In any industry how you set up your business matters, cannabis business owners specifically need to weigh the pros and cons of their business structure. The type of entity you form is one of the most important decisions you'll make as a cannabis business owner. Your choice will affect your tax and legal obligations, as well as your ability to raise capital, attract investors, and plan for growth.
The Redbud Advisors team are experts in business structure for the cannabis industry. We work with clients to help them select the best entity for their business. There isn’t a “one size fits all” option. Because of our expertise, we bring you information on how your business entity affects your cannabis business.
Where to Start
When starting any business there are a million decisions to be made from the entity structure to the name. This can all be overwhelming to someone who might not be versed in every aspect of starting or restructuring a business.
One of the first things you will need to decide is how to structure your business entity. This is important because it will literally set your business up for success or potentially set you back.
There are many entity types for business and selecting the right one is challenging, especially if you do not have a good understanding of the advantages and disadvantages. Below Redbud Advisors will break down the entity type and the advantages and disadvantages for cannabis businesses.
Business Entity Types- Advantages and Disadvantages
Unfortunately, there isn’t a one size fits all business entity that is designed for a cannabis business to best suit the complexities of the IRC 280E and maximize allowable deductions.
Sole Proprietorship
A sole proprietorship is typically one owner. This person takes the responsibility for any debts and liabilities. The owner reports their income and expenses on their personal taxes.
This entity is referred to as a single-member entity for income tax purposes meaning the income is only taxed once and the owner can deduct up to 20% of qualified business income through 2026. This is also known as Qualified Business Income (QBI) deduction and has not yet been challenged in tax court for cannabis businesses so it is an area up for debate by many accountants because it is considered a “deduction” and as you know with IRC 280E there are “no deductions or credits.”
A sole proprietorship is the easiest entity to set up because there are no additional forms to get started and it isn’t regulated much by the government. This is also the easiest business entity to dismantle or restructure.
An advantage to a sole proprietorship is the ease and the tax breaks. This is a good option if you are starting out and your business will bring in less than $50,000 in net revenue.
A disadvantage of a sole proprietorship is there is no government protection because this business is not registered. This means all liabilities fall to the business owner. If you ever find yourself in hot water because of your business there is no separation between business assets and personal assets. A sole proprietorship can run into issues with funding as well.
A sole proprietorship is ideal for small businesses bringing in less than $50,000 in net revenue and looking to simplify being a business owner.
Partnership
A partnership is owned by two or more individuals with a contractual business agreement. These business owners typically will share in the business's profit and the business's loss equally. A partnership is considered a pass-through entity.
In a partnership, the business owners report their share of the income and losses on their personal tax returns, just like in a sole proprietorship. There can be tax breaks associated with a partnership entity.
It is important to note there are a variety of partnership entities and we are talking about a general partnership specifically.
An advantage to a partnership is the ease involved with starting up. The owners can file for an Employee Identification Number (EIN) or use their social security number to pay taxes.
A disadvantage of a partnership is the lack of government protection. Partners assume liabilities of the business as there is no separation from business assets or personal assets. Also depending on the type of partnership you are in you may also be liable for self-employment taxes.
Corporations
There are a variety of corporate entities but we will focus on a C corporation (C Corp) and an S corporation (S Corp).
It is essential to understand there are strict requirements a business must meet to be eligible to operate as any type of corporation. There is paperwork that needs to be filed with both the IRS and the state. A corporation has to comply with state and federal regulations.
Corporations are not run by the shareholders- they employ directions and officers. If a shareholder decides to sell their shares in the corporation it can still exist and function.
C Corporation
A C Corp has no limit to the number of shareholders allowed and is a separate legal entity. The C Corp is responsible for its income, liabilities, assets, and taxes. Establishing a C Corp gives owners protection from personal liability.
C Corps are taxed on profits at the corporate level and again at the shareholder level. A C Corp is allowed multiple classes of stock. This type of business entity allows for more capital and investment opportunities.
An advantage of a C Corp is the protection of personal liability. The ability to raise capital through the sale of stock and not be subjected to a capital gains tax. Another advantage is the flat federal and sometimes state tax. In some states, it’s more favorable to be taxed as a Corporation because they allow you to add back the non-deductible 280E expenses that are not allowed at the federal level.
The disadvantages of a C Corp are ease and taxation. If you are looking for an easy way to start a business this probably isn’t it. Taxation is another disadvantage as C Corps are subject to double taxation - meaning the Corporation pays tax and then if you take a dividend you personally will be taxed on that as well. It’s not always a bad thing, but something you don’t want to overlook.
If you own a medium business or a high-risk business, like a cannabis business, this is a good entity option for you typically. If you are looking to expand and grow your business this can be a good option as well as investors are attracted to C Corp entities.
S Corporation
An S Corporation must file with the IRS and the state along with meeting the strict guidelines of a C Corp. S Corps are a corporation that is treated as a pass-through entity for tax purposes, eliminating corporate taxation. An S Corp is eligible to have one class of stock.
S Corps comes with the security of limited liability protection. But very much like a partnership all profits or losses are passed through to its shareholders who report their share of income on personal tax returns.
Depending on the state your cannabis business is located an S Corp can be subject to different standards of taxation.
An advantage of an S Corp is the limited liability protection you receive with a C Corp but the ability to avoid corporate taxation because it is a pass-through entity. Another advantage is being able to file taxes as a C Corp if needed easily, this is as simple as checking a box if requirements are met.
A disadvantage of an S Corp is the strict qualifications, only one class of stock, and attracting fewer investors.
If you want your business to have the advantages of a corporation without double taxation this entity type might be a good fit.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is subject to state regulations and can be different from state to state. When starting an LLC check with the state your business is located for specific regulations.
An LLC can be owned by an individual, a corporation, another LLC, or even a foreign entity. LLCs provide limited liability protection to owners eliminating the owners from personal liability in most cases.
Classification of an LLC can be a partnership, corporation, or disregarded entity. Converting or filing taxes as a partnership or a corporation when your business entity is an LLC is relatively easy. Owners will be responsible for self-employment tax.
The advantages of an LLC is the combination of the pass-through taxation of an S Corp with the limited liability protection of a corporation. Establishing an LLC is straightforward and simplified taxation.
The disadvantages of an LLC are not being a viable option if your overall goal is to have a publicly traded company. An LLC, depending on the state regulations, upon the bankruptcy or death of a member may need to be dissolved.
An LLC is a good business entity option if you are a small to medium business owner who is looking for more protection than a sole proprietorship but fewer hassles than a corporation.
Conclusion
As a cannabis business owner, there are many business entity options to choose from. This is not a decision that should be taken lightly and business owners should consider their long-term goals as well as their initial goals when starting or restructuring a business.
Unfortunately, there isn’t a one size fits all business entity that is designed for a cannabis business to best suit the complexities of the IRC 280E and maximize allowable deductions. At Redbud Advisors we always recommend discussing entity structure with your accountant or your attorney to find the best possible solution for your business.
If you don’t have an accountant or an attorney don’t worry. Redbud Advisors is a full-service cannabis accounting firm ready to assist you with any questions you may have about entity structure or other business-related needs.
