Choosing the right corporate structure can make or break your cannabis business. Applying for licenses, obtaining local permission, and raising capital are all essential and difficult steps in starting a cannabis business. But if you choose the wrong corporate structure, you will not be able to profit from your hard work. Even worse, you may face serious tax issues or criminal charges if you improperly structure your cannabis business.
For these reasons, you should consult with an experienced California marijuana business attorney who can advise you on incorporating a marijuana business and choosing the corporate structure that will protect your business from liability and crippling taxes. If you want to make the most out of your marijuana business, call McElfresh Law today at (858) 756-7107 for a consultation.
What Does Corporate Structure Mean?
Corporate structure refers to how your business is internally organized and formally registered with federal and California authorities. Different corporate structures will impact how your business’s profits get distributed, how your business and its owners get taxed, and whether you and your partners will be shielded from your business’s liabilities.
You may choose any of the following corporate structures for your business:
- Sole proprietorship- If you are the sole proprietor of your business and don’t register your company as a corporation, your business income will be taxed as your personal income. If someone sues your business, a court may order you to pay the judgment from your personal funds. This is the simplest and riskiest approach to starting a business.
- Partnership- The partnership is a business built from the capital and labor of two or more individuals. The partnership’s income is not taxed. Instead, each partner will pay taxes on their share of the partnership’s profits. Traditional partnerships do not shield partners from liabilities incurred by the business. Thus, most partnerships elect to register with the authorities as a limited liability partnership (LLP), which protects partners from civil liabilities much in the same manner as a corporation.
- Corporations- Corporations are separate legal entities from their owners, investors, and managers. If someone sues your company, they cannot recover damages from your personal assets. If your company owes a debt, you do not have to pay it out of your own pocket. So if your corporation goes bankrupt, it will not devastate your personal finances. Some corporations, such as limited liability corporations (LLC) or S corporations, are taxed like partnerships.
What Corporate Structure Offers the Most Federal Tax Advantages?
Most small businesses choose S corporation tax status, which offers so called “pass through” tax benefits similar to a partnership. This means that the state and federal authorities only tax the profit that passes through the company to its owners. If you are the owner of an S corporation, you would pay your business’s income tax on your personal tax filing. C corporations, on the other hand, do not offer these advantages. The authorities levy an income tax on your business and the profits that you receive from your business, which amounts to a double tax.
Owing to Internal Revenue Code Section 280E, the benefits of an S corporation are severely diminished when it comes to cannabis businesses. Under this law, you cannot claim business deductions on your company’s tax returns if your company engages in trafficking of a controlled substance – which cannabis remains, at the federal level. This means that cannabis businesses get taxed on their gross income instead of their net income.
If you claim regular business deduction anyways, as many cannabis businesses do, the Internal Revenue Service (IRS) may eventually send you a bill for back taxes. If you are the owner of an S corporation, you are liable for your company’s taxes. But if you are a C corporation, you cannot be held liable for the taxes owed by your business. Thus, you can choose to be an S corporation and pay less taxes while facing the possibility of huge tax liability. Or you could pay higher taxes as a C corporation, and enjoy the certainty that you won’t be held liable if the IRS come after you under Section 280E.
Does Corporate Structure Matter for My State Taxes?
Legal marijuana businesses are allowed to take deductions on their state taxes, unlike for their federal taxes. Besides this point, the taxation of your cannabis company will be similar at the state and federal levels. If you pay your taxes as an S Corporation at the federal level, you would do the same at the state level.
If you have registered as an LLC, you may elect to pay both your federal and state taxes as either a sole proprietorship, a partnership, or a corporation. For example, you cannot choose to pay your state taxes as a corporation, and your federal taxes as a partnership in the hopes of minimizing the effect of section 280E.
How Do I Register My Company?
If you intend to be a sole proprietorship, you do not need to register your company, but for other corporate forms, you must take formal steps to open your business. Before you register with the California Secretary of State, you’ll need to choose a name, and an agent who can accept service of process (court papers) if someone sues you. Both the registration of the name and the agent may cost a small fee.
Unless you are registering an LLC, you do not need to draft an operating agreement for your company. Even if you aren’t required to, it is a good idea to have a written record of how you intend your business will be managed. The operating agreement, which you should write with the help of a business lawyer, should touch on the following topics:
- Your investors or LLC members, what they contribute, and what portion of profits they receive
- The rights and duties of your LLC members
- The management structure of your company and its day-to-day operations
- How members may “cash out” of the business, or transfer their interest to someone else
- How you can amend the operating agreement
If you are starting a corporation, you will need to prepare articles of incorporation. This is a form in which you provide the Secretary of State with your company’s name, purpose, address, and registered agent. LLCs require a similar form including the same information, but it’s called articles of organization. For partnerships, you need to submit a statement of partnership authority, which again includes the same information.
Once you have completed the necessary documents, you must send them to the Secretary of State along with the appropriate fees. Compared to choosing a corporate form, incorporating your business is a straightforward process. Before you incorporate, you should seek the counsel of an experienced California marijuana lawyer who can help you choose the corporate structure that will maximize the potential of your business.
McElfresh Law Can Help
At McElfresh Law, attorney Jessica McElfresh has built a reputation by helping San Diego cannabis businesses navigate complex regulations and fend off criminal and administrative action from the authorities. If you want to give your business the best chance of succeeding, call her today at (858) 756-7107 for a consultation about your marijuana business.