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 will break down some of the key points for consideration of the right entity type for a cannabis business. Today, I want to look specifically at corporations.
A note on limited liability
Before I jump into things, I want to define the concept of limited liability. Limited liability is one of the fundamental features of a corporation, LLC, and some other 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 corporation.
Corporations are not the right entity for simplicity
Corporations are the classic business entity type. The problem with corporations is that they are much more complicated than, say, LLCs. They have shareholders (owners) who elect directors to manage the big picture operations of the company. Directors in turn select officers to run the day-to-day affairs of the corporation. So the owners of the business have no stake in the operations unless they are also directors and/or officers.
States have all kinds of detailed corporate governance rules that are generally much more aggressive than LLC governance rules. California, for example, requires that there be at least three directors at all times in a general stock corporation (with a few exceptions). California also limits the number of shareholders a close corporation can have, and so on. Failure to abide by these many rules can mean trouble for a cannabis business.
Depending on the state, there may be many different kinds of corporations. For example, California has general stock corporations, close corporations, non-profit mutual benefit corporations, cooperative corporations, etc. The list goes on. I’ve seen each of these types used for cannabis businesses over the years, but I won’t get into each different type today. If a founder does not form the right type of corporation in a state like California, they may be in for stormy waters.
All in all, corporations can be more difficult to manage than LLCs. But that does not mean they can’t be the right entity for cannabis businesses, as explained below.
Corporations may have beneficial tax status
Corporations, by default, are “C-corporations” for tax purposes. This means that a corporation is taxed on its income. If the corporation issues dividends to shareholders, the shareholders are taxed individually. This is known as “double taxation.” When corporate taxes were higher, the corporation model was often less than ideal. But now, the federal corporate tax rate is 21%. Now that the rate is lower, corporations may be the right entity for a cannabis business in some contexts. Here is an analysis we did as an example a few years ago:
For example, a C corporation that earns $100,000 will pay tax of $21,000 ($100,000 *21%). If that same corporation dividends 100% of its earnings to shareholders, the maximum tax at the individual level is $23,800 ($100,000*23.8%). So the combined amount of tax is $44,800 ($21,000 + $23,800). In comparison, a partnership (or S corporation) results in less overall tax to the owners $37,000 ($100,000 *37%).
However, a C corporation is the preferred structure if the plan is to limit the amount of dividends paid to shareholders. For example the total tax hit to a C corporation and its shareholders that paid out dividends of $50,000 is: $32,900 [$21,000+ $11,900($50,000 * 23.8%)]. In this case, a C Corporation saves $4,100 of taxes compared to operating as a partnership. The C Corporation has the additional benefit of insulating shareholders/owners from personal liability for federal income tax.
This is just an example and isn’t meant to serve as tax advice. Each cannabis business and its shareholders have vastly different situations and need guidance from tax professionals. But if a cannabis business makes limited distributions, the tax rates can be effectively lower than in a pass-through taxation company.
As an alternative to the C-Corporation model, corporations can elect to be treated as “S-corporations” for tax purposes. To do this, they need to make an election with the IRS within a certain timeframe. S-corporation election means that the corporation is taxed as a partnership (discussed below). S-corporations also have many restrictions, such as limits on the number of their shareholders and U.S. residency requirements for shareholders. S-corporations won’t work for many businesses – especially ones that intend to have a large array of shareholders. If pass-through taxation is important, a different entity type is probably a good idea. I’ll discuss LLCs and other pass-through businesses in a later post. If exponential growth is important, a C-Corporation may be better, which I discuss below.
Corporations may be the right entity for cannabis capital raises
Corporations tend to be the better choice for raising equity and investments. Institutional investors are more comfortable investing into corporations than LLCs, where they can secure director seats, define the classes of preferred or other equity they will get, etc. You can do almost all of this in an LLC as well, but LLCs still limit the types of investors a cannabis company will be able to seek. Companies wanting to bring in tons of equity will usually opt for corporations – at least for their holding companies.
Corporations are often the right entity type for holding companies
Most cannabis companies – especially larger ones – don’t exist as standalone entities. That is, they are owned by larger companies called “holding companies.” A holding company is almost always a C-corporation and the companies it owns (subsidiary companies) are LLCs, S-corporations, or other business entities with pass-through taxation. This allows independence of operations, limits liability at each company level, and allows pass through taxation so the effect of double taxation is only felt at the holding company level.
Overall, companies that opt for the holding company model overwhelmingly do what I just described. Even standalone cannabis businesses are often set up this way. But this is not always the case! I’ve seen holding companies set up as LLCs more than once. Whether a corporation is the right entity for a cannabis business requires a situational analysis. In the next post in this series, I’ll look at LLCs.