One of the most fundamental questions facing any businessperson in the cannabis industry and every other industry is: “What type of business entity should I use?”
This is such a loaded question that your lawyer or accountant will first respond with, “That depends,” and then they will need to ask you at least ten follow-up questions to understand your goals and expectations, as well as the goals and expectations of your business partners and financiers. Some of these follow-on questions are tax-driven; others are regulatory-driven; others are dictated by financing relationships; and still others deal with control and flexibility within your business.
This is Part 1 of a two-part series. In Part 2, I will discuss more in depth the difference between and among various legal entities from which you can choose. For those who are wondering whether it is “really necessary” to use a business entity instead of just hanging out your shingle, know that your properly established and maintained business vehicle puts the “limited” in “limited liability.” And don’t forget insurance (here and here) and clean business contracts (here), both of which are also essential in helping you sleep at night.
Some types of industries are relatively low risk (NOT cannabis); some business owners are relatively judgment-proof (but it’s hard to start a business if you have no assets); and some business owners like to drive their cars without windshields and seat belts (neither they nor their businesses tend to last very long). I get that many potrepreneurs are used to taking on more than their fair share of risk, but my short response is: forming a business entity is a relatively inexpensive foundation upon which to build a solid business. Don’t ever cut corners in your business, but really don’t cut corners when it comes to your business entity (or getting good insurance or having great contracts in place).
Let’s go over some of these important questions to help you decide how to move forward with your entity selection.
The tax-related questions:
- Do you or any of your fellow owners need to offset revenue in other business ventures?
- Do you or any of your fellow owners need to maximize losses in this business venture? (i.e. will you be 50/50 in the business ownership, but your business partner wants to capture 100% of the losses in the startup years of the business?)
- Are any of your owners non-residents?
- If taxed as a pass-through, will you and other owners be prepared to pay all taxes owed while the company builds out its balance sheet?
- Does your business plan involve real estate ownership?
- Will your business own other assets that are likely to appreciate over time?
- What is the anticipated impact of IRC 280E and your business model?
The regulatory questions:
- Do your state’s cannabis regulations require you to use a particular business entity? (i.e. some states required all licensees to be nonprofit entities or “entities operated on a not-for-profit basis”).
- Do your state’s regulations require full transparency in entity ownership?
- If possible, do you want to keep some of the business’ owners out of the public eye?
The purpose-related questions:
- Are you going to operate your business with a specific mission so that you can draw investment funds from particular types of investors?
- Are you going to operate your business with a specific mission so that you can provide something good to the world by furthering education, providing charitable assistance, or stepping in to help where governmental resources cannot address needs in your community?
The financing-related questions:
- Do you intend to have outside financiers involved, such as private equity or venture capital? If so, have your prospective investors made any requests regarding the type of entity in which they prefer to invest?
- Do you intend to give all owners equal rights to profits, or do you intend to have different classes of ownership (i.e. preferred vs. common ownership interests and voting vs. nonvoting interests)?
- How many owners do you expect to have in the first five years of the business?
- Will any of your owners consist of C corps or S corps?
- Do you intend to take the company public as soon as your business model and U.S. laws permit it?
- How do you intend to get funds from the company to the owners: via salary, debt payments, distributions, or something else?
The control and flexibility-related questions:
- Do you intend to have a small group of owners or a larger group?
- Do you intend that all owners will have equal rights to profits and to decide when profits are distributed?
- Are you a part of the minority owner group or majority group?
- What type of governance structure do you envision working best for your company? Small or large?
- Do you intend to hire outside management for the business?
The answers to these questions will help your legal or tax advisor help you make the right decision on what type of entity to choose and what to do with that business entity. For instance, just because you are already using an LLC does not mean that you cannot take advantage of making a Subchapter S election with that LLC. You just need to have a good reason for doing so, time it correctly, and your accountant needs to know and agree with you. The same is true if you want your business to be taxed as a C corporation or you want to convert your entity to another type of entity.
In a future post we will dig in more deeply to the advantages and disadvantages in the various types of entities you can choose. Stay tuned!