Cannabis tax lawyer 280EWhen folks in the medical and adult use marijuana industries hear “280E,” they tent to shudder since they know it means a large protion of their revenues will be going to the IRS without the usual deductions. However, just this week, Grover Norquist, a GOP political advocate and the well-known president of Americans for Tax Reform (which favors repealing 280E), opined that our GOP-led Congress may enact sweeping tax reform this year that would reduce the stress of 280E on state-legal marijuana businesses by lowering corporate income tax rates.

In case you missed it, 280E is the provision of the Internal Revenue Code creates such an onerous tax burden for cannabis businesses because it provides as follows:

“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”

Congress passed 280E in 1982 in response to a Tax Court ruling that a taxpayer could deduct expenses relating to his sales of cocaine, amphetamine, and marijuana. Deductible expenses included the costs of packaging, travel, and even scales used to weigh the illegal substances. This is no longer possible in the world of 280E.

Since cannabis is a Schedule I controlled substance, the IRS uses 280E to disallow marijuana businesses from deducting their ordinary and necessary business expenses. The result is that marijuana companies — regardless of their legality under state law –face higher federal tax rates than similar companies in other industries. There are differing opinions on the level of tax rates imposed on marijuana companies – from 40% to 70% to as high as 90% – all of which are higher than the 35% corporate tax rate paid by most other businesses in the United States.

But if Norquist’s predictions are accurate, there may be a bit of light at the end of the 280E tunnel for cannabis businesses. though if Norquist’s predictions are accurate. In an interview with MJ Business Daily, Norquist stated:

There’s a big tax bill this year – the tax reform package that takes corporate rates to 20% – which solves some of the problem for marijuana producers because now you’re paying 20% on all your sales instead of 35%. But we still need to get normal and reasonable and legal deductions made legal and normal for the marijuana industry, as well as for all other industries. Marijuana could get into that package if some of the libertarian Republicans made that a condition of voting for the whole package.

*  *  *  *

So, as we build support for a fix, we need to build support state by state, where we say, “Look, you don’t want federal tax law used to gut the effectiveness of federalism. Because you could say something can be legal at the state level, but if the federal government is going to tax it into oblivion, you really haven’t allowed federalism at all.

Norquist then went on to predict these tax law changes will occur within the “next few years.” Though our cannabis tax lawyers do see cannabis tax changes coming, they are less confident than Norquist on timing. There has been no successful standalone 280E fix bill in Congress and the current presidential administration’s back and forth policies on marijuana legalization make predicting such federal action difficult. But with legalization in California and marijuana reform in 28 other states and more coming soon, the odds of Congress rectifying this tax situation are increasing. We cannot and should not expect favorable 280E changes from either the Tax Court or the IRS unless and until Congress mandates such changes. It is therefore good to know that such changes are at least on the table.

Oregon cannabis lawyersOur Oregon office forms three or four cannabis companies per week. Our Washington office has formed hundreds of these businesses in the past four or five years, and our California office has seen a major uptick in company formation work since AUMA passed last fall. Though every state brings unique considerations for entity choice and structuring, most of these businesses (outside California) end up registering as either LLCs or C-corps. And most of them involve owners who bring different things to the table.

The most common example of differing contributions comes when one person brings skill and labor to the table, while another brings cash. The “sweat equity” partner may have expertise and relationships related to production or processing of cannabis, for example, while the traditional equity partner has the ability to immediately fund the marijuana business. In a classic scenario, these two individuals come to one of our cannabis business lawyers and say they would like to own the business “50/50”, or thereabouts. This raises some serious tax implications for the sweat equity partner.

The Internal Revenue Code values capital over labor, especially when that labor constitutes future services a person will contribute to a business in exchange for ownership. From the IRS’ perspective, if Party A contributes $100,000 in cash to an LLC or corporation, and gives a 50% interest to Party B (for a sweat equity contribution), the IRS will also value Party B’s interest at $100,000. Unfortunately, Party B will have to pay tax on that income, which is sometimes referred to as “phantom income.”

The following are a few of the more common ways to deal with phantom income in a situation where one member of a cannabis business provides the capital, and the other provides services:

Vesting. It is possible to have the sweat equity partner’s interest vest over time, through options allocated to that partner under a shareholder or operating agreement. The sweat equity partner will purchase and pay for his or her equity through distributions or dividends earned as an owner of the company. The vesting schedule here is very important. If the schedule is too long, the value of the membership (and the amount payable) may increase. If the schedule is too short, repayment may not be viable.

Company Loan. Often, the partner without cash at the onset will issue a promissory note to the company. Here, the sweat equity partner is acknowledging having received a valuable interest in the company, for which he or she owes a debt. The promissory note can be made with a commercially reasonable repayment period and interest rate, and the member can pay down the note with income received from the company. It is important to remember, though, that the note payments will be made from taxable income. This is simply a way to extend the tax hit over time.

Owner Loan. Sometimes, neither partner will contribute a sizable amount of cash up front. Instead, both partners will contribute a nominal amount, like $1,000, and the partner with cash will make a loan to the LLC. This option should be considered carefully, for a couple of reasons. First, from a tax liability perspective, the IRS may consider a company with a debt to equity ratio over 3:1 or 4:1 to be “thinly capitalized” and subject to scrutiny. From a legal liability perspective, an undercapitalized company may leave its owners open to vicarious liability on a “piercing the corporate veil” theory.

The above are simplified, high-level summaries of common methods lawyers and CPAs use to deal with phantom income in cannabis start-ups. It is important to note that each situation is unique and depends on a variety of factors. It is also important to note that sweat equity is not the only way phantom income is created in cannabis companies. Almost all pot companies have some amount of phantom income due to IRC 280, for example. That rule alone is a crucial business planning consideration for every marijuana entrepreneur.

Legal and tax structuring are critical decisions that can determine whether a marijuana venture succeeds or fails. Learning to look out for phantom income is key part of this analysis. That’s true for both sweat equity and cash investors — especially in this unique and highly dynamic industry.

California CannabisOn January 18, 2017, California state regulators attended a cannabis event in Sacramento to discuss cannabis policy and what lies ahead for California. Though previous reports indicated that California cannabis licensing could be delayed for an additional year, state regulators at the event promised a licensing program would be operational by January 1, 2018.

Lori Ajax, the Chief of the California Bureau of Medical Cannabis Regulation (soon to be renamed again to the Bureau of Marijuana Control under Proposition 64), told the audience:

We will not fail. We will make this happen by Jan. 1, 2018, because we have to […] It may not be pretty. But we will get there.”

Since Prop 64 passed last November, California regulators are now in charge of crafting comprehensive regulations and issuing state licenses to not only medical marijuana businesses but to recreational cannabis businesses as well. This includes 17 license types for medical businesses and 19 licenses types for recreational businesses, covering cultivation, manufacturing, retail dispensaries, distribution, testing, and transportation. The authority to regulate and license these cannabis businesses is divided among ten California state agencies.

The California Department of Food and Agricultural will oversee cannabis cultivation activities, and it created a new division, the CalCannabis Cultivation Licensing program, to issue permits and develop regulations for cultivators, including setting up a track and trace system for all cannabis plants that enter the California market. Amber Morris, a branch chief for CalCannabis Cultivation Licensing, was also in attendance at the event in Sacramento and she said that California state departments are working with economists to create a tiered permit fee program that will assign fees to cannabis cultivators based on the size and scale of their businesses.

A big challenge faced by state regulators is the lack of banking available to cannabis businesses and affiliated companies. Ajax expressed her hope that there would be some clarity on the matter by the time state licenses are issued, stating that banking is “a challenge for us, too. As we set up our online permitting system, we would like to accept credit cards. We don’t want to have to accept wads of cash.”

The banking issue has been high on the mind of California lawmakers, as we get closer to statewide regulation. In December, California Treasurer John Chiang wrote a letter to President Donald Trump seeking guidance ahead of California’s licensing program. In his letter, Chiang wrote that the new program could “exacerbate” the banking problem because California’s cannabis economy will be so large.

Due to federal prohibition on marijuana and anti-money laundering regulations issued by the Financial Crimes Enforcement Network (FinCEN), banks are reluctant to work with cannabis businesses. The banking challenge is not unique to California and it affects businesses in legal marijuana states across the United States. Several U.S. senators sent a letter to FinCEN in December asking for more guidance and explaining how the dearth of cannabis banking promotes tax fraud and creates a public safety issue because cannabis businesses are forced to deal in large amounts of cash.

Under the new California cannabis licensing program, state agencies will need to collect fees from licensed cannabis businesses. Yet most of these agencies have only one office — in Sacramento — which means anyone paying their fees in cash will need to carry that cash with them all the way to the capitol. To address this issue, California legislators recently introduced new legislation to increase the number of government offices that can accept payments from cannabis businesses for state fees and taxes. The legislation, known as the Cannabis Safe Payment Act, is sponsored by the Board of Equalization (BOE), which has been collecting sales tax from California medical marijuana businesses since 1996.

The BOE currently accepts payments in cash from cannabis businesses at its 22 offices across the state. However, to reach these offices, many California cannabis cultivators have to travel great distances with “bags of cash” in their cars, which BOE Chairwoman Fiona Ma agrees “is not the safest method of paying your taxes.” Thus, Ma states that the BOE’s “priority has to be increasing safety—for the business owner, the public, law enforcement, and state employees by enabling cannabis businesses to pay their taxes and fees in as many a safe and secure locations as possible.” Under the Cannabis Safe Payment Act, California counties that receive approval by board of supervisors and tax collectors will be able to accept cash payments from local cannabis businesses on behalf of the BOE and other state agencies.

With promises from the Marijuana Bureau to begin issuing state licenses by January 1, 2018, collaboration from state agencies to develop regulations and set permit fees, and efforts from state lawmakers to alleviate banking challenge, California legislators are showing they are hard at work creating a viable state licensing program for cannabis businesses. For cannabis businesses planning to take advantage of California’s new cannabis program, a lot of work lies ahead and you should start preparing now.

California cannabis attorneyCalifornia officially legalized recreational cannabis on November 8, 2016 through Proposition 64, and the next day several provisions under the initiative went into effect. Cannabis users in California over the age of 21 now have new freedoms to possess, use and even cultivate cannabis for their personal use. In contrast, marijuana businesses will have to wait until January 1, 2018 to receive their state licenses to cultivate, manufacture, and sell recreational cannabis in California. Prop 64 also applies new state level marijuana taxes to licensed businesses. A cultivation tax will be assessed on all harvested marijuana that enters the commercial market and collected from commercial cultivators. In addition, a 15% marijuana excise tax will be assessed on any retail sales of cannabis and collected by dispensaries. However, for qualified patients or caregivers who provide dispensaries with a Medical Marijuana Identification Card, Prop 64 exempts them from having to pay additional sales and use tax on top of the 15% excise tax.

The provisions of Prop 64 for both the cultivation tax and excise tax specifically state that they are “[e]ffective January 1, 2018,” but this language is not included in the subsection regarding the sales and use tax exemption for medical marijuana patients. While the authors of Prop 64 state that this was an unintentional error in drafting, the California Board of Equalization (BOE) has ruled that under the language of Prop 64, medical marijuana patients are immediately exempt from any sales tax. The BOE even went so far as to send letters to dispensaries across the state advising them to stop collecting sales and use tax as of November 9th.

What all this means is as of now through the end of 2017, the small percentage of medical marijuana patients in California who have or obtain a state-issued ID card can take advantage of this unintended tax break. California reportedly brings in around $50 million in annual tax revenue from sales of medical marijuana and some are worried that the state could miss out on millions in tax revenue through 2017. However, others claim that the effects will not be so great as currently only about 6,000 patients in California have the state-issued ID cards necessary to claim the exemption. The impact of the error may depend on how many California patients actually take the time (and the $100) it takes to register with the state as well as whether dispensaries will check for ID cards or simply offer their customers an unlawful discount. Considering most dispensaries do not bother to collect and pay sales tax at all, it’s hard to tell what effect this could have on California’s tax revenue next year.

The supporters of Prop 64 are also looking for a way to correct the problem if the BOE does not change its interpretation. One solution would be for two-thirds of the state legislature to amend the language, as is required under Prop 64, but this would not occur until the next legislative session begins in January. Alternatively, if California’s newly elected Attorney General Kamala Harris decides to weigh in with a more definitive ruling, we could see a swift end to this unintentional tax break. For now, cannabis consumers in California can enjoy a marijuana tax holiday, just in time for the holiday season.

California cannabis taxesOn November 8, Californians will have the chance to vote to legalize recreational cannabis use through Proposition 64 (also known as the Adult Use of Marijuana Act, or AUMA). In addition to legalizing and regulating recreational cannabis across the state, Prop 64 will also add state level taxes for licensed dispensaries and cultivators.

Beginning in 2018, a 15% marijuana excise tax would be assessed on the gross receipts of any retail sales of cannabis. Though the tax is technically owed by the purchaser of the marijuana or marijuana product, the obligation to collect the tax is on the seller (e.g. the dispensary) as with other sales and use taxes applied in California. There is an exception to the excise tax for sales of medical cannabis and medical cannabis products, but only if a qualified patient or caregiver provides a Medical Marijuana Identification Card issued by the state. Though the decision to register as a medical marijuana patient with California has until now been completely voluntary, Proposition 6 will require a card if a patient seeks to avoid paying the 15% state tax.

Also beginning in 2018, a cultivation tax on all harvested marijuana that enters the commercial market will be assessed at a rate of $9.25 per ounce of flowers and $2.75 per ounce of leaves. The tax will be collected from licensed cultivators but excludes any marijuana cultivated for personal use or by a qualified patient or primary caregiver under California’s Compassionate Use Act.

In addition to the potential state level tax, both the Medical Cannabis Regulation and Safety Act (MCRSA), which regulates medical cannabis businesses in California, and Prop 64 grant authority to California cities and counties to impose local taxes on licensed cannabis businesses. Thus, several municipalities have included local tax measures on the November 8 ballot as well.

In Northern California, proposed tax measures for cultivators in Lake County, Calaveras County, Monterey County, and Humboldt County will be assessed based on total square footage of the grow. Mendocino County has two separate tax measures on the ballot, one from the County’s Board or Supervisors and one from local cannabis advocates, both with a 2.5% tax based on gross sales of medical marijuana but with the latter including a higher 5% tax on recreational sales.

In Southern California, a proposed tax measure in San Diego will tax dispensaries starting at a rate of 5% and rising to 8% in 2019. This falls within the range of local taxes for dispensaries currently in place in major California cities like Los Angeles, Long Beach, Palm Springs, San Jose, Oakland, Sacramento, Stockton, and Berkeley. Palm Springs and Cathedral City are currently tied for the highest local taxes in California with rates of up to 15%, but a tax measure in Santa Barbara could begin taxing businesses there at a rate of 20%. Stockton and Berkeley are currently tied for the lowest local taxes at a rate of 2.5%, though a November tax measure could raise tax rates in Stockton if passed. Several of the desert towns in the Southern California region have also recently started permitting and taxing cannabis businesses in an effort to raise tax revenue to bolster their local economies. Coachella will vote on a measure to add taxes of up to 6% on gross sales and $15 per square foot of space each quarter.

Any marijuana taxes are assessed on top of California’s usual state and local sales taxes that are determined based on locality. Currently those tax rates range from 7.5% to 10%, which means with everything added together some cannabis businesses could be looking at an effective tax rate of almost 45%. For California cannabis businesses owners, as well as for any California cannabis consumers concerned about the prices they pay, a lot will be at stake during November’s elections.

Cannabis taxesIt is no secret that taxes are a big problem for the marijuana industry. Cannabis businesses are regularly hit by exorbitantly high tax bills on the federal, state, and local level, and often marijuana excise taxes are assessed on top of the standard business taxes. Some cannabis business owners have been fighting back, but usually to no avail. On August 30th, California lawmakers offered cannabis businesses a sliver of hope by passing Assembly Bill 567, which, if approved, would create a tax amnesty program for certain California collectives under the Medical Cannabis Tax Amnesty Act.

The Board of Equalization (BOE) is responsible for collecting sales tax owed on any sales of products to consumers in the state of California. Generally, sales of tangible personal property are taxable unless an exemption applies. The BOE has repeatedly declared that medical cannabis and cannabis-related products are included in tangible personal property subject to state sales taxes. In fact, the BOE has provided a guide for marijuana businesses on its website that explains how sales tax applies specifically to dispensaries and growers in California.

Still, the legislature admits in the bill that “the uncertainty created by state and federal differences has left medical cannabis-related businesses with the fear that compliance with state tax laws could lead to federal prosecution. Thus, many of these businesses have been noncompliant since their inception, and would owe massive penalties and interest if they were to come into compliance.”

According to BOE estimates, there are currently 1,623 medical marijuana dispensaries operating in California and two-thirds of cannabis businesses have not paid taxes due on their sales of marijuana to consumers. This estimate is based on the rate of unpaid taxes in other legal cannabis states, such as Colorado. In total, that would mean that California cannabis retailers owe the state about $106 million. Though the amnesty program would not forgive this debt in its entirety (and don’t hold your breath that the state would ever do this), the program would waive all penalties applied to any assessed tax liabilities.

At a penalty rate of 25 to 50 percent of the total tax liability, penalties can add up quickly, especially if a business hasn’t paid its taxes over the course of several years. The amnesty program would take place over a six-month period in late 2017, from July 1, 2017 to December 31, 2017. Tax liabilities due before January 1, 2015 would qualify for amnesty under the program. Even with the penalty waiver, the BOE estimates that it will be able to collect between $27.4 million and $54.7 million in past due taxes.

In addition to the penalty waiver, the bill would also provide amnesty from criminal prosecution for tax evasion to any business that comes forward and pays its taxes (and interest) owed. However, for the businesses that do not step forward and take advantage of the amnesty program, the bill requires the Department of Consumer Affairs refuse to issue them a state cannabis license or suspend their existing state-issued license. These “deadbeat” businesses, as BOE chairman Jerome Horton called them, could also be facing “audits, investigations, prosecutions and arrests.”

The bill is currently in the hands of California Governor Jerry Brown, who will have the option either to approve or deny the program. For any California cannabis business owners who know they owe sales tax, this is an issue you will want to follow closely. But even outside the implications for delinquent taxpayers, this move by California lawmakers is a further indication that they are taking the tax matter seriously and businesses that do not pay their taxes will not be receiving a cannabis license from the state once new statewide regulations take over.

EDITOR’S NOTE: Speaking of California cannabis, three of our California cannabis lawyers (Tiffany Wu, Alison Malsbury and Hilary Bricken) will be putting on a FREE webinar this Wednesday (September 14), moderated by our lead cannabis corporate lawyer (Robert McVay). This webinar will focus on what you should be doing now to prepare your existing or future cannabis business for California’s soon to be legalized landscape. Go here on Eventbrite to sign up to attend.Get your free tickets now and attend on Wednesday!

California cannabis lawyers
Los Angeles County? Better have a Plan B.

Until recently, the “Wild West” of U.S. cannabis lacked robust statewide regulations which left California cannabis companies subject to unclear rules and risk of federal shutdowns. The Medical Marijuana Regulation and Safety Act (MMRSA) created these regulations, but ultimately left control in the hands of local cities and counties.

At last count, California has 58 counties and 482 incorporated cities across the state, each with the option to create its own rules or ban marijuana altogether. In this California Cannabis Countdown series, we plan to cover who is banning, who is waiting, and who is embracing the change to legalize marijuana — permits, regulations, taxes and all. For each city and county, we’ll discuss its location, history with cannabis, current law, and proposed law to give you a clearer picture of where to locate your cannabis business, how to keep it legal, and what you will and won’t be allowed to do. Our last California Cannabis Countdown post was on the City of Los Angeles, and before that, the City of Desert Hot SpringsSonoma County, the City of Sacramento, the City of BerkeleyCalaveras CountyMonterey County and the City of Emeryville.

Welcome to the California Cannabis Countdown.

Continue Reading The California Cannabis Countdown: Los Angeles County

Cannabis Taxes
Cannabis Taxes: Few things are more certain.

Though it is commonly said that nothing is certain but death and taxes, this doesn’t stop people from trying to cheat both. In the cannabis industry, the uncertainty of the current status of federal and state laws only magnifies the issue and many marijuana business owners fail to file returns and pay taxes due for years at a time. But as the industry is slowly finding out, failing to pay  your tax liabilities usually doesn’t payoff in the long run.

On the federal side, the Internal Revenue Service assesses huge tax liabilities through Section 280E even though cannabis remains illegal under federal law. The proper way to determine those taxes is still being battled out in well-publicized Tax Court cases. However, there is movement on the state side as well, with lawsuits being filed in several states with regulated (and taxed) marijuana systems in attempts to avoid paying state and local taxes altogether.

Recently, a medical marijuana dispensary owner in California tried to argue that since the dispensary is organized as a collective under state law, it is not technically selling marijuana, but instead accepting “equitable contributions” from patients who cultivate the marijuana collectively. Consequently, since no sales have occurred, no sales tax can be collected. The California district court didn’t buy this argument and instead ruled that the dispensary owed the city of San Jose $767,058 in taxes and fees due to its failure to pay the city’s Marijuana Business Tax since 2012.

In Washington State, another dispensary owner took a different approach and sued the state in federal court claiming that because he was under federal prosecution, he could not be forced to pay state and local marijuana taxes without waiving his Fifth Amendment right against self-incrimination. The lawsuit challenged the state’s authority to tax marijuana businesses in conflict of federal law where sales of marijuana are illegal. That case is currently on appeal and set for court this September.

In Colorado, an attorney filed a similar lawsuit against the state’s governor and the mayor of Denver, also claiming that paying special marijuana taxes levied by the state violate an individual’s right against self-incrimination for dealing in an illegal controlled substance under federal law. The plaintiffs in this lawsuit went one step further and argued that the state of Colorado is knowingly participating in illegal money laundering by collecting taxes from the marijuana businesses.

The potential tax revenue from marijuana businesses is a big incentive for states to legalize medical and recreational marijuana. Reports estimate that total marijuana tax revenue in 2016 will grow to over $180 million for Colorado and over $130 million for Washington, and project that California could gross over $640 million per year at a 15% excise tax rate. There is a lot at stake for both states and marijuana businesses and thus the fight over taxes is unlikely to die down anytime soon.

For current marijuana business owners, the fight is oftentimes more personal. If you don’t file tax returns, an audit will be painful and may even result in your business going under if you can’t afford to pay back taxes.  Bankruptcy courts do not allow marijuana businesses to file for bankruptcy to avoid tax liabilities by reorganizing their businesses or liquidating their assets. This means those taxes will stay with the business and may even follow you personally if you ultimately decide to shut it down. Some taxes, like state sales and payroll taxes, are always the responsibility of the business owners, which means that if liabilities are assessed, the state can come after your personal accounts and assets to collect. Tax audits in the cannabis industry often result in hundreds of thousands of dollars in tax liabilities even when tax returns are filed with the best intentions. Shoddy record keeping and reliance on poor tax advice are not excuses for failure to pay taxes due.

Finally, don’t think that just because you haven’t been audited for last year’s return you are in the clear.  Government agencies tend to be years behind on reviewing returns and they generally will look several years back once an audit has begun. With interest and penalties accruing all the while, the longer you wait, the bigger your tax problem grows. If you are striving to operate a legally compliant marijuana businesses, it is crucial you properly record, compute, and timely pay your taxes on the local, state, and federal level. This is not an area to cut corners as the costs you save now will be pennies compared to what you’ll end up paying later. If you need tax help, get it now, as tax problems definitely do not improve with age.

Cannabis excise taxesHigh Times has a column out this week arguing against excise taxes for marijuana. The main point is that excise taxes on marijuana are unfair to consumers because they aren’t proportional to the harm caused by marijuana. Marijuana taxes are higher, for example, than alcohol taxes, even though alcohol is a more dangerous product. The column also argues that revenues from these taxes are not steady, as they are tied to wholesale prices which are rapidly declining. Since marijuana excise taxes are neither tied to harm nor do they generate steady revenues, they should be dropped entirely or kept as low as possible.

Are marijuana excise taxes really that unfair? Continue Reading Cannabis Excise Taxes: Are They Fair?

Cannabis Business LawyerI recently worked on a relatively typical, relatively straight-forward LLC member buyout of a cannabis business. Member A wants to stay with the company, but Member B is ready to exit. Member A will be the sole Member of the company after the purchase. The parties have agreed on a price and on payment terms, but major questions emerged: What is the mechanism of purchase? Is Member A buying directly from Member B, or is the company itself buying the interest back? Does it even matter?

Setting aside this example for a moment, minority buy-ins and buy-outs in closely held cannabis companies are coming up more and more often in states with more mature cannabis marketplaces. The mechanism of these transactions depends on several factors, the most important being entity form. Corporations work in very different ways than LLCs do in this regard. Corporations are primarily creatures of statute, with the inherent rights stock ownership grants to stockholders largely determined by state law. LLCs, on the other hand, are creatures of contract. The precise meaning of “membership interest,” “membership unit,” and other oft-used terms vary widely between entities, as all of these terms are defined predominantly in LLC operating agreements.

Looking at buyouts from a corporation perspective, the main question is who is doing the buying? There are four main choices here:

  1. The corporation itself
  2. Corporate officers and directors
  3. Other shareholders
  4. Third parties

When a corporation repurchases stock directly, it may be doing a favor to a shareholder looking for liquidity, or it may be signaling that current shareholders and management think the stock is worth more than the repurchase price. In all circumstances, there are some short terms pros and cons for the remaining investors. On one hand, the total number of outstanding shares of the company has just decreased, meaning that each investor owns a proportionally higher stake of the company. On the other hand, the company has likely used cash it could have used for company investment or even shareholder dividends to pay off a few selling shareholders. Otherwise, the remaining shareholders don’t see much change.

When individuals are involved in the buyout, there are a few other concerns. In general, directors and officers of a corporation cannot take opportunities for themselves that they don’t grant to shareholders at large companies. Separate agreements that corporate shareholders often enter into, including voting agreements, management rights agreements, and right of first refusal agreements, can alter these rules somewhat. When members of management are doing the purchasing directly from the owners that are being bought out, the shareholders that aren’t involved in the transaction don’t see their proportional ownership of the company change at all. The shareholders involved in buying out the exiting shareholder will see all of their proportional interests increase, but the source of the repurchase resources are different as well. These resources must come from personal funds, not corporate funds. Remaining shareholders in these circumstances may not be diluted, but the power structure of the company can shift in these circumstances, if a group of shareholders is able to move from a minority ownership in the company to a majority ownership position because of their buyout.

Finally, third party purchasers likely need to be approved by management for any small closely held company. Securities laws restrict the right of resale without registration, and most small companies have not registered their stock for offering on the open market. Before a shareholder takes it on him or herself to sell to a new party, that shareholder needs to be aware of any restrictions on those sales rights.

There are some key differences for LLCs, especially two person LLCs. Looking back at the example from above, the various rights of non-participating shareholders are not a concern, as all of the interest holders in the company are involved. But though the law treats corporate shares as specific discreet pieces of property, its treatment of LLC membership interests is much fuzzier. The idea of an LLC repurchase of its interest doesn’t really make sense unless that process is specifically outlined in the operating agreement. The idea of member exit in general isn’t necessarily common, as most state LLC statutes disallow membership exit from an LLC unless the operating agreement provides for it. For a two-person cannabis company, the issue is one of taxation more than anything else. There are various tax ramifications for different scenarios based on when the transfer of profit allocation rights in the company takes place and what the payment terms are of the transaction. In general, accountants should be included (along with attorneys) in any circumstance involving such a buyout, as it can be incredibly challenging to determine an owner’s outside tax basis in a company before and after these types of transactions.

There are a lot of moving parts in these types of deals, usually including all sorts of cannabis law issues as well. States like Washington want to approve of any ownership change in a company prior to that ownership change taking place, even where the ownership change just involves shifts among current owners. In Oregon, a change that takes one or more investors over a 10% ownership threshold in a business may spark additional state-required disclosures from those individuals. We will continue to see these types of moves, though, as some people choose to exit the industry and others decide it’s time to take a chance on pot.