How Do Cannabis Employee-Owned Companies Avoid Tax Burden?
ESOPs: A Strategic Tax Solution for U.S. Cannabis Companies Facing 280E Burden.
US cannabis companies face heavier taxation compared to other industries due to the substance's illegality at the federal level.
This is because cannabis companies can't deduct most regular business expenses under Internal Revenue Code (IRC) Section 280E, which prohibits tax deductions or credits for expenses related to businesses trafficking in Schedule I or II of the Controlled Substances Act (CSA), where cannabis is listed in Schedule I.
As a result, cannabis businesses face an exceptionally high tax burden.
However, in recent years, cannabis companies have begun seeking strategic solutions to circumvent the burdensome Section 280E, and some have discovered that employee stock ownership plans (ESOPs) provide a pathway for reducing tax liabilities.
What is an ESOP?
ESOPs are employee benefit plans that allow employees to own shares of their employer's company. They can borrow funds to buy these shares, and if certain conditions are met, the sale of these shares can be exempt from specific taxation.
This would allow cannabis companies to use ESOPs as a strategy to circumvent the burden imposed by Section 280E.
Darren Gleeman, managing partner of MBO Ventures, explained that ESOPs offer tax incentives and subsidies structurally similar to private equity deals. Leveraging debt for acquisition, ESOPs provide tax benefits such as deferring capital gains taxes and deducting full loan amounts. The unique tax advantages are driving ESOP adoption in the cannabis industry.
"It took me a while to introduce ESOPs in the cannabis space. As soon as I learned about the burden of 280E on cannabis companies, I knew that this could be a huge advantage for them. So, what I ended up explaining to people was how the ESOP structure could benefit business owners. I approached lawyers and accountants in the industry, and it was an uphill battle because no one believed me at first. After several meetings with numerous attorneys, they finally came back to me convinced about the effectiveness of ESOPs. In 2023, we helped three cannabis companies adopt ESOPs, and we plan to close about eight or nine by 2024," he said.
Typically established by business owners, ESOPs allocate company shares to employees over time. As employees accumulate shares, they build wealth and have a vested interest in the company's success. Employees can cash out their shares when they leave or retire, providing a means of retirement income. ESOPs offer tax advantages to both the company and its employees.
The adoption of ESOPs in the cannabis industry is new. ESOPs are usually adopted in sectors like manufacturing and construction. Gleeman suggests that ESOPs may not be suitable for high-tech companies due to valuation methods based on fair market value, potentially undervaluing rapidly growing firms compared to valuations offered by venture capital firms.
In addition to the substantial tax advantages for cannabis companies transitioning to ESOP ownership, Gleeman explained that ESOP ownership enhances employee retention, as employees become more engaged and productive when they have a stake in the company.
ESOP's Drawbacks In The Cannabis Industry
However, adopting an ESOP has its own drawbacks.
ESOPs require careful management, often involving the implementation of a vesting schedule where employees gradually become eligible for stock ownership over several years.
Gleeman suggested that ESOP adoption is feasible for cannabis companies with at least 20 employees and an EBITDA of at least $2.5 million. Nonetheless, he cautioned about potential drawbacks, such as regulatory audits and valuation challenges from the Department of Labor, which could lead to legal disputes and adjustments in valuation. He also stressed the importance of education for successful ESOP implementation.
"The biggest problem is education: people have no idea what this is. And there's a lot of false information out there. So, they end up not having a clue what this ESOP structure is," he said.
Adam Hoffer, Director of Excise Tax Policy at the Tax Foundation, finds the ESOP adopted in the cannabis industry to be a brilliant idea, though not without complexities. While ESOPs offer a workaround for cannabis retailers grappling with Section 280E tax burdens, he believes their setup entails significant accounting and legal expenses.
"I don't think ESOP is convenient at all, but it seems a great short-run solution to some of the challenges that cannabis retailers are facing," he said.
Rescheduling Cannabis And The Burden Of 280E
A cannabis company that wants to adopt an ESOP should carefully consider also the risks associated with legislative changes.
Scott Solomon, CEO of Operational Security Solutions, explained that the IRC Section 280E was initially intended to disallow deductions for Schedule I or II substances. However, the rule now seems outdated, considering the legal status of cannabis at the state level.
"The 280E rule seems unjust, especially for someone like myself who works in a company supporting these businesses. Repealing this rule would be beneficial," he said.
The current U.S. administration is considering rescheduling cannabis from Schedule I to Schedule III of the Controlled Substances Act. This shift would allow cannabis businesses to claim federal tax deductions currently restricted by IRS code 280E. However, uncertainty surrounds this potential reclassification, making it further inconvenient to adopt an ESOP for cannabis companies if cannabis is rescheduled.
Are ESOPs Worth It For Cannabis Companies?
Peter Su, a cannabis banking expert and director of specialty banking for Hanover Bank, who doesn't represent the views of the company on this matter, suggested that while ESOPs offer various benefits beyond tax advantages, if a cannabis company adopts an ESOP solely to avoid the 280E tax burden, unwinding it poses a complex challenge if cannabis is moved to Schedule III, and, overall, the benefits of an ESOP may not outweigh the risks.
"From a banking perspective, when a bank evaluates a cannabis company seeking to borrow money, understanding the corporate structure is crucial. The addition of an ESOP layer complicates matters further, especially in the event of default, as the company's ownership is placed into a trust. While an ESOP may protect the company, it poses challenges for banks in terms of understanding and managing risks. Additionally, if the company has already incurred debt to implement the ESOP, it adds to the complexity for both the company and the bank," he said.
Sue also mentioned that adopting an ESOP might not be worthwhile, particularly as some cannabis companies have challenged the 280E tax burden without resorting to ESOPs. For instance, Truelieve Cannabis has recently received $113 million in 280E tax refunds. However, since Trulieve hasn't disclosed its legal analyses and tax refund strategy, it remains unclear if this approach applies to other cannabis companies.
The Consequences Of 280E Burden On Cannabis Companies
Solomon highlighted how businesses often struggle with the burden of Section 280E, leading them to raise prices abruptly. Initially entering the market with a reasonable price point, they frequently find themselves compelled to implement broad price increases of 15% to 20% to offset these challenges. Additionally, the elimination of deductions for employee salaries, utilities, insurance premiums, and marketing expenses necessitates inventive strategies to retain personnel.
"Consequently, we are seeing a growing trend where stock options or equity stakes within companies are becoming relatively common," he said.
Solomon referred to the case of one of his new clients in New York, who is quite business-savvy with multiple conventional businesses and has recently ventured into the legal cannabis sector. They obtained a license and are facing an effective tax rate of 70%, a stark contrast from their previous businesses, where the rate was around 40% to 43%. This shift prompted them to reevaluate their revenue and profitability targets to maintain purchasing power. This analysis revealed a significant disparity from their initial estimates.
"Interestingly, we've observed that many clients aiming to enter the market with a $2 million investment end up doubling their spending to sustain the business beyond the initial two years," he said.
Hoffner believes that adopting an ESOP in the cannabis industry is suitable only for a specific structure of companies, not for everyone. It depends on factors such as the number of employees, revenue, and other considerations. While some employees may eagerly embrace stock ownership in a potentially successful company, others may prefer a traditional wage. However, an ESOP could be a clever solution for companies expected to endure long-term, allowing them to offload costs through employee ownership plans.
"I wish I had come up with the ESOP idea. It's quite a clever idea," he said.
