By Heather Burke
With commercial cannabis permits coming online throughout California, farmers across the state are interested in forming entities to protect their farms and personal assets. Before rushing in, it is wise to first critically assess the different entity choices when making their decision.
First, know your options . That is, know each entity structure available to you. Second, understand the benefits and burdens of each option. While the old cannabis rules required cannabis companies to operate as nonprofits, the new rules have NO requirement that your company be a nonprofit moving forward. Given this change, most companies elect a traditional “startup” structure for their businesses, which generally involves operating through either a limited liability company (“LLC”) or Corporation.
While farmers are encouraged to fully consider creative corporations like benefit corporations (“b corps”), social purpose corporations, and the new cannabis cooperative model, this blog will focus on the taxing and legal differences between the two primary choices, (1) LLCs and (2) Corporations.
Part 1 . THE TAXING STUFF
Income Taxes
Single-member LLCs (i.e. LLCs with one owner) are generally considered “disregarded entities” for tax purposes. This means, for tax purposes only , the LLC is ignored and all of the entity’s income is taxed to the owner as if the entity did not exist. Consequently, the owner needs to report all of the entity’s income on his or her personal tax return and is responsible for personally paying any tax due on such income.
Multi-member LLCs are generally treated as partnerships for tax purposes, meaning that the income of the entity is “passed through” to its owners, typically in proportion to their ownership interests in the company. A partnership needs to file its own tax return, but all of the income reported on that return is passed through to the owners and reported on each owner’s personal tax return . The owners, again, are responsible for paying any tax due on the company’s income.
In contrast, a corporation is generally treated as its own taxpayer.[1] a corporation files its own return and is responsible for paying its own taxes. Additionally, if the corporation makes distributions in a given year to its owners (called “dividends”), the owners are taxed on the dividends that they receive. This is what is referred to as “double taxation” because the company pays tax on its income at the time it is earned and the owners are again taxed on any dividends they receive in the year the dividends are paid. Although this system can be punitive, the Tax Cut and Jobs Act of 2017 significantly reduced the corporate tax rate and dividend payments can qualify for reduced tax rates if structured properly.
Notably, an LLC can essentially elect at any time to be taxed as a corporation. This can generally be done without adverse tax consequences and without actually changing the overall form of the company (i.e., the company will still be an LLC for all purposes other than tax). A corporation (or an LLC that has elected to be taxed as a corporation), however, cannot convert to an LLC (or elect to be taxed as a pass through entity) without potentially adverse tax consequences.
Employment Taxes
Although income taxes are a significant factor when determining which type of entity to use, employment taxes also must be considered. For single-member LLCs and multi-member LLCs, owners typically have to pay self-employment taxes, which are significantly higher than the typical payroll taxes an employee pays.
For corporations, owners are only taxed when they receive dividends. The corporation and its employees will be responsible for their portion of any payroll taxes due.
In certain circumstances, this can result in a corporation actually having a lower overall tax burden than an LLC despite a corporation being subject to “double taxation.”
Part 2 . THE LEGAL STUFF
Protection from Liability
However, although an LLC does offer protection against personal liability (e.g. if you’re sued), members of an LLC may be personally liable for any additional tax owed due to the LLC’s nature as a “pass-through” entity. Essentially, if you are personally responsible for the company’s tax liability, you will also be personally responsible for any tax increases that the IRS imposes upon an audit of such entity. You will not, however, otherwise be held responsible for the debts and obligations of the company other than taxes.
Although a Corporation is responsible for its own taxes and thus is audited differently, liability protection for lawsuits is not really that different between the two entity types. At the margins, a corporation may offer a little more protection from personal liability, but in day-to-day operations, there is not really a distinction as long as corporate formalities are followed.
One of the biggest benefits to the Corporation is that it can completely segregate certain business operations. This can be extremely helpful for §280E purposes since business lines subject to §280E can be segregated from other business lines that generally wouldn’t be subject to §280E, which is more difficult to do when pass-through entities are used.
Thus, if a farmer is also involved in different types of business other than the farm, such as selling branded items, taking rental income, or even different license types such as distribution and/or retail , it is critically important that farmer discusses this issue more fully with an experienced attorney or CPA.
Regulatory Distinctions
In the California cannabis context, a corporation may be more attractive to investors because an investor can hold up to 20 percent of the company without being an “owner” for the purpose of state cannabis licensing and the required background checks. For the LLC, any “managing” member is considered an “owner” for state regulatory purposes, so a member-managed LLC may not be an attractive entity structure if you’re seeking investment in the near future.
Corporate Formalities
LLCs tend to have fewer legal formalities, such as required meetings, which is one reason farmers are often drawn to LLCs over corporations. While some formalities in the corporation can be waived, the corporation may require you give your company a little more attention than if it were an LLC. However, since the commercial cannabis industry is already subject to massive regulatory obligations, the corporate formalities shouldn’t be too difficult for the compliant farmer.
Conclusion
To understand these options more fully, it is critical to consult with a lawyer or a CPA familiar with California’s complex cannabis laws when choosing which entity type is best for your particular farm. Protecting yourself in the new regulated era means knowing your options and making an informed decision about how you do business.
What you do today matters to the future of your farm, so please think about it now!
#protectourfarmers #madrespect
The information in this article is provided for general informational purposes only, and may not reflect the current law in your jurisdiction. No information contained in this post should be construed as legal advice from Greenspoon Marder LLP or the individual author(s), nor is it intended to be a substitute for legal counsel on any subject matter. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this Post without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from a lawyer licensed in the recipient’s state, country or other appropriate licensing jurisdiction.
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