Entity structure considerations for MSOs | Cannabis Business Executive – Cannabis and Marijuana industry news

Multi-state operators may need to weave a complex web when it comes to corporate structure. Operators entering new jurisdictions must consider many factors, the most significant being tax exposure, licensing restrictions, and potential exit scenarios as they determine which entity structures will best support their expansion and goals. The goal of structuring is to create…
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Multi-state operators may need to weave a complex web when it comes to corporate structure. Operators entering new jurisdictions must consider many factors, the most significant being tax exposure, licensing restrictions, and potential exit scenarios as they determine which entity structures will best support their expansion and goals.

The goal of structuring is to create an efficient model that benefits investors, is attractive to acquirers, and helps maximize gains and control taxes.

In most established (fully legalized) industries, the choice is often straightforward. Many start-ups will default to a limited liability company (LLC) that is treated as a partnership and reduces tax liability. In cannabis, however, industry-specific factors, such as restrictions on deductions (Internal Revenue Code 280E) and the likelihood of stock transactions in the event of a sale, make the entity choice less straightforward.

Look at tax exposure

One of the more straightforward considerations in entity structure when entering a new jurisdiction is the impact on owner/investor income taxes and cash flow. When initially structuring the entity, owners must determine when they anticipate receiving dividends. Would they prefer to wait a number of years and avoid a second layer of taxation, or do they expect immediate annual or semi-annual payments?

Owners of C Corps are essentially taxed twice on income: 21% is levied against the corporation, and another layer of tax at the personal level, which can be as much as 23.8%. In contrast, pass-through entity (S Corp or LLC) shareholders or members are taxed once on their share of the annual profit. In other industries, this tax benefit often provides a strong rationale for the pass-through entity structure, as tax advisors can be more aggressive in deducting expenses and lowering tax exposure.

When companies experience financial losses – certainly typical in the startup phase or when entering new states – pass-through entities can share those losses with shareholders and take advantage of them on their personal tax return. With a C Corp, on the other hand, losses remain inside the company until the organization reports income.

The nature of the cannabis industry negates many of the benefits of the pass-through entity structure. Tax code 280E restricts cannabis companies from deducting a significant range of expenses, making the carryforward of losses and the income reductions a moot point.

Look at state-specific licensing requirements and guidelines

Different licensing requirements and guidelines for dispensaries and cultivators in various states introduce opportunities to maximize the tax benefits of both C Corps and pass-through entities.

In some cases, it may be advisable to consider holding different cannabis licenses in different entities in order to take advantage of flow-through taxation or entity level taxation when appropriate.  There may be opportunities to maximize the tax savings with transactions between the various entities.

The result can be complex, but tax-efficient and advantageous for investors.

Look at your exit plan

Given the status of legalization (cannabis is still illegal at the Federal level), exit strategies for cannabis operators have in many cases involved acquirers listed on the Canadian stock exchange. Selling to a public company may mean an exchange of stock rather than cash, and a C Corp is the most well-suited entity structure for this scenario.

C Corps allow companies to conduct a tax-free stock transaction with an acquirer. Eventually, tax will come due when the stock is sold, however that liquidity event may be timed at the seller’s discretion. This gives the seller the opportunity to bide their time, waiting until the stock price increases in value before turning the sale into a taxable cash event.

C Corps also provide advantages under the qualified small business stock (QSBS) exemption. When owners have held stock in a company for more than five years, they may eliminate up to $10 million of gains on the sale of that stock. That translates into significant potential savings upon exit.

The choice of structure is not a one-size-fits-all recommendation—there is variation from web to web. MSOs must take time to understand owner goals, state-specific nuances, and their near or long-term exit strategy before settling on entity structure across their corporate holdings.

 

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