What is an ESOP? And should New York cannabis businesses consider it? (Guest Column)

This post was originally published on this site.

This guest column is from Paula Collins, EA, Esq., a tax attorney dedicated to the cannabis industry, a co-founder of the NY Consortium of Cannabis Accountants, and an adjunct professor at Pace University’s Elisabeth Haub School of Law, where she teaches Cannabis Law and Policy. The views and opinions expressed in this article are those of the author, and do not necessarily reflect the views or positions of NY Cannabis Insider.

On Dec. 21, 2023, news spread (as it does in this industry) that Massachusetts-based Theory Wellness had found a way to work around IRC 280e, while also going tax exempt, AND while creating an employee-owned model through an employee stock ownership plan (ESOP).

I got several DMs and a few email messages along the lines of, “What the foq is an ESOP and how soon can you set one up for me?” Let’s start there.

I hate to be a buzzkill, but setting up an ESOP is a long, complicated process that starts by interacting with the IRS and 26 US Code Section 401. Yes – it is a lot more involved than setting up your Quickbooks for you.

Keep in mind: an ESOP falls under the Employee Retirement Income Security Act (ERISA). On top of all of the compliance requirements you already have as a cannabis business owner, a cannabis business owner who elects to set up an ESOP will have to comply with rigorous audits from the Federal Department of Labor (DOL), the IRS, and possibly the SEC. (Even if the company isn’t publicly traded, it would need to set up its ESOP or any other retirement account in compliance with SEC rules.)

But wait – cannabis companies can’t even have a simple checking account. And we don’t have any case law or prior guidance from any of those entities (the IRS, DOL, or the SEC) as to whether the Schedule I issues will keep us out of qualifying for an ESOP. Are you seriously telling me that we can’t bank at a regular bank, but we can set up an ESOP? I honestly don’t believe it.

Full disclosure: I haven’t seen the numbers or the fine print for the Theory Wellness ESOP. I’d like to be proven wrong, in which case I will issue an apology and, hopefully, an explanation.

The whole topic of ESOPs for cannabis companies intrigued me, so I immediately dove into research mode to see if this could help our New York businesses. Could an ESOP really be a workaround for 280e? Could an ESOP make the company tax exempt? And could an ESOP work for my licensed clients? As far as I can tell, the answer to the question is “No. No. And another No.” I just don’t see an ESOP working for a New York cannabis company for quite some time.

But what is an ESOP? And why am I confident in saying that an ESOP could not work for a New York cannabis company right now?

First of all, the IRS application process for establishing an ESOP requires that the company has an accredited valuation. I’m not talking about the wild, late-night projections by new licensees who think they could either make $3 million profit in their first year or else “sell the damn license for a million cash” (actual quote from a client). I’m talking about a business valuation from a credentialed Accredited Senior Appraiser (ASV), a Chartered Financial Analyst (CFA), or a CPA who holds the AICPA designation known as “Accredited in Business Valuation” (ABV).

Heh-heh – you thought the cannabis-trained accountant was expensive. And no – those guys don’t usually work pro bono.

So far, the NY cannabis landscape does not look promising. Revenues are down (according to frantic-but-unofficial reports from just about everyone). The legal environment is still quite uncertain, with a new lawsuit filed on Dec. 18, 2023. Honestly, we don’t know what the future holds in regulated cannabis in general, and NY in particular.

On the one hand, we have been promised that hundreds of new licenses will be issued soon. (And we don’t know yet where the tipping point is for having too many licensed shops.) On the other hand, we’ve witnessed the market paralysis that occurs when a judge imposes an injunction. I’m pretty comfortable thinking that a credentialed appraiser would come back with two thumbs down for a NY business right now. Sure, we all have hopes for the long-term future. But you can’t value a company on hopes.

As a business owner setting up an ESOP for your employees, you would need to pick a compliance team dedicated to advancing the ESOP application. That’s because you would be looking at months of compliance evaluations, forms, reports, and meetings with the IRS, possibly the SEC, the DOL, and your team. You only thought the application for the license was a quagmire of forms! Filing for the IRS ESOP determination letter is no joke.

Your compliance team will need to set up an ESOP plan to submit to the various authorities. The compliance team will then select an ESOP trustee. Think of it this way: the employees are working and setting aside money for their respective futures, matched with contributions from the company. A trustee has a fiduciary responsibility to make sure that the funds, which are ERISA-protected, aren’t stolen, invested poorly, or spent. Yes – the trustee will charge ongoing fees. You didn’t think this would be free, did you?

Then the business needs to finance the ESOP. This might be from company profits (which don’t really exist for a company that hasn’t been in business for less than 1-3 years), or borrow money (hah – same problem you had with doing your buildout!).

Let’s say I’m wrong, and a NY cannabis company makes it through all of those steps. Then, by ERISA requirements, they need to have a team dedicated to communicating the details of the plan, educating the employees about how the plan works, its benefits, and the implications for retirement savings. As the shares accumulate, do the employees become True Parties of Interest? NY has specific rules about TPIs that will have to be squared with the rules of the ESOPs.

Let’s say in two years an employee wants to withdraw a chunk of their ESOP money for a down payment on a house. They do so by withdrawing stock and then selling it. By the way, the employee will then be taxed on that. Gotta make sure they have been educated in the process, according to the ERISA rules. They need to know that it takes time to liquidate their shares. This is way more complicated than running to the teller machine on a Friday afternoon and selecting “Savings” instead of “Checking.”

How about this scenario – maybe they are leaving the company, and they want to rollover their shares and reinvest the proceeds under Section 1042, qualified replacement property.

Sorry. Did your eyes just glaze over? Here’s my point: the average budtender is just not about this sort of thinking. At $20 an hour, they are honestly just trying to earn enough for subway fare and rent. A reasonable question is this: do the employees even want an ESOP?

Finally, there will be an ongoing fee to the ESOP trustee (I told you these guys don’t work for free!) to maintain the plan, keep records, and to file reports with DOL, possibly the SEC, and the IRS. These fees will continue for the life of the plan, which is a retirement plan, so presumably forever. (Even though 55% of budtenders leave the job in less than 12 months, if their funds are in the ESOP, your relationship with them continues in perpetuity or until they liquidate them.)

About that tax-exempt status. The contributions that a company makes to an ESOP plan are tax deductible (Did you catch that – you are making contributions to your employees’ retirement plans! This is in addition to paying the employer-side of FICA!) I will wait for the US Tax Court case on deductibility of these contributions, since 280e states that “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business … consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act)…”

Maybe there is a little bit of wiggle room in deductibility of deferred compensation in the form of employee stock shares. I’ll let some other big corporation pick up the accounting and legal fees for that tax court case.

In truth, I’m not 100% confident that the employees could benefit from the capital gains tax deferrals of an ESOP due to 280e. Remember: there is recent case law that says a manager of a retail cannabis dispensary cannot file for protection from creditors under the federal bankruptcy court rules. If they won’t even allow cannabis industry employees to file for bankruptcy, I just don’t see the federal government offering them a retirement plan.

So in concept will an ESOP ever work for a NY cannabis company? Hmm. Maybe if cannabis is re-scheduled or de-scheduled; and maybe if NY’s market finally hits its stride and goes a year without an injunction; and maybe if the financial statements of cannabis companies in NY show consistent, multi-year profits after taxes; and maybe if we see that employees make long-term, multi-year commitments to their NY cannabis jobs; maybe then we can talk about an ESOP.

But given the cost of getting the business valuations, funding the ESOP, paying the trustee, and caring and feeding the ongoing maintenance costs, I think NY cannabis companies are better off hiring a cannabis-trained accountant and making prudent financial decisions pursuant to federal taxation IRC 280e and regular taxation under NY state DTF rules.