Edward Culhane is a seasoned transactional attorney with hands-on experience running and managing legal cannabis businesses. Ed’s depth of knowledge in the industry, coupled with his history working with cannabis clients, makes him a true cannabis industry pioneer. We asked Ed, “What’s the Best Legal Entity for a New Cannabis Company?”
Before we dive into Ed’s answer, here’s a bit of background about Ed and how he began working in the cannabis sector.
Ed was a Partner at a large regional law firm in Minneapolis for 15 years. He specialized in private equity, venture capital, mergers and acquisitions, complex corporate transactions, and intellectual property transactions. His clients began investing and deploying capital in cannabis markets as early as 2014. Realizing the cannabis industry’s immense potential and his clients’ need for a cannabis legal expert, Ed began focusing on the cannabis industry.
In 2017, Ed left “Big Law” to help launch and be General Counsel for Mike Tyson’s cannabis company, Tyson Ranch, located in Los Angeles, CA. Now Ed’s national law practice assists cannabis and hemp business conduct private placements, execute joint ventures, acquire other companies or make a successful exit. Ed specializes in capital structures for cannabis companies, equity incentive plans, raising capital related ‘balance sheet’ issues.
What’s the Best Legal Entity for a New Cannabis Company?
Ed recommends that new cannabis companies form a holding company that is a Delaware LLC (“Holding Company”) that wholly owns a C-corp incorporated in the state where the cannabis operation is licensed (“Operating Company”). As explained below, there are specific reasons for this structure.
Structuring the Operating Company. Local cannabis regulators are familiar with the corporate structure in their state and expect the structure of the cannabis operator to conform to that statute. Many cannabis statutes and implementing rules simply do not contemplate limited liability companies and their more flexible governance practices. So applying for a cannabis license in a local corporation simplifies communication and interaction with cannabis regulators. Additionally, since business entities cannot be formed for an unlawful or illegal purpose, incorporating under the laws of the same state that issues the cannabis license dramatically decreases the risk that the Operating Company’s purpose is deemed to be unlawful.
Importantly, a C-corp doesn’t have pass-through tax treatment. To break this down, let’s say a cannabis operator experiences an adverse tax audit and faces an unexpected tax liability due to application of Section 280E, and owes $2,000,000 more in federal income taxes. If the operation is a C-corp, the tax liability generally stays with the C corp taxpayer. This is good because it gives the operators and their investors the option to either fund the tax deficiency or terminate the business. However, if the operation is taxed as a “pass-through” entity (like an LLC), the $2,000,000 tax liability will be distributed pro rata to the owners and investors, who would then be personally liable for their share of a $2,000,000 federal bill that is generally not dischargeable in bankruptcy. Ouch.
Structuring the Holding Company. Structuring the Holding Company as a Delaware LLC facilitates future efforts to raise capital because most investors know and are familiar with Delaware law. Having a corporate structure and cap table that looks like a typical emerging growth company makes it easier to raise capital or execute an exit.
Choices for Existing Cannabis Companies.
If the cannabis business is already established, Ed recommends that it seek the guidance of an experienced cannabis tax expert and experienced cannabis legal counsel to ascertain the consequences of making any changes to its corporate structure or tax election.
We Can Help.
If you own a cannabis business or are thinking about starting a cannabis business, we’d like to help. As a partnership of highly skilled and seasoned cannabis industry consultants and advisors, Bridge West Consulting is ready to guide you through this exciting and challenging landscape. Feel free to reach out to us anytime to schedule a consultation.