Early investors in the cannabis industry were less focused on accounting and transparency when it came to choosing where they wanted to invest their money. But they have since learned that they must take a hard look at the numbers involved and be much more demanding of cannabis, CBD and hemp startups. Despite some markets enjoying a strong 2023 so far, recent data is showing others like California, Colorado and Washington State are experiencing a sluggish period.
A top investor concern is correct accounting and taxes
Since investors don't want to risk fines, penalties or a loss of license, they expect the businesses they invest in to have their accounting and taxes done correctly, for the entity structure to suit their needs, and for compliance to be a top-level priority. Correct accounting, tax preparation and reporting in the cannabis industry requires proper operational setup and processes, expertise and tools. Maximizing tax benefits can be challenging to impossible if the right steps are not taken at the right time.
Informed cannabis accountants must have both a big picture and granular understanding of Section 280E of the Internal Revenue Code. Correct operational setup and proper monthly cost accounting that accords with the specific needs of each vertical (dispensary/retail, manufacturing, processing and cultivation) enables them to assist cannabis CEOs and operators with laying the necessary groundwork and ensuring "audit ready" books as well as better reporting, improved cash flow, and better forecasts and projections.
While 280E makes taking deductions impossible for cannabis businesses, correct adherence to another section of the Internal Revenue Code provides at least part of the solution. Through proper reliance on IRC 471, which is, unlike 280E, a very complex code, accountants and CFOs can determine which costs that can be allocated to inventory, and eventually into COGS (cost of goods sold).
C corporations generally preferred by cannabis investors
The entity structure a budding cannabis CBD or hemp business chooses largely determines which kinds of investors they can attract, and they often prefer C corporations. This structure has the C corp paying the taxes (i.e., taxes don't flow to the individual owners tax returns). This company structure also will limit the liability of its shareholders and directors. With the C corp structure, it's easier to raise capital, the corporation pays a tax of 21% (currently), and potential financial exposure is limited.
In other words, investors do not have to worry about an audit of a business they have invested in extending into their own personal assets. Only the C corporation itself can be audited. Protecting personal assets is obviously a huge concern for investors, so those who choose to form an LLC should be fully aware of how doing so may impact their personal audit risk.
Another thing investors like about the C corp entity structure is IRC Section 1202, aka the Small Business Stock Gains Exclusion. The impetus behind it was to inspire greater investment in small businesses, and the incentives are definitely substantial. Section 1202 allows 100% of capital gains to be excluded from federal taxation, as long as the stock is held for a minimum of five years (as well as other requirements are met). The limit on the amount of capital that can be excluded is $10 million, or 10 times the adjusted basis of the stock.
Ask many lawyers and founders outside of the cannabis, CBD and hemp industry what they think of the C corp structure and they'll likely list double taxation and the corporate tax as its drawbacks. While it is true that increases in the corporate tax rate can increase the amount of tax burden on C corp businesses, the LLC entity structure often falls short of adequately mitigating risk for investors.
The biggest drawback for the C corp structure is double taxation. As an entity, C corps pay income tax at the corporate tax rate. Shareholders are paid dividends from the C corporation's after-tax income. The C corps' shareholders are required to claim their dividends on their personal income tax statements, hence the "double taxation" drawback.
LLC entity structure
Greater exposure to audit liabilities, as well as annual taxable income distributed via a K-1, is what often makes the LLC a less desirable choice. In corporations with many investors, the risk of exposure to any one individual may be limited, but in an LLC structure, the consequences could be more substantial.
If, for example, a business has only three investors and one investor is a minority owner (i.e., owns less than 50% of the company), that owner might get taxable income every year without access to distributions (and without the power to change the operating agreement). Nevertheless, there are situations where the LLC can be better for all involved. Meeting the needs and interests of the shareholders and operators is often a balancing act.
Better tax rates are possible in an LLC entity structure, but the specifics vary greatly, depending on the investors and shareholders concerned. There is no double taxation with LLCs, and whereas C corps definitely require a lot to maintain, LLCs can be set up easily, often within just a few hours.
Understanding cannabis investors' concerns is crucial, whether you're starting out as a cannabis investor yourself, want to support investors, or are working with cannabis, CBD and hemp startups or recently funded businesses in the space.
