Choosing the Right Entity for Long-Term Success in California’s Cannabis Industry
If you are operating or planning to start a cannabis business in California, one of the first and most important decisions you’ll face is choosing the right business structure. While some industries can afford to treat entity selection as a formality, cannabis entrepreneurs don’t have that luxury. With legal restrictions, limited access to banking, and the ever-watchful eye of the IRS and California’s FTB, the structure you choose can make or break your bottom line.
Our Los Angeles-based CPA firm works with cannabis businesses across dispensaries, cultivators, manufacturers, and distributors. We have seen firsthand how the right (or wrong) structure can impact tax burdens, personal liability, compliance, and the ability to scale. As you navigate the complexities of this industry, remember that the entity you select isn’t a formality or mere paperwork. This foundational decision will significantly impact your financial health and long-term success.
Below is a quick breakdown of the most common structures, i.e., LLC, S Corporation, and C Corporation, and what they mean for your cannabis business.
LLC (Limited Liability Company)
Pros:
- Flexible management structure: Imagine you and a partner are launching a small cultivation operation. With an LLC, you have the freedom to define your roles and responsibilities in a way that suits your needs, without the rigid formalities often associated with corporations. You can decide amongst yourselves who handles what, offering a streamlined approach in the early stages.
- Pass-through taxation (profits are taxed on the owner’s personal return): This advantage is solely experienced when compared to the double taxation of a C Corp. Let’s say your dispensary has a profitable year. As an LLC owner, you’ll report your share of the profits on your personal tax return. This avoids the double taxation that corporations face, potentially simplifying your tax obligations initially.
- Limited liability protection: If an unfortunate event happens, for example, a customer slips and falls at your retail location, they may decide to sue. Operating as an LLC can help shield your personal assets, like your home or personal savings, from business debts and lawsuits. This separation between your personal and business finances offers a crucial layer of protection.
Cons:
- Still subject to IRC 280E: Now, here’s a hurdle you absolutely need to be aware of. Even as an LLC operating a manufacturing facility for edibles, the IRS views your cannabis activities as “trafficking” in a Schedule I substance. This means you can’t deduct many of the normal business expenses that other industries take for granted, significantly increasing your taxable income.
- LLC members in California may be hit with the annual $800 Franchise Tax + an LLC fee based on gross receipts: Even if your newly established delivery service has modest revenues in its first year, you’ll still owe California’s $800 Franchise Tax. As your gross receipts grow, you’ll also face an additional LLC fee, impacting your profitability.
- Less favorable for reinvestment; profits are taxed regardless of whether they are distributed or retained: Imagine your cultivation business has a great harvest and substantial profits. As an LLC member, you’ll be taxed on your share of those profits even if you decide to keep the money within the business to invest in new equipment or expand your operations. This can make reinvestment less tax-efficient compared to other structures.
- Sometimes, pass-through taxation can be a disadvantage: Since cannabis is a cash-intensive business, you as an owner/partner may not have the funds to pay for the taxes that pass through from an LLC or an S Corp to your personal returns, and that adds an additional burden on your personal financial situation.
Best For:
Startups and smaller operations looking for flexibility and ease of setup, particularly single-owner businesses. Just be aware that in California, if you choose an LLC for your cannabis infused beverage company, the FTB will likely be paying close attention to your compliance from the outset.
S Corporation
Pros:
- Pass-through taxation like an LLC: Similar to the LLC, if you structure your distribution business as an S Corp, the profits and losses will flow through to your personal tax return, avoiding taxation at the corporate level.
- Potential to reduce self-employment taxes through reasonable compensation plus shareholder distributions: Envision yourself as the owner-operator of a successful cannabis testing lab. By structuring as an S Corp, you can draw a “reasonable salary” subject to payroll taxes, and then take the remaining profits as shareholder distributions, which aren’t subject to self-employment tax. This can lead to significant tax savings for profitable businesses.
- Some liability protection: Like an LLC, an S Corp can offer a degree of protection for your personal assets from business liabilities.
Cons:
- More rigid ownership rules: If you plan to bring on multiple investors for your cannabis retail store, keep in mind that S Corps have stricter ownership rules. For instance, shareholders generally must be U.S. citizens or resident aliens, and there’s a limit on the total number of shareholders.
- Still impacted by 280E: Just like with an LLC, your S Corp-structured manufacturing business will also be subject to the limitations of 280E, meaning many of your operational expenses will not be deductible for federal income tax purposes.
- Can’t deduct fringe benefits for shareholders who own more than 2% of the company: Imagine you, as the majority owner of your cannabis delivery service structured as an S Corp, want to deduct health insurance premiums. Unfortunately, S Corp rules prevent you from deducting these as a business expense, thereby increasing your personal tax burden.
- Requires payroll setup and compliance: If you choose an S Corp for your cultivation business, you will need to establish a formal payroll system to pay yourself a reasonable salary. This adds administrative complexity and costs compared to an LLC.
Best For:
Cannabis business owners who can take a salary and want to minimize self-employment taxes, especially if your extraction company is generating consistent profits. However, it’s crucial to keep your books clean! S Corps demand stricter accounting and payroll compliance for your dispensary.
C Corporation
Pros:
- Can retain earnings without immediate tax consequences: Picture your large-scale cannabis cultivation operation generating significant profits. As a C Corp, you have the flexibility to retain a portion of those earnings within the company for future expansion or investment without the immediate tax implications faced by pass-through entities.
- Easier to attract investors (venture capital prefers C Corps): If your cannabis technology startup is seeking venture capital funding, structuring as a C Corp is often the preferred route for investors. The corporate structure aligns better with their investment models and exit strategies.
- More fringe benefit deductions allowed: Does your established cannabis manufacturing company want to offer comprehensive benefits to its employees, including yourself? As a C Corp, you can often deduct a wider range of fringe benefits, such as health insurance, on a pre-tax basis.
- Separation of owner and business liability: A C Corp provides the strongest shield between your personal assets and the liabilities of your cannabis distribution business. This legal separation can be particularly important as your business grows and faces more complex operational risks.
Cons:
- Double taxation: profits are taxed at the corporate level and again when distributed as dividends: If your profitable cannabis retail chain is structured as a C Corp, you will first pay corporate income tax on its profits. Then, when those profits are distributed to you and other shareholders as dividends, you’ll be taxed again at the individual level. This “double taxation” is a significant drawback for many smaller businesses.
- Still subject to 280E—perhaps even more painfully than pass-through entities: For your C Corp-structured edibles company, the impact of 280E can feel even more pronounced. The inability to deduct most operating expenses at the corporate level can lead to a larger corporate tax bill, which is then compounded by individual taxes on dividends.
- Requires detailed recordkeeping and formal governance: Operating your cannabis testing lab as a C Corp demands meticulous recordkeeping, regular board meetings, and adherence to formal corporate governance procedures. This adds administrative burden and costs.
Best For:
Larger cannabis businesses that are planning to reinvest heavily, seek outside funding, or eventually go public. C Corps offer the clearest long-term growth path for your multi-state cannabis operation, but the tax bite can be brutal without smart planning.
A Word on 280E (Because You Can’t Ignore It)
Section 280E of the Internal Revenue Code is a reality that every cannabis business, regardless of structure, must confront. It prevents your cultivation, manufacturing, distribution, or retail operation from deducting most normal operating expenses. The only silver lining is the Cost of Goods Sold (COGS). This underscores why strategic entity selection is fundamentally about maximizing the limited deductions available to you and developing a robust tax strategy.
We have worked with dozens of cannabis businesses in California who didn’t realize until tax season how much 280E would impact them. It’s avoidable—with planning and strategic advice.
So, What’s Right for You?
There’s no one-size-fits-all answer. If you are launching a small cannabis delivery service as a sole proprietor, an LLC might provide the initial flexibility you need, but with a clear roadmap to potentially convert to an S Corp or even a C Corp as you scale. By contrast, if your cannabis extraction company is experiencing rapid growth and seeking significant investment, a C Corp might be the more strategic choice from the outset. S Corps can be a sweet spot for profitable owner-operated businesses like your testing lab, offering self-employment tax savings while maintaining pass-through taxation.
The best thing you can do is consult with a CPA who understands the nuances of California’s cannabis industry. That’s where we come in. We help cannabis businesses in LA and across California build solid financial foundations, starting with the right structure.
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Contact us today to learn more about how we can help you select the ideal business structure for your LA, California cannabis business.