Determining which corporate structure is best for your cannabis business is completely dependent on your specific circumstances. There is not one corporate structure for a cannabis business that works better than others. The perfect entity choice for one company could be terrible for another operation.
Therefore, the best corporate structure will depend on each business owner's specific needs, financial position, and business goals. This article dives into the types of entity types available, the pros and cons of each type, and the tax implications. If you have any questions about which corporate structure is right for you, our experienced cannabis lawyers can help you understand the legal ramifications of choosing an entity. Contact us today to understand your options.
Pros and Cons of Business Entities
As mentioned, there are several options to pick among when choosing the corporate structure of your cannabis business. The option you select should be tailored to your specific needs, and can be any of the following types of entities:
- General Partnership (GP)
- Limited Partnership (LP)
- Limited Liability Partnership (LLP)
- Limited Liability Company (LLC)
This section will explore 1) what each type of entity structure is and 2) the pros and cons of each.
The biggest pro with general partnerships is that they are very straightforward to set up. Partnerships are formed when two or more people decide to operate a business for profit – that's it. You do not need to file any documents or execute any agreements to get your business up and running. It is essentially an unincorporated business where each business partner agrees to business responsibilities.
The glaring con that comes with general partnerships is that you will receive no liability protection. If a creditor sues the partnership, that creditor may be entitled to your personal assets, such as your home, car, and personal belongings. With a general partnership, you are personally liable for the debts of a partnership. This con makes general partnerships a risky and unappealing option for a cannabis business.
Limited Partnership and Limited Liability Partnerships
Limited partnerships have two different kinds of partners: general and limited partners. General partners are involved in the business's day-to-day operations, and they are typically liable for the debts and obligations of the company. Conversely, limited partners are not engaged in running the business. Still, they benefit from having their personal liability limited to the amount of their individual contribution to the partnership.
While it is a pro that some members do have limited liability, it is still a con that general partners have to take on total liability for business debts. A limited liability partnership (“LLP”) is where all partners have limited liability and are allowed to manage the business. LLPs are frequently used for professional service companies, like legal and accounting firms.
The biggest pro with LLPs is that all partners have limited liability protecting their personal assets. Another beneficial aspect of any partnership formation is that they offer flow-through taxation. This means that the partners only pay taxes on income earned through the partnership on their individual tax returns.
Limited Liability Company
Like a limited liability partnership, a limited liability company protects its owners from suits for their personal assets. LLCs are managed by the respective owners, called members, or by designated managers. One of the main advantages of selecting an LLC for cannabis cultivation is maximum operational flexibility.
LLCs allow decision-making power to be delegated to different people and for specific parameters to be set around that power. For example, cannabis businesses frequently select a manager or designate a managing member to handle the business's day-to-day operations. Meanwhile, more significant decisions, like real estate acquisitions or purchases above a specific dollar amount, are delegated to a majority or super-majority of the members.
LLCs are also relatively easy to maintain compared to a corporation. Corporations require board meetings, stock certificates and many other corporate governance documents. LLCs do not require the same level of burdensome paperwork and time demands for the entity's governance.
Moreover, LLCs have flexible tax reporting options, allowing the members to choose how they want the business to be taxed. An LLC can either be taxed as a partnership, where taxes are paid on the individual members' tax returns, or as a corporation, where the business pays taxes and the individual members pay taxes on the distributions they receive from the company.
It may sound like the LLC may be the way to go based on all these pros; however, there are two significant drawbacks to choosing an LLC for your cannabis business. First, it may be hard to get a consensus opinion on how to structure a business and draft an operating agreement for a larger LLC with 20 or more members. Larger LLCs can get stuck in decision-making gridlock, and disputes between members that can harm the operation of the business can occur. Second, an LLC may not be the best entity choice for raising outside capital. This is because corporations can more easily market shares to attract investors, whereas LLCs do not have the same ability with membership interests.
The C-corporation is a common entity structure for cannabis businesses. Unlike partnerships and most LLCs, it exists as a separate legal and tax entity from its shareholders. C-corporations are also the most defensible to debt, as the legal entity will absorb most of any built-up debt. C-corporations also make it easy to raise capital and bring on outside investors because the corporation can offer stock in exchange for investments. Finally, C-corporations can be useful vehicles on exit, with the 1202 capital gains exclusion as an appealing option.
Just like LLCs, C-corporations come with several disadvantages. First, corporations are quite burdensome to set up and require several different corporate governance documents to be filed regularly including, board meeting minutes, shareholder meeting minutes, and a table listing the owners and the amount of equity each owns.
Second, a corporation's internal structure is relatively rigid compared to an LLC, which doesn't allow for nuanced management structures. However, some may view this as a pro compared to a large LLC because the decision-making process in a corporation is more streamlined and reliable.
Finally, the biggest con with c-corporation is the "double taxation" problem. This "double" taxation refers to how the corporation pays an entity-level tax while the individual shareholders pay a separate tax on the dividends and salaries they receive from the company.
Unlike a C-corporation, an S-corporation passes its taxes through to its individual shareholders. This is seen as the main benefit of S-corporations compared to C-corporations, especially for potential owners who are worried about taxes eating into their profits.
However, S-corporations have several disadvantages, one of which can lead to a potentially devastating tax liability for shareholders. First, non-deductible business expenses pass through to individual shareholders in an S-corporation. Second, S-corporations are limited to having 100 shareholders, and shareholders must be US citizens or resident aliens. Third, in many cases, S-corporations are prohibited from seeking outside funding, greatly hindering the businesses' chances at success.
When Each Structure is Best
What cannabis entity structure makes sense in a situation will depend on the specific surrounding factual circumstances and goals of the business owners. Typically, smaller cannabis companies will choose the LLC structure, whereas larger companies with many owners will elect corporations.
Depending on the level of complexity of your potential cannabis business, you should strongly consider diversifying your entity structure based on the aspect of your business each entity will handle. For example, a partnership-taxed LLC generally holds the underlying real estate of a cannabis business. Moreover, Section 280E has a significant impact on how profitable your business could be based on the entity selection you make.
Significance of Section 280E on Entity Formations
One major mistake to avoid is overlooking the significance of Section 280E concerning structuring their overall cannabis entity structure. Section 280E of the Federal Tax Code mandates that legal cannabis companies can only deduct the cost of goods sold or the expenses in producing cannabis. This excludes costs associated with distribution, sale, administration, management, promotion, advertisement, and overhead as allowable deductions for provisioning centers under 280E.
The IRS has been directed to aggressively enforce 280E, which has resulted in audits that make profitable cannabis businesses on paper not profitable when a large tax bill is assessed. It is heavily advised that C-corporations be used for cultivation centers to prevent hefty tax bills from passing through to the owners.
Conversely, grow and processor entities reap more favorable benefits under 280E than provisioning centers. Grow and processor entities can deduct employee labor costs, rent, and most other costs associated with production. Therefore, forming grow and processor entities as S-corporations or LLCs would be a wise choice because these entities are significantly less likely to rack up a huge tax bill. Shareholders of a grow and processor S-corporation, or members of an LLC, will wind up paying fewer taxes on profits than a C-corporation because S-corporations and LLCs avoid the dreaded "double taxation" problem.
Making the Right Entity Choice Must be an Informed Decision
The cannabis market is a popular choice for aspiring business owners; cannabis sales hit a record $17.5 billion last year. Despite these startling numbers in this booming industry, success is not guaranteed. Building a successful cannabis business requires you to analyze your particular circumstances and future goals for your business and then tailor an overall cannabis business entity structure to fit those needs.
Be sure to meet with knowledgeable cannabis attorneys to discuss any regulatory implications. Each state has different licensing systems and processes, so it is important to consult with someone who understands your specific state's rules and regulations.
Further, do not overlook potential tax implications. Consider working with a CPA to determine the best way to structure your cannabis business for optimal tax treatment. Remember, it's worth investing a significant amount of time into planning your business before making any sales to avoid significant problems down the road.
Picking the right corporate structure for your cannabis decision may seem like a difficult decision. Our lawyers at Newburn Law have years of experience helping our cannabis business clients navigate cannabis laws and ensure they make the best choice.
Contact us today to learn how we can help you.