As most farmers are aware, the shift out of SB 420 (i.e. the collective/cooperative model) into MCRSA (i.e. the local permit/state license model) is in part intended to bring cannabis cultivation into the light, primarily the taxable light. In light of these changes, my farmer clients commonly ask if they should start a corporation in preparation for the future, or if they should continue on as they have in the past.
This article is intended to flesh some of the issues out regarding starting a lawful California cannabis corporation now.
I. Who Should Not Start a California Cannabis Corporation.
1. Do not start a shell corporation to establish priority.
A shell corporation is a business that is formed, but ignored in any meaningful manner. It is generally unwise to form a “shell” corporation to gain “priority” status under MCRSA or Prop 64, a tactic some attorneys and even our local policy organization advised in the past.
The statutes do not mandate local Cities or Counties give “priority” to prior-existing corporations, but instead order the State agencies issuing the state licenses. (Cal. B.P. Section 19321, 260554.2.) While the issues are related, the buying and selling of pre-existing corporations may prove to be a fruitless exercise that serves only to generate more money for the attorney who set the shell corporation up in the first place.
Local jurisdictions (Calaveras/Mendo/Humboldt) have thus far cared more about the pre-existence of the farm in light of CEQA than any “priority” offered by a shell corporation, so don’t get played.
2. If you aren’t ready to learn how to run a legitimate corporation, don’t start one.
Those who are not ready to operate in strict compliance with the collective/cooperative rules should refrain from starting a corporation now, as they could expose themselves to criminal liability for financial and tax crimes instead of the simple cannabis crimes. Financial crimes are far worse, as they are often felonies and may be considered “moral turpitude,” forever precluding any type of licensing.
If you ain’t ready, you ain’t ready.
II. Why Does Corporate Status Matter?
For those who are ready to move into the next phase of California’s lawful system of cannabis production, the remainder of this article is for you. The first thing to know is MCRSA and Prop 64 authorize commercial activity, which will operate within the U.S.’s hyper-capitalistic economy. Thus, in order to best protect yourself and your assets, a smart farmer should have a working knowledge of basic business, and of those corporate rules that come along with it. Here’s a few issues to be aware of:
Taxes on California cannabis are wild, and they appear to have no end in sight with the allowance given to locals to tax even further. This massive taxation will likely put some mom-and-pops out of business, but by thinking strategically about taxing now, you can take the right steps to avoid unnecessary taxes.
By my account, cannabis taxes thus far are:
- $148 per flower pound (due at harvest);
- $44 per leaf pound (due at harvest);
- 8% sales tax (which would be negated for wholesales from grower to dispensary/retailer if the growers can obtain a resale certificate, but growers who direct sale would be liable);
- 15% excise tax (applies only to purchases of cannabis products, so this is a bigger issue for retailers);
- Local cultivation and/or sales tax (TBD depending on your City/County);
- Absolutely no write-offs for cannabis-only related expenses, per 26 U.S.C. § 280E.
By making sure you’re not paying extra self-employment taxes and ensuring your small business can obtain “pass-through” taxing when you move out of the collective/cooperative model, you can eliminate or greatly reduce the possibility of double taxation (i.e. where your corporation gets taxed and then your salary from the corporation gets taxed again).
2. The Reputation and Goodwill of Your Business May Prove to Be Critical in an Industry Where Your History Matters.
I cannot understate the value of building your corporate personality and the “goodwill” of your business now, as the age of your corporation and its existing reputation matters, both for “priority” status under MCRSA and Prop. 64, and also for competitive local permits. Mostly, however, consumers care!
3. Allows Strategic Business Decisions in Quick Turn-Around Permits.
In addition to the obvious issue of taxation, growers may not get a lot of time to ponder these issues before having to make a quick decision about permitting in light of the quick ebb and flow of the local cannabis rules in each City and County. (Hello, Mendo!)
4. Allows Strategic Business Decisions in Non-Transferable Permits.
Many of local permits are non-transferrable, which means you may be stuck in the same corporate formation for several years if the County permits go on hold during a CEQA analysis. Taxes may prove to be unbearable if you don’t have corporate protection once taxes kick in in earnest in about 2019-2020 (once the collective/cooperative model dies).
5. Protects You From Personal Liability if Your Business Gets Sued or Goes Under.
With a functioning corporation, you get the added benefit of a corporate “veil,” meaning your personal assets would likely be protected if your business got sued. Considering there will be tons of lawsuits as these issues get worked out, protect yourself by making sure you and your business are distinct entities.
III. Overview of California Cannabis Corporations
1. Current Law Continues to Demand Not-for-Profit Status.
Current law still requires non-profit status, but allows for profit making in the future. This odd conundrum leads to the common question: “How can we protect ourselves now but prepare for the future of California cannabis?”
There are three primary choices: (1) do nothing, which essentially means you are a sole proprietor, (2) incorporate as a not-for-profit Mutual Benefit Corporation that can be transitioned to a for-profit company in the future, (3) organize a for-profit corporation that chooses to operate on a not-for-profit basis, or as a “management” or “holding” company for a distinct not-for-profit collective or cooperative.
2. Sole Proprietorships
California law continues to require a cannabis farmer be organized as (1) a collective or a cooperative, which (2) must be operated in a not-for-profit manner. Thus, operating as a sole proprietor of a commercial cannabis operation is arguably illegal at this time.
There is the rare case where a grower provides cannabis to a dispensary of which they are a member. If your garden is organized as a producer for a dispensary, however, your hard work is actually building someone else’s business.
Additionally, once you begin to file taxes on your commercial cannabis business, sole proprietors will be subject to self-employment taxes, which essentially doubles your standard taxes. This self employment tax is in addition to the other taxes described in the previous section.
3. Cooperatives and Not-for-Profit Mutual Benefit Corporations
In 2008, Jerry Brown declared medical cannabis cooperatives must be formed as “Consumer Cooperatives” or “Agricultural Cooperatives,” which are specific types of businesses where members are united in common purpose and generally get an equal vote on the corporation’s major decisions. Cooperatives have stringent voting requirements that greatly limit their flexibility as an entity.
At some point, dispensaries wisely began utilizing Mutual Benefit Corporations [“MBC”], another type of corporation that allows the Board and governing members greater flexibility in building the dispensary’s business. The MBC can have members with voting rights similar to a cooperative, or members who do not get to vote, or even members who can vote on only some things, and this pliability makes it a desirable form.
The downside, however, is a MBC may not make the best business sense once the corporation gets big enough to own assets (such as real property or personal property like a greenhouse or a tractor). An MBC cannot distribute assets or “dividends” to its members like a profit corporation can do for its shareholders, as the only time a MBC can distribute assets to members is at dissolution, unless the governing documents such as the Articles of Incorporation (AOI) or bylaws state otherwise. (Corp. Code Section 8717.)
California law thankfully allows a MBC to merge with or transition into a for-profit company (C.C. 8010), which cannabis-related MBCs should not do until:
- Collectives/cooperatives may legally operate on a for-profit basis (watch out for AB 64); or
- You’re governed by the rules of MCRSA/Prop. 64, i.e. where you have a local permit and a state license.
4. LLCs, Partnerships, and Other Traditionally For-Profit Corporations
An LLC is a common entity type for small businesses, as LLCs offer traditional corporate protection, but don’t have the same rigmarole as traditional corporations that issue stocks to shareholders. Most folks who have cannabis-related LLCs traditionally operate them in addition to their MBC and, in those cases, the LLC “manages” or acts as a “holding company” for the non-profit MBC’s assets or Intellectual Property, such as the company’s logo, the secret nutrient formula, or special growing techniques.
In such cases, appropriate contracts/leases would need to be drafted setting forth how the LLC interacts with the MBC to ensure the transactions between the two corporations are sufficiently “arms-length” to be unquestionably legitimate.
Technically, you can run an LLC in a not-for-profit manner by declaring so in the Operating Agreement (CC 17701.10), which is a common structure in areas where the local jurisdiction is more friendly to creative cannabis businesses. In Nevada County and the surrounding Counties, you will likely be prosecuted if you tell an officer your cannabis business is an LLC, even if you can prove your financials are managed in a not–for-profit manner. Thus, while a not-for-profit LLC is a legitimate possibility, its wisdom in practice largely depends on your jurisdiction.
If your cannabis business has a creative corporate structure involving an LLC or other type of for-profit, it is critical that Sierra Foothills farmers do not discuss their business model with law enforcement, and you should be wary of obtaining a permit in the name of the LLC.
5. What Corporate Structure is Best for the Small Farmer?
For the aggressively professional and forward-thinking Sierra Foothill farmers, the most strategic method is to maintain (and operate) two corporations (i.e., a not-for-profit to manage the cannabis and a for-profit to manage the assets), as growers may not get lengthy notice when the Sierra Foothill Counties finally do issue cultivation licenses. Thus, having one of each type of corporation allows you to make a strategic decision about which corporation to get the permit under, if and when they are issued. For example:
- If not-for-profit status is still required by the State when your County issues a permit, or if the County grades applicants on the length of their previously existing corporate status, then having a longstanding not-for-profit corporation would be extremely helpful; or
- If the County issues licenses after for-profit becomes legal, then it would be needlessly cumbersome to get the permit as a non-profit unless you desire to remain a non-profit in the future (which a lot of folks do) or unless you don’t get time for a lengthy transition before your application is due. If you’re in the latter category, you should ensure your governing documents allow for flexible transition now, or you could screw yourself in the future.
However, for the majority of small farmers just trying to make it through the day, a Mutual Benefit Corporation which allows easy transition to an LLC or stock corporation is perfectly workable, as it the safest option for now and can be converted to a for-profit in the future.
If you are in a friendly jurisdiction, you could skip the MBC and go right to the LLC, but that’s dangerous ground in hostile Counties and may hurt you if your jurisdiction requires proof of not-for-profit status when permits are available.
In sum, I am aware the corporate stuff is unfamiliar and daunting. But, while the massive taxes are my least favorite part of the end of prohibition, I strongly believe wise steps to protect yourself from over-taxation and the lack of any risk of arrest will make this transition worth it someday.
For now, just continue to hold on tight, start to ponder these concepts, and then take initial steps if and when you’re ready. Above all, please stay safe this coming season.
Written by Heather L. Burke, Criminal/Administrative/Corporate/Litigation
In consultation with attorney Fran Cole, Diamond Baker Mitchell, L.L.P, Corporate/Civil Litigation
***This blog is excerpted from a larger chapter in the The Farmer’s Corporate Handbook, due in May, 2017. Additional chapters include (2) How to Run a Legal Cannabis Corporation, and (3) What Legal Cannabis Producers, Manufacturers and Distributors Need to Know About Contracts, and more! Stay tuned!