Cannabis Entity Selection: Corporation, LLC or Something Else?

It’s a good time to revisit the very basics of cannabis company structuring, particularly in light of two new developments in 2018: tax reform and California state-wide legalization. Thus, this three part series “Reviewing Corporate Law Basics” will address:

• Part 1: Cannabis Entity Selection: Corporation, LLC or Something Else?
• Part 2: Equity Incentives for Your Startup: Restricted Stock, Stock Options, or Something Else?
• Part 3: Canna Exits in 2018: Sale, Merger, or Something Else?

Cannabis Entity Selection: Corporation, LLC or Something Else?

Prior to California’s Prop 64 taking effect on January 2018, entity selection for “direct operator” marijuana companies was relatively straightforward. State law required companies to operate on a not-for-profit basis, and non-profit mutual benefit corporations became pervasive, with a smattering of other non-profit entity types. In 2018, these not-for-profit entities are converting en masse to for-profit entities.

Transitioning companies, as well as new operators (both direct operators and ancillary companies), are asking the ever-popular early-stage question: should we be a corporation, an LLC, or an *insert creative choice*? Luckily, for most companies the decision becomes clear based on a few key factors. And for the remaining companies, the founders can make a decision based on their assumptions. Changing corporate forms is an option if necessary.

The tax analysis also should be considered, in conjunction with an expert in cannabis company taxation. A detailed analysis of your business’ goals and growth path are needed to do this analysis fully–and you should always consult your trusted corporate attorney–but this article may help you to consider the advantages and disadvantages of your options.

Note that we assume all companies will incorporate in California, which is the default recommendation for businesses in the cannabis space operating in California. However, even for an ancillary company that may choose to incorporate in Delaware, or the newest favorite – Nevada – the state-to-state analysis is not fundamentally different.

C Corporation

General Background.

Are you planning to raise funds through successive equity financings? Are you planning to raise funds from Institutional investors? If the answer to either of these questions is yes, then there’s a 90% chance that a C Corporation is right for you. If both answers are yes, then you’re certainly going to go with a C Corporation.

Simply put, a C Corporation is the overwhelming choice for companies that will raise funds, because of its ability to issue stock to investors, and create classes of preferred stock for equity investment rounds. Further, corporations have better options when it comes to issuing equity incentives to employees. While it’s true that an LLC can mimic a corporation in many respects, and can issue classes of “units” similar to stock – this non-standard structure offers no advantages for financing through equity investments, and it will severely limit the types of investors the business can approach. For a business seeking to get the best terms for an equity financing, immediately cutting out the majority of potentially interested investors makes little sense.

Further, even though an LLC can mimic a corporation in many respects, the differences in tax treatment of a C Corporation versus an LLC must be considered carefully.

Tax Considerations.

Previously we wrote about the tax consequences of entity selection. We also covered the fact that you can make a “tax election” to have your business be taxed as a C Corporation.

Before the Tax Cuts and Jobs Act (“TCJA”) the C corporation was not the first choice of closely-held businesses. The first drawback was that C corporations had a relatively high tax rate of 35%. Under the TCJA, that corporate rate was reduced to a flat 21%.

The second drawback, was the issue of “double taxation”. A corporation is subject to income tax at the entity level. In addition, dividend distributions are taxable to shareholders. Because of the historically high corporate tax rate, this double taxation generally discouraged companies from operating as C corporations.

Under the TCJA, a corporation and its shareholders are still subject to double taxation; however, the corporate tax rate has been lowered such that double taxation may still result in the most favorable tax outcome.

For example, a C corporation that earns $100,000 will pay tax of $21,000 ($100,000 *21%). If that same corporation dividends 100% of its earnings to shareholders, the maximum tax at the individual level is $23,800 ($100,000*23.8%). So the combined amount of tax is $44,800 ($21,000 + $23,800).  In comparison, a partnership (or S corporation) results in less overall tax to the owners $37,000 ($100,000 *37%).

However, a C corporation is the preferred structure if the plan is to limit the amount of dividends paid to shareholders. For example the total tax hit to a C corporation and its shareholders that paid out dividends of $50,000 is: $32,900 [$21,000+ $11,900($50,000 * 23.8%)]. In this case, a C Corporation saves $4,100 of taxes compared to operating as a partnership. The C Corporation has the additional benefit of insulating shareholders/owners from personal liability for federal income tax.

These parameters are why we recommend that our clients use their current business plan and think about how much cash they wish to distribute each year. From there they can use some real data to make a much better decision regarding entity formation,  We have run numbers for other clients to determine what entity structure best fits within their goals.  At the end of the day, a client that manages its cash distributions can operate as a C corporation and usually achieve a better tax result than being structured as a flow-through entity.

LLCs

General Background

If you answered “no” to the questions posed up top, and you can answer “yes” to any of the questions posed below, then an LLC may be right for your business.

Are you planning to keep the number of owners small? Do you anticipate the business will not require significant funding, or do you intend for the principals of the business to self-fund the company’s growth? Will you have a small number of capital partners, that you know are already comfortable with an LLC?

If so, an LLC could suit your business. The primary LLC advantages are:

• Ease of establishment and maintenance
• Ease of amendment
• Highly customizable

LLCs are set up by and managed through an Operating Agreement, which is essentially a contract between the LLC Members governing the management and structure of the business. As such, the Operating Agreement can be modified a myriad of ways, allowing the business to have fewer moving parts that require meetings and maintenance (such as shareholders and directors). LLCs are pass-through entities, meaning profits and losses pass through directly to the members. For a business with a few principals, this may keep it simple and straightforward. But for outside investors, the LLC may generate “unrelated business taxable income.”

Tax Considerations

Even if the company’s future fundraising plans are not determinative, sending you down the C Corporation path, founders should also undertake a detailed tax analysis before making their choice. Our firm has developed a model for determining whether a cannabis LLC should be treated as a partnership/flow-through entity or as a C Corporation for federal income tax purposes. Generally, taxation as a partnership/flow-through entity will be more favorable under the following circumstances:

• The individual tax brackets of the LLC members are below 37%;
• The individual member/partners qualify for the favorable 20% deduction for flow-through income under IRC section 199A;
• The business plan emphasizes distributing cash to investors over reinvesting cash into the business (growth).

Anecdotally, roughly ninety percent of our clients that go through the exercise of comparing LLCs and C Corps, end up choosing a C Corp. That said, a fair number are more comfortable with LLCs through their experience in real estate investing, private equity, or other business experience, and go with the LLC without much additional thought. By and large, these are businesses where the principals anticipate contributing their own capital to fund the company’s growth, or possibly reaching out to a small pool of capital partners or other financing.

Something Else

Cannabis investors and operators should also consider whether a hybrid structure would be advantageous. Real estate investors, for example, should consider the application of the Real Estate Investment Trust (“REIT”). The REIT is a legal entity not subject to federal income tax. Instead, a REIT may deduct dividends it distributes to investors, essentially acting as a conduit. REITs must have at least 100 shareholders and are suitable only for large scale investments.

Likewise, certain corporations may be treated as cooperatives under federal income tax law. Cooperatives may or may not be taxable entities under the federal income tax law. An organization that is considered a cooperative under state law does not mean that the organization is a cooperative (or tax-exempt) under federal income tax law. One possible advantage to operating as a federal cooperative is that certain patronage dividends are deductible by the co-op and taxable to the recipient. Cooperatives may avoid double taxation; however, the operating requirements are highly technical and strictly enforced.

There are a few other “hybrid” corporate forms that we regularly see proposed—the California Benefit Corporation and the Social Purpose Corporation. In essence, these entities require that corporate leadership consider factors in all business decisions: a Benefit Corporation must advance “general public benefit” and consider not only profit, but also how its business decisions affect its community, society, and the environment.

While these are commendable goals, B-corps can be problematic: any shareholder can bring a derivative lawsuit against the corporation alleging that its leadership, in any business decision, did not consider all of the required factors. Growth stage startups need to be able to make decisions quickly and confidently—and not under the constant threat of a suit. Also, from an investor point of view, B-Corps and Social Purpose Corporations often carry too many unknowns. Therefore, founders moving from a C-Corp to B-Corp may find their investors moving from a “Y” to “N.”

Stay tuned for parts 2 and 3 of this series, on equity incentives and company exits.

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Author: Carlton Willey