Jul 25 What Type of Business Entity Should Your Cannabis Company Be?
There are many factors for cannabis operators to consider when choosing the type of business entity to establish. The choice will ultimately have many tax and legal implications, and the most optimal choice will likely depend on your business’s specific circumstances. However, there are significant advantages and disadvantages to each business entity type that cannabis companies typically choose from. This is taken a step further because cannabis remains illegal on the federal level and is subject to IRC Section 280E which prohibits deductions and credits for companies carrying on trade or business involving the trafficking of controlled substances, such as cannabis. As a result, selecting a business entity becomes an even more difficult challenge. Cannabis companies are typically formed as either a partnership (through a limited liability company), a C corporation, or an S corporation.
Partnerships and S Corporations
Partnerships and S corporations are similar in that they are both referred to as “pass-through entities” as the income, deductions, credits, and losses are passed through to each owner’s tax return. Both avoid any double taxation that is seen with C corporations. However, because the tax liability is passed through to the owner, the owner is directly responsible for paying the onerous taxes created by IRC 280E. The tax being levied will occur regardless of the amount of distributions paid to the owners. This could result in a scenario where the tax liability exceeds the distributions paid out.
Additionally, self-employment taxes are typically assessed on the owners’ returns. S corporations have further restrictions on the number of owners in the entity and who can have ownership. Also, S corporations must pay owners “reasonable compensation,” which would be non-deductible due to IRC 280E.
C Corporations – Advantages and Disadvantages
Shareholders in C corporations have the advantage of not being personally responsible for the debts and obligations of the company. Under a C corporation, the corporation is responsible for the tax, and that liability does not pass through to the owners. However, any funds distributed to the shareholders as a dividend will be taxed individually. This is referred to as double taxation because the corporation first pays taxes on its profits. Then shareholders pay personal income taxes on the dividends received from the company’s profits.
However, C corporations tend to be favored by outside investors. As its typically a matter of when it comes to IRS audits of cannabis companies, not if, investors in a C corporation do not have to worry about an audit extending to their assets. This is typically seen as a significant advantage of C corporations over the other entity types, as protecting personal assets is a huge concern.
An additional advantage of a C corporation is that they can take advantage of IRC Section 1202, which allows eligible shareholders to potentially exclude from capital gains the greater of $10 million or ten times their basis in the corporation on the sale of qualified small business stock (“QSBS”). While Section 280E denies any deduction or credit, Section 1202 excludes a gain from tax recognition which means it is neither a deduction nor a credit. The resulting benefit of Section 1202 is a significantly reduced capital gains tax for the shareholder or potentially no tax liability at all at the time of sale.
To qualify as QSBS, the stock must satisfy all the following:
- Be a domestic C-corporation
- Have at least 80% of its assets used in an active trade or business
- Stock was issued after August 10, 1993
- Stock is owned by an individual or entity other than a C-corporation
- Stock was acquired by the owner on the original issuance
- Stock must be held for more than five years
Additionally, farming activities are prohibited from QSBS, which would likely prohibit cultivators from taking advantage of this tax law.
Each type of business entity has its pros and cons, and each cannabis operator needs to weigh all the factors when determining which one makes the most sense to them. Cannabis operators should evaluate their growth goals and their investors’ needs when determining the appropriate business entity type. A consultation with a qualified tax professional should occur before any business entity is picked to ensure that you choose the right entity for your company’s needs.
About the Author
Adam Holzberg, CPA, MBA is a Partner at Sax and focuses on increasing the overall operational efficiencies, financial reporting best practices, and internal controls for clients. As a member of the Sax Cannabis Practice, Adam supports companies from seed to sale in a variety of areas including but not limited to innovation and growth strategies, attestation services, tax compliance, and pre-licensing consulting. He can be reached at [email protected].