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.
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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.
LLCs are usually the right entity for simplicity
In my post on corporations. I mentioned that corporations have a lot of highly specified formalities that depend on the state and type of corporation. LLCs are much more dynamic and simple to operate (at least from a corporate governance point of view).
Where corporations have shareholders, and directors, and officers, LLCs only need to have members (the owners). These kinds of LLCs are called “member-managed LLCs.” LLCs can also be organized as “manager-managed LLCs,” with managers who serve functions similar to directors and officers of a corporation. Managers can but need not be members of an LLC, and the LLC can allow the managers to appoint separate officers.
All of this is done via an LLC’s operating agreement and depending on state law. The point is that members of an LLC have a lot more flexibility to choose how an LLC is managed than shareholders of a corporation would. This can be very good for simplicity, for smaller businesses, for operating companies, and for startups or new entrepreneurs.
LLCs are flexible entities for taxation
As mentioned in my corporation post, corporations are taxed on income at a federal rate of 21% (“C-corporations”) though they can be taxed on a pass-through basis if the shareholders so elect and if they meet certain criteria (“S-corporations”). LLCs are the opposite. Single member LLCs are “disregarded” for taxation purposes and multi-member LLCs are also taxed on a pass-through basis (a.k.a. “partnership” tax status). This means that profits and losses of an LLC are treated as profits and losses of its members for tax purposes unless the LLC timely elects to have C-corporation taxation.
Generally, taxation as a partnership/flow-through entity will be more favorable for a cannabis business under the following circumstances:
- The individual tax brackets of the LLC members are below 37%;
- The individual member/partners qualify for the favorable 20% deduction for flow-through income under IRC section 199A;
- The business plan emphasizes distributing cash to investors over reinvesting cash into the business (growth);
- The business is not a retailer, and is able to claim a reasonable amount of costs of goods sold (COGS) in its tax reporting.
I would also add here that LLCs are usually not the right entity for a cannabis business looking to act as a holding company, or to go public. Of course, these are just examples and are not meant to serve as tax advice. Cannabis LLCs and their members need tailored guidance from tax professionals. But in most cases, this tends to be what we see.
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.
Alternative Business Types
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.