Budding Companies: Forming Cannabis Startups
By Charles S. Alovisetti, Partner
Sep 6, 2019
Welcome to the first post in our “Budding Companies: Forming Cannabis Startups” series, where we explore different issues involved in the formation of new marijuana and hemp companies!
Setting up a cannabis company correctly from the start is critical, especially if the ultimate goal is to take on outside capital, exit, or take a company public. Investors, buyers, and the capital markets all have certain expectations regarding corporate organization and governance, and will often balk or require some kind of corporate restructuring or purchase price reduction if they feel a company’s governance is not up to par.
There are additional complexities at play for any entity in the cannabis industry, as either a license-holding company or an ancillary business. That’s why it’s so beneficial to take the time to make sure the company is set up correctly at the onset. Fixing mistakes later can be more expensive.
If the goal is not to seek outside capital or a potential exit, as might be the case for a family-owned farm, the considerations are different. This series of posts will focus on the typical scenario for a cannabis business the founders hope to scale rapidly using outside capital and eventually exit or take public.
First things first: Entity choice
An initial and critical issue when starting a new business is what entity type to use. There are numerous entity types available, but most startups are set up as corporations or limited liability companies (LLCs). The purpose of this post is not to tell entrepreneurs what entity type to select when forming a company; that’s a business decision for the founders. Instead, we’ll explore the pros and cons of using corporations and LLCs so founders can make an informed decision.
LLCs and corporations are taxed in fundamentally different ways. A corporation is a separate tax-paying entity, meaning that a corporation pays an income tax (currently 21% at the federal level). In addition, if dividends are issued to shareholders, those shareholders must pay an additional tax on these dividends. This is called “double taxation” because the corporation’s profits are being taxed at two levels. An LLC, on the other hand, is a pass-through entity for tax purposes and any gains are directly allocated to its members, who pay individual taxes on their profits (up to 37% at the federal level).
If a corporation loses money, these losses are only available to the corporation itself to reduce taxes and not to its shareholders. However, with an LLC, losses, deductions and other tax benefit items generally pass through to its members and may offset other income on their individual tax returns (though this advantage is subject to some key limitations).
While double taxation can result in earnings being subject to a higher effective tax rate before making it into the owners’ hands and may initially seem like a material negative to using a corporation, there are some advantages. Firstly, a corporation can help shield shareholders from personal tax liability related to 280E, the section of the IRS tax code that disallows ordinary business deductions if a business is engaged in trafficking a Schedule I or II substance. This is critical to cannabis corporations as marijuana, though not hemp, remains on Schedule I. Since the average cannabis company’s tax rate is often significantly higher than that of a business not subject to 280E, phantom income often gets allocated to owners in entities taxed as partnerships (such as LLCs), meaning these equity holders owe more taxes than the cash they received pursuant to their ownership stake. Since initial tax liability falls on the entity, this is not an issue in a corporation. This also protects the shareholders, who will generally only need to pay taxes when they receive a dividend.
Finally, the pass-through taxation of an LLC can create issues when the company takes on debt. The cancellation of debt, which may occur in a convertible note financing, bankruptcy, or in another circumstance, can create income for an LLC that results in recognition of ordinary income to the members in an amount equal to the canceled debt. Members may have losses previously allocated to them to use to offset this gain, but this may not always be the case. It can also make it challenging to do convertible note financing transactions, which are a popular structure for raising capital for early-stage companies.
It should be noted that a corporation can make an S corporation election and be taxed as a pass-through entity (i.e., the corporation itself is not subject to federal income tax and the shareholders are taxed upon their allocated share of the income). This can be an option for a small business or family operation, but it is not practical for a business that may seek outside capital to finance the growth of its operations. An S corporation may only have individuals or trusts as shareholders and can only have one class of shares – this makes it impossible to issue preferred equity or to have institutional investors (since these investors would use entities to hold their equity stakes).
It is also possible for an LLC to elect to be taxed as a c-corporation, which would allow it to avoid the complexities of pass-through taxation, while still taking advantage of the greater flexibility of the LLC form. For purposes of this article, unless otherwise noted, it is assumed that corporations have not made an S corporation election and LLCs have not elected to be taxed as c-corporations.
Click here to read Part 2 in the Budding Companies: Forming Cannabis Startups Series, where we discuss double taxation and 280E, the IRS tax code that disallows ordinary business deductions if a business is engaged in trafficking a Schedule I or II substance.