By Avis Bulbulyan
Whether expanding an existing operation or transitioning into the regulated landscape of cannabis, one of the challenges many individuals face is how to structure their business. While no two cannabis businesses are the same, the general considerations for structuring any business are indistinguishable.
When considering different corporate formations, the general goal is to structure the business in a manner which effectively limits personal liability and maximizes the business’s profit retention while also issuing as much earnings as possible to its owners.
The most common business formation structures in the cannabis industry are C Corporations (‘C Corp.’), S Corporations (‘S Corp.’) and limited liability companies (‘LLC’), therefore the discussion below will be limited to the aforementioned business structures.
With the exception of two key distinguishing characters, an S Corp. and C Corp. are quite similar. These basic corporate structures create a divide between the individual shareholders (owners) and the debts and liabilities the business entity might incur. The distinctions are twofold: (1) C Corps. are double taxation entities, whereas S Corps. are pass-through entities; (2) S Corps. are limited to 100 owners, whereas the structure of a C Corp. allows an unlimited number of owners, thereby allowing the company to go public to raise investments.
LLC’s are a fairly new business structure with very little legal precedent to guide us. As a result, LLC’s are not regulated by a governing agency in the same manner as C and S Corps. LLC’s are often described as the hybrid structure of a corporation and a partnership because they have acquired features from both.
For instance, an LLC is much like a partnership because the owners of the LLC, whether members or managers, have the liberty to manage and operate the business under the agreed-upon terms in the business’s operating agreement. And similar to S Corps., LLC’s are pass-through entities. Similar to corporations, LLC’s may be formed as a manager-managed entity, creating a divide between silent investors and operators.
The following are three significant factors that should be considered when determining how best to structure your own business.
280 E Tax Implications:
Generally, when filing federal tax returns, businesses can subtract ordinary business expenses from its annual gross income, and pay tax on the deducted value. However, the Internal Revenue Code precludes operators and owners from deducting ordinary business expenses from their gross income if the expense is related to the “trafficking” of a Schedule I or Schedule II substance as defined by the Controlled Substances Act.1
Despite state legalization, cannabis remains a Schedule I controlled substance, thereby affecting even business that have lawfully obtained a local and/or state authorization to operate their cannabis business. Without this deduction a cannabis business may be taxed more than the amount the business actually makes in a given year. Therefore, understanding 280E and its application is critical to the long-term success of your business.
Administrative costs, employee salaries and storage expenses are being strictly scrutinized under 280E. However, the courts have yet to overturn the binary business structure employed by a San Francisco dispensary, where the ordinary cost of providing ancillary services or products were proportionately deductible.2
While 280E impacts all cannabis operators, certain activities within the cannabis supply chain experience larger issues when considering the cost implications. For retail operators, the implications of 280E can be a primary factor when considering which type of business structure to pursue, since the costs and risks of operating a retail dispensary are higher than other operations.
Pass through vs. double taxation
When considering business structure in light of 280E implications, the thought largely rests on how much tax liability will be incurred and who will incur it. The issues are indivisible. Though to answer the ‘who’, a more profound analysis of how businesses are taxed is necessary.
As stated above, the nature of a C Corp. will yield the company and its owners to double taxation, whereas LLC’s and S Corps. yield owners to single taxation. In essence, a C Corp. will be taxed once to the business itself, and again to the shareholder who receives a dividend. While this results in double taxation, it shields the owners of the C Corp. from being personally liable for the taxes of the business entity.
Any cannabis business owner should consider if, and how a double taxation or pass through taxation might advantage or disadvantage their cannabis business.
For example, a retail dispensary operating as a C Corp. will always have to pay the business tax; it is owners will be individually liable for the second taxation if the business operates at a profit and the owners receive a dividend.
On the other hand, a retail dispensary operating as an LLC or S Corp., whether profitable or not, will have to file income taxes. Under this scenario, the owners of the dispensary will be personally responsible for the tax consequences even if the dispensary operates at a loss.
Generally, LLC’s allow the owners more freedom in the management structure of the business as well as allowing owners to implement creative paybacks or fringe benefit structures.
Disclosure: This article is not intended to act as legal advice. Please consult with an attorney and tax advisor.