How ESOPs Can Help Cannabis Operators

As we have discussed previously, employee stock ownership plans (“ESOPs”) are becoming more and more prevalent among various industries and types of corporations. Cannabis companies have become the latest players seeking to capitalize on the advantages that ESOPs may bring.

At a basic level, ESOPs are a type of employee benefit plan that allows employees to own part or all of their employer’s company via shares of stock (or employer securities)^[1] ESOPs can borrow funds from the employer, its shareholders, or third parties in order to buy the employer’s shares of stock. The sale of those securities, if certain requirements are met, can be exempt from the Employee Retirement Income Security Act (“ERISA”) prohibited transaction rules. ESOPs are regulated under ERISA and the Internal Revenue Code (“IRC”), and specifically the IRC Sec. 401(a) rules relating to qualified plans apply to ESOPs.

Tax Treatment of Cannabis

Under federal law, it is unlawful to produce, distribute, or sell cannabis. Although many states have relaxed prohibitions on the use of cannabis for medical and recreational purposes or have completely legalized its use, cannabis remains classified as a Schedule I controlled substance under federal law. This means it is federally considered to have no useful benefits.

Under IRC Sec. 280E, the tax code disallows ordinary business expense deductions (i.e., rent, employee salaries) for businesses engaged in the sale of controlled substances, which includes cannabis companies. This disallowance results in a significantly higher tax bill for cannabis operators and limits these operators’ ability to deduct expenses for marketing or research and development. Generally, these businesses are limited to the ability to deduct costs of goods sold (“COGS”) when calculating taxable income.

Nearly twenty states, including California, New York, and Texas, have decoupled from IRC Sec. 280E and established their own tax treatment of cannabis operators to help reduce the state level tax on the operators. However, cannabis businesses feel the full effect of the tax disallowance in most other states.  

Despite these limitations, the cannabis market is expected to reach worldwide revenue of over $60 billion in 2024 and is expected to have a compound annual growth rate of 14.06% between 2024-2028.  This growth would essentially double the worldwide cannabis market by 2028.  

ESOPs and Cannabis 

While ESOPs can have considerable tax benefits, these benefits are only available to ESOPs that hold 100% of an S corporation. One large benefit is that pass-through income from an S corporation is not subject to federal income tax. ESOPs also do not pay state income tax in most states nor any unrelated business income tax (“UBIT”). The ability to by-pass income tax could substantially lessen the negative tax implications of IRS Sec. 280E on cannabis businesses. More capital would be available to help cannabis companies increase cash flow and, in turn, that cash flow can be used to repay debt or pursue growth opportunities that competitors may not be able to afford.

In addition, ESOPs provide a useful retirement benefit that supports employee and company interests alike, which could help retain and draw talent. Cannabis shareholders may benefit from implementing an ESOP as they could receive the right to purchase a company’s stock at a specific price and at a specified date (often referred to as a “warrant”) in a tax-free entity to buy back a portion of the company from the ESOP at some point in the future. Warrants, unlike stock options, are issued directly by the company, and when offered alongside an ESOP, can allow shareholders and employees to buy into the equity of the company at discounted prices. Shareholders who receive warrants may be able to make election.^[3] Additionally, shareholders can fund the ESOP through outside debt or seller notes.

Why Should Cannabis Operators Adopt ESOPs?

The main benefit from participating in an ESOP is that employees own a share of the employer’s securities and thus have a stake in the company. Shareholder employees can benefit from ESOPs by allowing them to defer, or possibly eliminate, capital gains taxes on the sale of their shares in the company. Employees would also benefit from having cost-effective retirement benefits, as noted above.

The cannabis workforce had nearly half a million jobs in 2023.These numbers will likely increase as states loosen their cannabis operator restrictions in the years ahead. ESOPs may act as a useful marketing tool to attract employees to work for them. In December of 2023, Theory Wellness became the first employee-owned cannabis company in Massachusetts and the largest such company in the country. With over 200 employees and 3 million customers, Theory Wellness clearly saw the benefits that an ESOP can bring to the cannabis industry.

Cannabis operators still need to do their research to understand the impact of specific ESOP structures that can be utilized to meet the needs of everyone involved. Engaging with a trusted tax advisor will help companies determine if an ESOP is right for them.

This is the third part of a multi-part series on employee stock ownership plans. To learn more see:

ESOPs: How They Function and How They Are Structured

The Tax Benefits of an ESOP

^[1] IRC Sec. 4975(e)(7); Reg. 54.4975-11.

^[2] Cannabis - Worldwide | Statista Market Forecast

^[3] PLR 201610006.