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Employee stock ownership plans (ESOPs) have been used as a business succession strategy by employers across many industries. In the cannabis industry, ESOPs have come and gone and come again as a trendy topic promising to fix many of the tax and liquidity issues operators in the industry face. But are the benefits real, or is this just another pitch by consultants looking to generate fees? The answer is “yes”.

An ESOP is similar to a 401(k) plan except that an ESOP invests primarily in employer stock instead of mutual funds. Because of this unique feature, an entrepreneur can sell his or her business to an ESOP, thereby turning the employees into owners.

Tax Treatment of Cannabis

Cannabis business owners are painfully aware of Section 280E of the Internal Revenue Code. Section 280E disallows a deduction “for any amount paid or incurred … in carrying on any trade or business … [that] consists of trafficking in controlled substances … prohibited by” state or federal law. This has the effect of taxing cannabis companies—which operate legally in many states—on gross profits instead of net income.

ESOPs and Cannabis

ESOPs have significant tax benefits that can nullify the effect of Section 280E. Any S corporation that is owned by an ESOP has a tax advantage over its competitors. The income and other tax items of an S corporation are passed through to its shareholders. Because an ESOP is tax-exempt, an ESOP pays no income tax on income of an S corporation that it owns. If an ESOP owns 100% of an S corporation, 100% of the company’s income passes through free of federal and most state income tax. Therefore, the disallowance of a deduction by Section 280E has no impact on a cannabis company that is owned 100% by an ESOP.

In addition, if the cannabis company is structured as a C corporation before the sale, the capital gains tax on the sale can be deferred indefinitely.

Tax benefits should not be the only driver of a sale to an ESOP. An ESOP can make good business sense. When an owner of a cannabis business sells to an ESOP, the sale price is at fair market value, as determined by an independent trustee based on a valuation of a valuation advisor. Employees pay nothing for the shares of company stock that are allocated to their accounts. Over time, if the company does well, participants—who include rank and file employees—can see their ESOP accounts grow significantly more than their 401(k) accounts, enabling all employees to realize the benefit of owning the company.

ESOP As a Liquidity Event

It’s an understatement to say there have been fewer quality exit opportunities for cannabis company equity owners these past few years—capital has tightened, the market is maturing and becoming more competitive, and federal action seems once again to be stalled. In this environment, ESOPs can sound like a perfect solution as they check a lot of boxes: exit event for equity owners at a fair price, powerful tax incentives, current management can continue stewardship of the company, and potential employee engagement that cannot be duplicated without employee ownership.

So What’s the Catch?

Like everything in our industry, the devil is in the details. With all the potential benefits, ESOPs are easy to pitch but can be hard to deliver. Here are some of the problems you’ll need to solve:

• Regulatory Hurdles: how your ESOP can be structured will depend on your state ownership regulations. This hurdle is easy to overcome in some states. In others, regulations will need to change for a transfer to employee ownership through an ESOP to be feasible.
• Valuation: it’s easy to find a hired gun that will give your cannabis company an outsized valuation. That won’t work for a sale to an ESOP. ERISA prohibits an ESOP trustee from paying more than fair market value. An outsized valuation will risk having your ESOP undone in a DOL audit or ERISA litigation. Since you are a cannabis company, you know you’re going to be audited.
• Your Debt: Putting an ESOP in place will almost certainly require taking out your current lenders. Paying off large senior secured lenders can quickly eat into equity owner proceeds.
• Financial Partner: the capital to buy out current equity holders needs to come from somewhere. That capital can come from seller financing, a cannabis-friendly fund or financial institution, or a combination thereof. Third-party financing in the cannabis space has interest rates, fees, and other terms that can offset an ESOP’s tax benefits.

If you are considering whether an ESOP is right for you, please reach out to either Alan Kandel, Marshall Custer, or another member of Husch Blackwell’s Cannabis Practice. ESOPs can be done in this industry, but you will face unique hurdles to put one in place.

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