate all the time.
There are many different types of business entities in the U.S. and abroad. Depending on the state, there are limited – and in some cases no – restrictions on what type of entity can be used in a cannabis business. That does not mean that opting out of the corporation model is a good idea. There’s a reason that the majority of businesses in the space are corporations and LLCs. Still, whether an alternative business type is the right entity for a cannabis business depends on a number of business-specific factors, and not based on some analysis in a vacuum.
Stay tuned to the Canna Law Blog for more posts on corporate cannabis issues.