When it comes to planning your business exit in the cannabis industry, one strategy stands out from the rest for its tax savings potential. Unlike many federal tax benefits, cannabis business owners can utilize the advantages of Internal Revenue Code (IRC) Section 1202, if their companies qualify.
Under Section 1202, certain shareholders of C corporations can exclude a portion of their capital gains on the sale of eligible qualified small business stock (QSBS), drastically reducing their tax obligation upon exit.
While this is a strategy for exiting your business, it is best planned for before entering it, due to one major requirement: C corp structuring. Since the Section 1202 exclusion is only available to non-corporate C corp shareholders, the tax benefit cannot be realized by shareholders of any other type of entity, even if it elects to be taxed as a C corp.
Many states, including New York, prohibit statutory conversion to C corp. If you are establishing a business in one of those states, you may have only one chance to choose this structuring, and ultimately take advantage of Section 1202 benefits. Even if your state does allow the conversion, it can be a costly and complex process for your business to undertake.
When structuring their businesses, many owners instinctually avoid a C corp because of its higher tax bracket and “double taxation” on the corporate and individual level. But with Section 1202 as your exit strategy, the higher taxes could be worth it in the long run. A careful evaluation of the requirements, benefits and other considerations will help you decide if this exit strategy is right for you and your cannabis business.
Many U.S. domestic C corps are eligible to take advantage of the Section 1202 exclusion, but certain restrictions and qualifications do apply. To be eligible, the following criteria must be met:
- Company must be a U.S. domestic C corp
- Aggregate gross assets of the business cannot exceed $50 million prior to and immediately after transaction
- 80% of assets (by fair market value) must be used in a qualified active business
- QSBS must have been held for more than five years (in case of gifting or death, the holding period is carried over from the prior owner)
- QSBS must have been directly acquired from original issuance from the C corp
- Eligible shareholders must be non-corporate taxpayers (individuals or partnerships owned by individuals)
Section 1202 offers the distinct advantage of excluding all (or a majority of) qualifying gains when eligible shareholders sell their QSBS. The amount of the exclusion depends on when the QSBS was acquired. Non-corporate taxpayers selling QSBS acquired before September 28, 2010 qualify for a 50-75% exclusion on qualifying gain, while shareholders selling QSBS acquired on or after September 28, 2020 are eligible for up to a 100% exclusion.
Generally, the exclusion delivers the following benefits:
- Eligible percentage of capital gain excluded from federal capital gain income tax and net investment income tax
- Increased internal rate of return (IRR) due to low (or zero) tax rate
- Offers another incentive to attract to potential investors
Excluded gain is capped at either $10 million or 10 times the taxpayer’s original basis (per QSBS issuer).
While the tax savings potential of Section 1202 is unrivaled by most other exit strategies, there are other considerations a cannabis business owner should make before pursuing it through the C corp structure.
The composition of owners is one consideration to make before deciding on an entity structure. For example, if you are hoping to attract funding from shareholders, particularly foreign investors, the C corp will likely be your best option.
Business structuring should also take into consideration the tax laws and regulations of the state and city in which your business will operate.
Ultimately, business structuring and succession planning require thorough analysis of many different factors, including tax strategies at the beginning and end of your business journey. Thinking about your business exit from the very start is one way to make the most confident decisions and ensure the best financial outcome.