Cannabis companies find tax workaround via ESOPs

Some cannabis companies are getting around the tax problems they typically face by setting up employee stock ownership plans.

Darren Gleeman, managing partner of MBO Ventures, has a patent pending for an ESOP methodology that effectively makes the 280E tax liability irrelevant when an owner sells 100% of their company to the employees by way of the ESOP structure. His firm first implemented an ESOP with a multistate operator called Theory Wellness and has since executed the cannabis industry’s inaugural ESOP transactions, making it probably the only investment bank focused on cannabis ESOPs. 

“Cannabis companies are really choked with tax, and they’ve been choked with tax for quite some time, and don’t even realize it until they start the company, and then they finally figure out there’s this part of the Tax Code called 280E,” he said. 

Section 280E emerged after a 1981 Tax Court case, Edmondson v. Commissioner, in which the Tax Court sided with a convicted cannabis dealer who wanted to deduct his business expenses from his taxes. Congress passed legislation classifying marijuana as a Schedule 1 substance and prohibited cannabis companies from deducting expenses such as rent, salaries and marketing as other businesses can. He estimates that cannabis companies pay a tax rate of about 60% as a result. 

However, he sees ESOPs as a way to solve the problem. “A company that’s 100% owned by an ESOP, there’s no federal income tax forever, and the company also pays no state income tax forever,” said Gleeman. “When you’re paying no income tax, it does not matter whether you’re taking any deductions.”

ESOPs have been around since the Employee Retirement Income Security Act of 1974, and the Taxpayer Relief Act of 1997 added considerable tax benefits by allowing ESOPs to own stock in S corporations and gave them tax-exempt status on their profits. However, employees are still responsible for paying taxes when they receive distributions from their ESOP accounts.

He has closed eight ESOP deals and expects to close another six in the next few months. He is also the author of a recent book, The Cannabis ESOP Architect. He believes cannabis companies can be sold at full market value and avoid capital gains taxes while retaining warrants to buy back the stock at a certain price in the future before a specific date. 

“The capital gains can be deferred, if it’s structured correctly,” said Gleeman. “That’s a big advantage. Another thing about ESOPs is when you structure it, you can also get a package of warrants in the future.”

He predicts there will be more use of ESOPs by cannabis businesses in the future and sees it as a “huge game changer” enabling them to double their cash flow compared to their competitors.