One of the most important decisions a new cannabis business can make is what form of entity it will use. In fact, one of the first questions businesses ask is whether the right entity for a cannabis business is a limited liability company (LLC), a corporation, or something else. Like virtually any other legal analysis, the answer depends on many company-specific factors. In this series, I detail some of the key points to consider when determining the right type of entity for a cannabis business. In my last two articles in this series, I looked at corporations and LLCs. In this third and final article in this series, I’ll look at some of the types of alternative businesses we’ve seen or heard of.
A Note on Limited Liability
For those of you who haven’t read my other two articles in this series, I want to define the concept of limited liability. Limited liability is one of the fundamental characteristics of certain types of businesses. If a person owns a corporation with limited liability protections, the person is generally not personally liable for debts, liabilities, etc. of the society. Except in a few limited scenarios, if the business is sued and loses, the owner will lose nothing except, at most, their investment in the business. But as mentioned, not all companies have limited liability by definition. I will discuss it below.
A note on taxation
In my previous articles, I have covered general tax principles applicable to corporations and LLCs. A company is taxed on its income. Then, if the company pays dividends to shareholders (after paying taxes on its income), the shareholders are taxed individually. This is commonly referred to as “double taxation” and the business structure is referred to as C-corporation. LLCs and partnerships, on the other hand, have transfer taxation, where the corporate form is essentially ignored (I’m oversimplifying) and the profits and losses of the business flow directly to its owners for tax purposes. There are advantages and disadvantages to each structure, which I have already covered. But taxation is another key area for selecting the right entity for a cannabis business.
A individual business is a single-person, unincorporated business. There is no legal distinction between the owner and the business. Even if a jurisdiction allows sole proprietors to obtain cannabis licenses, it is never the right entity for a cannabis business. It’s a bad option for any business, really, because there’s no limited liability. Limited liability is absolutely essential and is something you get by default in a corporation, LLC or other limited liability entity. Although there are certain expenses associated with setting up a business (filing fees, drafting legal documents, corporate taxes), this generally pales in comparison to the liabilities that could accrue personally when the house, cars or someone’s other personal property would be at stake.
Generally speaking, a partnership exists when two or more people come together to carry out a for-profit business. If people come together to form a corporation without forming an entity, this is called a “general partnership.” Like a sole proprietorship, partnerships do not have limited liability and are therefore never the right entity for a cannabis business.
Most states allow partners to form LLCs by making certain state filings and meeting certain governance formalities. As I said above, it really is a minute to ask when considering the downsides of not having limited liability. There are also entities called limited partnerships with limited partners and general partners. I can address limited partnerships in another article, as they can get quite complicated.
Partnerships are, like LLCs, taxed on a pass-through basis. People looking for C corporation taxation in a partnership type model usually opt for LLCs. With a few exceptions (LLPs for law or accounting firms and limited partnerships for funds), partnerships of any kind are quite rare for cannabis businesses.
DAO is the abbreviation of Decentralized Autonomous Organizations. This is a new type of entity that has started to appear in the Web3, NFT, and blockchain technology spaces. We’ve written about them at length here and here so I won’t repeat it all, but here’s a blurb that may help explain:
DAOs make it possible to create organizations on a cooperative and decentralized basis which can then achieve the common goals of their members. Smart contracts underpin the operations of a DAO by executing transactions between counterparties that automatically handle administrative tasks and related decision-making traditionally done by humans in management roles. Governance is then decentralized when control of smart contracts is transferred from DAO developers to DAO members.
So far I don’t know of any. authorized a cannabis business organized as a DAO, although it is likely licensed by state laws which broadly allow almost any type of entity to apply for a license. The problem with DAOs is that they rely heavily on smart contracts. This can help in simple organizations, but cannabis businesses are often much more complex to govern. So right now a DAO is probably not the right entity for a cannabis business.
Trusts and REITs
A trust is a legal relationship in which one party (referred to as a “trustee”, “grantor” or “grantor”) entrusts another party (“trustee”) with the holding of property for the benefit of a third party (beneficiary). Trusts are creatures of state law. State trust law varies widely – in terms of the types of trusts, whether a trustee can also be a beneficiary, and whether the trust is treated as a separate legal entity.
Personally, I have never seen a trust own a cannabis license. Instead, individuals often own cannabis businesses through trusts. This can get tricky for family trusts with beneficiaries under 21, as most states have age requirements for cannabis business ownership. Nonetheless, a trust with equity in a cannabis business is very common.
REIT is short for Real Estate Investment Trust. REITs are typically created to raise funds from third parties, and often in public markets (yes, even in the cannabis space). Their plans cover the full gamut of investments – from developing to operating and selling cannabis-related properties.
REITs are not subject to federal income tax. Instead, they are allowed to deduct the dividends they distribute to investors. They must have at least 100 shareholders and are only suitable for large-scale real estate investments. Again, this is not the type of entity you would see owning a cannabis license, although we see them investing in cannabis real estate all the time.
There are many types of business entities in the United States and abroad. Depending on the state, there are limited — and in some cases no — restrictions on the type of entity that can be used in a cannabis business. That’s not to say opting out of the societal model is a good idea. There’s a reason the majority of businesses in the space are corporations and LLCs. Nonetheless, whether an alternative business type is the right entity for a cannabis business depends on a number of business-specific factors, not a vacuum of analysis.
Stay tuned to the Canna Law blog for more articles on corporate cannabis issues.