Which is the Right Structure for Your Cannabis Operation?
When planning for the future, cannabis business operators and entrepreneurs like you must make one essential decision that will have sweeping effects on the financial and operational path of your company: non-profit vs. for-profit. This deceptively simple question will affect everything, from how your company is organized, to your tax obligations, exit strategies, and more. As a professional services firm, we do not advise on the legal aspects of the decision -- that's best left to experienced cannabis industry attorneys -- but we can provide information on the tax and accounting ramifications. To help you make an informed decision, ELLO’s experienced professionals lay out the good and bad for each structure.
The Choice is New for Many
In California, all experienced cannabis operations are well-versed in life as a non-profit, as all the state’s cannabis operations were required to be non-profits before MAUCRSA took effect January 1, 2018. The non-profit requirement still stands for operations that choose to solely provide medicinal cannabis. But for operations considering expanding into adult-use cannabis, they can now choose between non-profit and for-profit.
What is a Non-Profit Cannabis Operation?
Generally speaking, a non-profit is an organization created to pursue a greater social good, and in pursuit of that purpose, is exempt from many state and federal taxes. Following are some more specific details of non-profit organizations:
- Non-profits do not have “owners” and are instead run by directors and officers, following the organization’s by-laws.
- Directors, officers and employees are paid a fair wage, but there are no distributions of assets or properties.
- Excess profits must be redirected into the organization or to another state-approved end (e.g. another non-profit organization).
Specific to the cannabis industry in California, most non-profit cannabis organizations are organized as mutual benefit corporations (“MBCs”). The major difference between traditional non-profits and MBCs is that when the MBC shuts down, it can freely distribute assets to its members, per organization by-laws. Additionally, an MBC can potentially merge with a for-profit corporation should the MBC want to transition to a for-profit organization (whereas a traditional non-profit has to be dissolved for a new for-profit business entity to be created).
Advantages and Disadvantages of being a Cannabis Non-Profit/Mutual Benefit Corporation
- Tax-free Operation: Non-profit corporations can receive exemptions from both state and federal corporate taxes, and from state and county local taxes.
- Protection from Personal Liability: As a non-profit, board members, officers, and employees are protected from liability for corporate debts and lawsuits. Creditors can only go after corporate assets, and not individual employees and volunteers. The legal ramifications can be complex, so it is necessary to discuss the details with qualified attorneys.
- Optimal Structure: Forming a non-profit requires a significant amount of planning and paperwork. A central part of this is the creation of by-laws, procedures, operating rules and a mission. Properly prepared rules about the delegation of authority can result in a smoothly run operation.
- Enduring Life of the Organization: Since there are no “owners” of a non-profit, in the traditional sense, the organization exists separately from its officers and employees. In this way it can continue operating long after the people who launch it move on.
- Additional Reporting/Paperwork: Attaining and maintain non-profit status requires diligent and detailed recordkeeping and paperwork. You must submit articles of incorporation to the state, create exacting by-laws, and keep minutes from meetings. And that’s just the start, hiring employees, achieving tax-free status, and employee taxes all require forms and approval.
- Cannot Take Distributions: As stated previously, a basic tenant of a non-profit is that any profits must be reinvested in the business and cannot be distributed to owners and employees.
- Cannot Sell Ownership: The key to many businesses getting off the ground is the ability to sell ownership stake/shares to raise capital. Since non-profits do not have “owners” this is impossible. Additionally, a non-profit cannot be purchased by a larger entity, so there is no opportunity for buy-outs.
- Strict Regulatory Compliance: Operation as a non-profit is contingent on state and federal approval of your status. As a result, non-profits are subject to strict reporting and compliance requirements. Failure to comply will result in the loss of non-profit status.
What are For-Profit Cannabis Operations?
For-profit organizations can take many forms (the CA Secretary of State’s office has a nice rundown of various entity types), but for cannabis ventures there are a few key entity types to focus on:
- C-/S-/B-Corporation: A legal entity that exists separately from its owners. The owners are protected from personal liability, taxes are levied on the corporation as well as on the shareholders. The sale of stocks or bonds can generate additional capital and the corporation can continue to exist with new owners. There are two major types of corporations:
- C-Corporation: Owners must pay personal income tax on profits and the business must pay corporate income tax. There are no restrictions on the number or nationality of shareholders.
- S-Corporation: This is a “pass-through” entity, meaning the business does not pay a corporate tax, and instead, income is reported on the owners' personal tax returns. There is a cap of 100 shareholders and they must be US citizens or resident aliens.
- B-Corporation: Also known as a "Benefit Corporation," this structure is new to California as of 2018 and many cannabis operations are exploring it. In short, it exists as a sort of middle ground between non-profit and for-profit structures, allowing for consideration of social goals, in addition to revenue growth. The B-Corp is an intriguing option that will be explored in its own article soon.
- Limited Liability Company (LLC): Considered the least complex for-profit structure, an LLC offers many benefits, including the ability to act as a “pass-through” entity, which avoids corporate tax, legal protections for owners, and there are no residency requirements. LLCs cannot sell ownership shares to create capital.
- Partnerships: There are a few different types of partnerships, but generally this is a business where two or more individuals are engaged to make a profit. There are varying amounts of liability, based on the type of partnership. These can operate as “pass-through” entities and there are no limits to the number of owners or nationality requirements. Also cannot sell ownership stakes to create capital.
- Sole Proprietorship: In this structure an individual owns and operates a business. The sole proprietor has total control of the business, receives all profits, and is responsible for business taxes and liabilities.
What are the Advantages and Disadvantages of Cannabis For-Profit Structures?
- Able to Distribute Profits: In general, for-profits have no restrictions on owners and employees enjoying the success of the business
- Able to Sell Shares: C- and S-corporations can sell ownership shares to attract investors and build capital.
- Flexibility to act as a “Pass-through” entity: For-profit structures that allow pass-through activity can limit the tax burden on owners and partners.
- Transferability of Ownership: For-profit structures allow a business to be transferred, purchased, or merged with other for-profit entities. This is attractive for entrepreneurs seeking to cash out upon exit.
- Liquidity of Assets: Should a for-profit business fail, there are no limits on the ability to sell company assets to pay debts or as a profit for the ownership.
- Tax on Profits: For-profit entities must pay taxes on profits, which can take a significant amount away from gross profit. Many businesses diligently utilize all available business income tax deductions, but deductions are limited for cannabis enterprises due to 280E restrictions.
- Distribute or Re-invest Profits?: Profitable businesses must make the difficult decision whether to reinvest earnings in further growth or to distribute to shareholders through dividend payments. The demands of shareholders could ultimately limit growth potential.
Which Cannabis Business Structure is Right for You?
Choosing the right structure is a complex question with a variety of answers that depend on the nature of your business, your long-term goals, and many other variables. Ultimately, you must consult with experienced legal advisors while deciding your choice of entity.
If you’d like to discuss the tax and accounting merits of for-profit and non-profit entities with ELLO’s experienced advisors, feel free to reach out to us.