Choosing the Right Entity for a Cannabis Business: LLCs

One of the most important decisions a new cannabis business can make is the 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), corporation, or something else. Like basically every other legal analysis, the answer depends on a lot of business-specific factors.

In this series, I will break down some of the key points for consideration of the right entity type for a cannabis business. In my last post in this series, I looked at corporations. Today, I cover LLCs.

A note on limited liability

In case you didn’t read my last post in the series, I want to define the concept of limited liability. Limited liability is one of the fundamental features of an LLC. If a person owns an LLC, the person is generally not personally responsible for the debts, liabilities, etc. of the LLC. Except in a few limited scenarios, if the LLC is sued and loses, the owner won’t lose anything – except, at most, their investment in the LLC.

LLCs are usually the right entity for simplicity

In my post on corporations. I mentioned that corporations have a lot of highly specified formalities that depend on the state and type of corporation. LLCs are much more dynamic and simple to operate (at least from a corporate governance point of view).

Where corporations have shareholders, and directors, and officers, LLCs only need to have members (the owners). These kinds of LLCs are called “member-managed LLCs.” LLCs can also be organized as “manager-managed LLCs,” with managers who serve functions similar to directors and officers of a corporation. Managers can but need not be members of an LLC, and the LLC can allow the managers to appoint separate officers.

All of this is done via an LLC’s operating agreement and depending on state law. The point is that members of an LLC have a lot more flexibility to choose how an LLC is managed than shareholders of a corporation would. This can be very good for simplicity, for smaller businesses, for operating companies, and for startups or new entrepreneurs.

LLCs are flexible entities for taxation

As mentioned in my corporation post, corporations are taxed on income at a federal rate of 21% (“C-corporations”) though they can be taxed on a pass-through basis if the shareholders so elect and if they meet certain criteria (“S-corporations”). LLCs are the opposite. Single member LLCs are “disregarded” for taxation purposes and multi-member LLCs are also taxed on a pass-through basis (a.k.a. “partnership” tax status). This means that profits and losses of an LLC are treated as profits and losses of its members for tax purposes unless the LLC timely elects to have C-corporation taxation.

Generally, taxation as a partnership/flow-through entity will be more favorable for a cannabis business under the following circumstances:

• The individual tax brackets of the LLC members are below 37%;
• The individual member/partners qualify for the favorable 20% deduction for flow-through income under IRC section 199A;
• The business plan emphasizes distributing cash to investors over reinvesting cash into the business (growth);
• The business is not a retailer, and is able to claim a reasonable amount of costs of goods sold (COGS) in its tax reporting.

I would also add here that LLCs are usually not the right entity for a cannabis business looking to act as a holding company, or to go public. Of course, these are just examples and are not meant to serve as tax advice. Cannabis LLCs and their members need tailored guidance from tax professionals. But in most cases, this tends to be what we see.

Overall, most operating companies or small companies tend to think that an LLC is the right entity for a cannabis business. This isn’t always the case but it’s what I see in most situations. But like with corporations, choosing an LLC requires a situational analysis. In the next post in this series, I’ll look at some alternatives to corporations and LLCs.

Source: https://harrisbricken.com/cannalawblog/choosing-the-right-entity-for-a-cannabis-business-llcs/