When our lawyers set up legal structures for cannabis companies, the choice of legal entity is one of the most important things we must consider. Many cannabis businesses use limited liability companies. For tax purposes, an LLC is typically treated as a partnership or as a disregarded entity. In both of these cases, the tax liabilities pass through to the partner/members. However, an LLC may check-the-box to be taxed as a corporation. In that instance, the LLC is subject to tax, whereas its partner/members do not pay tax. Once an LLC is formed, the next important decision is how to fund the LLC.
In this two-part series, we will outline some of the tax traps and opportunities in the initial funding of your LLC. Part I will discuss opportunities in capitalizing your businesses with equity and creating an ownership relationship with the business. Part II will discuss opportunities and risks in funding a cannabis business using debt and creating a debtor/creditor relationship with the business.
The Benefits of Contributing Property. Generally, the contribution of “property” in exchange for a membership interest is tax-free. Members often contribute cash, land, and equipment to a cannabis business in exchange for an interest in a partnership/LLC. This is a classic tax-free contribution. What is often overlooked is that intellectual property may be property for purposes of a contribution. Industrial processes, formulae, designs and “know-how” in the right circumstances are considered property and can be contributed to a partnership tax free. However, this approach should only be taken with careful consideration, analysis and documentation.
The most straight-forward contribution is a contribution of cash in exchange for a member interest in a Partnership/LLC. A member may contribute cash in exchange for a membership interest in an LLC. Such a contribution is typically tax free under federal partnership tax law. If an LLC elects to be taxed as a C corporation, a member may contribute cash in exchange for a deemed “stock interest”. Again, such contribution is typically tax-free. Many companies start with extremely small cash contributions, like $1.00 for each member. However, there is some risk there to equity holders, since some courts have pierced the corporate veil against undercapitalized entities. Nonetheless, there is no minimum amount of cash required to form a valid partnership or corporation for tax purposes. In determining the appropriate dollar amount of contribution, a cannabis business’s founders should use common sense and good business judgement.
Sweat Equity may be Painful but is not Prohibited. Investors often can bring valuable experience and “know-how” to a cannabis business and want to contribute such “know-how” in exchange for an ownership interest in the LLC. In general, a mere promise to contribute services in exchange for a membership interest is subject to tax. This is generally considered a “capital interest” in the partnership. Capital interests are defined by the IRS as ownership interests where the member has a right immediately following the contribution, to its share of the liquidation value of the partnership/LLC. To illustrate, imagine one member contributed $1,000,000 in cash to a new company, and the other member agrees to do all the work for the company, and they split the LLC up 50/50. Even if the business doesn’t generate any revenue, the member contributing sweat equity is going to be on the hook for $500,000 on that year’s tax returns. This is because if the LLC liquidated the next day, that member would be entitled to receive the $500,000 as a liquidating distribution. Although the guidance in this area can be complex, it is based on a simple, maxim – “You can’t get something for nothing (in tax)”
One way to get around this is for a member to receive a “profit interest” instead of a a standard equity interest. A profit interest is defined as an interest where the new member would not receive any value if the partnership were to be immediately liquidated after the contribution. Note however, that this treatment has some strict limitations and requires careful drafting of an operating agreement.
In capitalizing a cannabis business, founders all bring different skills and resources to the new venture. All founders should carefully consider the mechanics of offering equity interests to each new member. As we will discuss in Part II, the use of debt financing brings additional, flexibility, risks and opportunities to funding a new cannabis venture.