ESOP for Cannabis: A Hot Exit Strategy with Misleading Tax Claims

A few of my clients have mentioned receiving emails about Employee Stock Ownership Plans (ESOPs) for cannabis companies, touting it as a strategy to pay no federal or state taxes. This statement is hugely misleading as you can’t avoid tax—it can only be deferred, meaning you’ll have to pay eventually.

 That being said, ESOP is an excellent exit strategy… with a few caveats. Maintaining and keeping compliant is expensive and complicated, and it may create instability in your company’s cash flow.

 So today, let’s talk more about that so you’ll be better informed next time you get one of those emails.

What is an ESOP?

Let’s unpack. An ESOP is a qualified retirement plan that owns company stock. It’s also a method by which cannabis (or any other) businesses can sell. When selling to an ESOP, you essentially sell it to your employees. The government encourages this tactic by providing a lot of incentives and subsidies, not the least of which is deferred capital gains.

 The ESOP is typically funded via loan financing. Those funds are then used to purchase stock. The company then makes regular contributions to the fund, which are used to pay off the loan. As the loan is paid down, a portion of the stock is allocated to member accounts based on their annual salaries. When the employee leaves the company, the account is cashed out based on the market value of the stock in the account.

 So, where does the no federal or state taxes statement come in? An ESOP that holds 100% of the stock in an S-corporation is exempt from federal and state taxes because of the S-corp’s pass-through tax status. In other words, it’s not that the taxes disappear; they are just someone else’s problem. 280E is no longer an issue if there are no state and federal taxes being paid because there are no deductions to take.

The Misleading Tax Claims

Taxes can be deferred following the sale of shares to an ESOP if certain conditions exist. If the company is structured as a C-corp and the seller reinvests the income into another investment or business, they can defer capital gains.

 The requirements and rules around such a sale are complex and dependent on several variables too nuanced to get into here.

 You need to know that when cashing out of an ESOP, you’ll still have to pay income tax. No, it’s not attributable to the company, but it’s income, and the IRS wants its share. By reinvesting it, you could potentially defer your capital gains indefinitely, but eventually, you’ll have to pay once you sell through.

ESOP as a Cannabis Exit Strategy

While we can’t support ESOPs as a way to avoid tax entirely, it could be an excellent exit strategy. ESOP-owned companies have many advantages, not the least of which is that employees take ownership in the company’s success and tend to work harder because they know there’s equity in it for them. It’s a reason to stay with the company, and there’s potential for them to move up in the leadership echelon over time, supporting succession planning and long-term business continuity.

 Owners who sell all their shares to the ESOP often remain in an advisory capacity or serve on the board. They can also choose to buy back into the company at a later date, either using a stock warrant (non-equity stock purchase) or through a tax-free entity.

 The Challenges and Costs of Maintaining an ESOP

We should clarify—this article is not meant to deter any cannabis company from considering ESOP ownership. It’s more about dispelling the myths you’ve heard that it’s an easy way out of your 280E challenges.

 It could be right for you. Theory Wellness became employee-owned in 2024 and is now the largest ESOP in the nation. It seems to be working for them.

 Once you weigh the pros and cons, you’ll know. As always, we’re here to talk you through it and provide the best advice for your situation.

ESOP pros:

 ·       Sellers can defer capital gains if they meet specific requirements.

·       Owners can sell as much or as little as they want, whenever they want.

·       ESOPs can buy out owners with pre-tax dollars.

·       Employees now own the company.

·       Employees have retirement security.

·       ESOPs pay no federal or state taxes.

 ESOP cons:

 ·       It costs a lot to set up and administrate the plan. Legal fees to set up an ESOP are in the range of $125,000 and up. Annual fees can be $20,000 - $35,000 or more. Companies with smaller workforces will be challenged to carry this burden.

·       ESOPs must repurchase shares from outgoing employees.

·       ESOPs require all employees to be in the plan and can be inflexible in this way.

·       ESOPs typically have a higher contribution requirement than other types of retirement funds.

·       Cannabis companies may face increased regulatory scrutiny, which may carry penalties or require costly measures to ensure compliance.

·       ESOP trustees are fiduciary and must be held to the highest standards. If there are no qualified employees to take on this role, hiring an outside company at an additional cost might be necessary.

Is an ESOP Right for Your Cannabis Business?

After considering the pros and cons of ESOPs and maybe having a little daydream about a 280E-free future, one thing is for sure. An ESOP could be a viable exit strategy if your cannabis business meets certain criteria.

 It’s certainly not worth pursuing if you are a small company with a handful of employees or your income cannot support the fees, professional services, and administrative responsibilities required to support such a tactic.

 Beware of false assumptions about tax-free anything; ESOP may be a way to mitigate and defer taxes, but it is not a wormhole to a tax-free alternate universe and does not come without significant cost and compliance concerns.

 Set up a call today to discuss your options. We’d be happy to walk you through the process of setting up an ESOP and help you decide whether it’s right for you.