ESOPs May Be the Key to Operating Tax-free in the Cannabis Space

Cannabis operators focus heavily on tax mitigation, employee retention, growth strategies, and profitable exit. A properly structured ESOP is a great tool to accomplish all those goals and more. In a recent webinar, “Cannabis ESOPs – The Industry Game Changer”, AAFCPAs’  David McManus, CPA, CGMA, Tax Partner & National Cannabis Practice Leader and Joshua England, LLM, Esq., Partner & Tax Attorney joined Hannah King, Partner at Dentons, Mark Loyd, Partner and Co-lead of Dentons’ national tax practice, and Darren Gleeman, Managing Partner at MBO Ventures in a discussion (recorded live on April 25^th, 2024) on the many benefits to an ESOP business structure specific to the cannabis industry.

How It Works

An Employee Stock Ownership Plan (ESOP) is a business structure that provides employees ownership interest in the company. When forming an ESOP, owners are essentially selling their company to their employees. While some companies sell to private equity or to a strategic buyer—and larger organizations might sell by going public—another option is to sell your business to your employees through an ESOP.

When selling a business through an ESOP, employees do not need to pay into or invest in the firm as they would in a public company nor do they become actual shareholders or run operations. Instead, ownership is gifted to employees and leadership continues to drive strategic direction just as they always had. When you form an ESOP, you also establish an employee stock ownership trust, which acts as the sole owner of all company shares and represents all employee-owners collectively in negotiations with the company including determination of its fair market value. All employee-owners become beneficiaries of this trust.

From a social equity standpoint, ESOP formation can be a powerful position to take within the cannabis space since this is still an emerging industry and there are numerous cannabis startups that are just beginning to lock arms with their employees as they build the business together. This type of culture lends itself well to employee ownership in the right situations, given employees are leading contributors to the business’ overall success and growth.

But beyond this, an ESOP also provides valuable tax advantages. Consider that when you sell 100 percent of your company to employees through a properly established ESOP, your business can operate tax-free and thus avert both federal and state obligations. When an organization pays no tax, 280E becomes irrelevant. In some cases, former owners may receive warrants and, if they do, they also participate in the upside of the company by receiving some equity into the future.

To become an ESOP, a cannabis company would ideally earn at least $2.5 million in net income or EBITA and employ at least 20 individuals. The larger the company, the more potential savings. While the minimum sale to an ESOP is 30 percent of a company, you do need to sell 100 percent to avert all taxes within the cannabis industry until 280E goes away. An S Corporation that sells only 30 percent, for example, would put 30 percent of its income on its K1 to the ESOP, which would not pay tax on that portion. But the remaining 70 percent would still be distributed to its owners, who would then need to pay tax on that portion at its effective rate.

While capital gains taxes are extremely difficult to avoid when selling a company, an ESOP can help a cannabis operation owner defer capital gains tax as long as the company rolls that gain into U.S. stock or another suitable option. By rolling gains into a new asset, whether it’s U.S. stocks or real estate, your basis in the company also rolls over to that new asset and you do not need to pay that tax until you sell the asset. If you hold the asset indefinitely and get a step up in basis, those gains are lost entirely.

Planning Ahead

In the future, should 280E end (i.e., cannabis is rescheduled or becomes federally legal), we would expect to see a lot of merger and acquisition activity. While most cannabis operators have limited cash flow to fund expansion, larger or multi-state operations or those with multiple locations will become a more attractive acquisition target. If you sell to an ESOP and use some of that tax-free revenue to drive expansion activities, you are ensuring that operation is in a much better position when 280E is no longer an issue.

Remarkably, with all the tax and social equity advantages in an ESOP, particularly within the cannabis space, only a handful of cannabis operators have executed this structure. The biggest obstacle might be lack of awareness of its benefits. As more cannabis operators learn about the value in ESOPs and see it as a viable option, we should see more shifting to this structure.

In the cannabis industry, regulations vary from state to state. This has forced many operators to structure their business strategically and in unique ways. Structured in the right way, a cannabis business can gain immense benefits from shifting that focus toward an ESOP. Those who benefit most from ESOP formation tend to be retail and retail-heavy establishments, since those operations are often hit the hardest with taxation. Still, business structure is determined on a case-by-case basis. If you believe you’re a good candidate, expect a lot of preplanning as part of the complete transition.

Beyond its undeniable tax advantages, ESOPs boost employee retention, loyalty, and productivity. They are also more appealing to job seekers who often give preferential treatment to employee-owned organizations. Meanwhile, owners may exit, draw revenue from the business, and use that cash flow to grow strategically.

How We Help

AAFCPAs has advised cannabis businesses since 2012 and is now a recognized leader nationwide for those seeking licensure, expansion into newly legalized states, and data-driven strategies for profitability. We provide a valuable holistic approach that integrates tax strategy and compliance with audit, management consulting, outsourced accounting, as well as technology and risk advisory. AAFCPAs can help to advise on tax strategies for 280E along with federal regulations and the myriad state-by-state tax nuances.

If you have questions, please contact Joshua England, LLM, Esq., Partner & Tax Attorney at 774.512.4109 or jengland@nullaafcpa.com, David McManus, CPA, CGMA, Tax Partner & Cannabis Practice Leader at 774.512.4014 or dmcmanus@nullaafcpa.com—or your AAFCPAs Partner.