NOTE: When forming a legal entity it is best that all parties involved seek experienced, informed legal counsel. Preferably a tax AND corporate attorney that can help guide you in making legal decisions.
At the inception of a Cannabis or CBD company, one of the most important first steps is to decide on the entity structure, where the client will be deciding how the business will be taxed, how equity will be dispersed when investors come on board, and how to protect the assets of owners, among other considerations.
There are so many things to consider during this crucial stage, so if a Cannabis or CBD CEO approaches you and wants to know…
“What’s the best entity structure for my Cannabis business…?”
The answer should always be…
“It all depends.”
There are a number of factors to consider when deciding which entity structure to go with, but ultimately you want to start with a Cannabis CEO’s end goal. As a trained Cannabis accountant you will want to ask your clients a series of questions, such as:
These are just a few of many questions that you should be asking your clients.
There are a ton of scenarios, and there are financial implications that must be considered for shareholders, owners, and future investors. Let’s examine a few (of many).
LLCs tend to be a favorite for lawyers and accountants alike due to the ease of setup, management, and compliance.
There’s less paperwork, and it’s more straightforward in terms of accounting. Also, taxation is a bit more straightforward. 199a can be a bit confusing, and there’s a lot of considerations, but if there seems to be a benefit for all parties involved, then LLCs can be the ideal choice (although be aware this format may come with higher risks). However, individual financial situations need to be considered and future investment goals must be evaluated before defaulting to forming as an LLC.
Let’s say an owner has a wealthy family member that wants to invest in a Cannabis company. If the majority owner of a farm doesn’t have as many assets, the capital investor needs to consider asset protection more than tax minimization in most situations.
And let’s say each owner has different financial goals and tax situations.
199a for LLCs and flow-throughs may be great for the one owner, but it may be a better benefit for the investor with a ton of money to form the company as a C corp. While one owner may benefit one way, the investor with more personal wealth may need to have their considerations prioritized since they have a lot more to lose if things go awry.
The biggest downfall of LLCs is the ability to pierce the corporate veil when audited by the IRS or even in the event of a lawsuit. There’s limited liability protection, and that’s incredibly important for investors to consider. The potential for liability exposure with LLCs is much greater and often gets overlooked. Taking the easy route can be costly for investors, especially if they aren’t involved in the day-to-day operations. They will need air tight accounting in order to protect their investment first and foremost. And if for some reason the operators are negligent, state agencies and the IRS can and will come after all investors in an effort to collect fines.
Investors who also choose to go the LLC/flow-through route also need to ensure that forced distributions are included in the operating agreement so that owners aren’t on the hook to pay the tax bills out of pocket each year. Forced distributions would or could, at the very least, provide relief for investors so that the taxes are paid via company distributions, and not passed on to the owners, especially if they aren’t receiving money from their investment until they are able to exit.
Remember, 280E is incredibly crippling for Cannabis companies, and it’s not uncommon for owners to have to be on the hook for a huge tax bill if the operating agreements aren’t set up properly (even if cash balances are low). A passive investor could end up having to pay taxes on an investment year after year, so it’s best to ensure that they understand their tax obligations for each entity type so that they can ensure that they are protected. Flow-through/LLC strategies can create major headaches for investors if they aren’t careful.
C corps are much harder to set up and are more costly to maintain. As a startup, Cannabis companies may not even consider setting up a C corp for this reason; however, if they are counting on raising capital from investors, they may have to just figure it out, as C corps are much more desirable investment vehicles.
C corps make it easier to raise capital, easier for exits (potential 1202 capital gain exclusion is appealing), and are much better in regards to protecting personal assets. If the Cannabis company gets audited, they won’t be able to pull your personal stuff into the mix. They can only audit the business.
Aside from how costly it is to form and maintain a C corp, the greatest disadvantage to owners and investors is the corporate tax rate and double taxation. As the corporate tax rate gets debated and is in flux, inevitable increases in the tax rate can create additional burden on these businesses that are already subject to a huge tax burden.
Going back to the burden of setting up a Cannabis C corp, the company will need:
LLCs really only require a few of these items and are less of a pain for the company to maintain.
Oh, we forgot to mention that C corps also require board meeting minutes (ongoing), shareholder meeting minutes (ongoing), and a maintained cap table that lists the owners and the amount of equity owned by each. Whew!
Multiple entity structures can provide the most asset protection for investors. Having a C corp as a holding company of multiple LLCs - for example - can help owners and investors make the most of the benefits of each entity type, and maximize their tax savings. Also, if you have non-Cannabis divisions, it may be easier to mitigate tax liabilities, open bank accounts, obtain other forms of financing, and more. You’re also able to allow investors to invest in different aspects of the business as well which may give you more options when raising capital and expanding the business.
The key to employing a multiple entity structure that is effective for Cannabis companies is to not try to beat 280E as the only goal. It simply won’t work. There needs to be a real business purpose for each entity.
Setting up multiple entities requires even more work than C corps. And while it does provide the highest level of asset protection, each entity must maintain its own books, intercompany transactions must be properly recorded, there’s more tax returns and filings, there’s a possibility for consolidations, and the amount of legal docs that one must maintain is insane. So if your client is leaning towards a multiple entity structure for asset protection, it is good to know what it does protect, what it doesn’t, and what you’re required to do with multiple entities.
First things first, you’re going to need to make sure your client has a good corporate attorney on board. There are way too many legal docs involved, so don’t rush to Legal Zoom to set up your entity. Take the time to ensure your client has an attorney (a tax attorney, as well if you know of one), and be very clear about the goals for the business so that they have the proper guidance.
And just so that we are clear… do not allow your clients to choose an entity structure just because they want to beat 280E. The IRS is winning almost all of its cases; therefore, it likely won’t end well. Help your clients prioritize protecting their assets, and ensure that the business is in position to raise capital and take on investors at any time. If you cover these bases, you’ll be in good shape.
Want to learn more about accounting and the various entity structures? In our webinar about entity structures we discuss this in greater detail, and cover more details that should be considered. Click here to check it out!