Cannabis Industry Qualified Small Business Stock and Entity Selections

Cannabis Industry Qualified Small Business Stock and Entity Selections

By Ken Boiarsky and David Wunderlich

New business owners are presented with myriad options when organizing an entity, the first being choosing how to structure their new business: as a flow through entity, or as a tax paying “C” corporation.

Flow-through entities generally include sole proprietorships, partnerships, limited liability companies taxed as partnerships, and S corporations. Flow-through entities generally do not incur entity level taxation, and items of income or loss are subject to U.S. federal income taxation at the partner, member, or shareholder level. This is advantageous to smaller businesses that may not have the capital to bear a heavy tax burden right off the bat.

C corporations and limited liability companies electing C corporation taxation are subject to U.S. federal income tax at the company level. The principal disadvantages of the C corporation form are the double taxation of C corporation income and the inability of C corporation owners to use C corporation losses to offset owner income from other sources. In some cases, however, the tax benefit provided by IRC section 1202 to C corporations outweighs the disadvantages. When it applies, IRC section 1202 can eliminate the tax on gain from the sale of C corporation stock.

Section 1202 excludes from an individual taxpayer’s gross income 100 percent of the gain recognized on the sale of “qualified small business stock” (“QSBS”) that was held for at least five years before the sale. The amount of the exclusion is limited to the greater of $10 million or ten times the taxpayer’s tax basis in the QSBS stock. This limitation applies on a per-company basis for each individual.

In order to qualify as QSBS, the following requirements must be met:

  • Stock is acquired by the taxpayer upon original issue in exchange for money, property (not including

stock), or as compensation for services.

  • The corporation is engaged in an active trade or business.
  • The corporation is engaged in a qualified trade or business.
  • The corporation is an eligible domestic entity.
  • The aggregate gross assets of the corporation do not exceed $50 million immediately before and after the issuance of shares.


It is important to keep in mind some additional factors. Section 1202’s exclusion does not apply to corporations engaged in certain types of businesses. In particular, Section 1202 does not apply to businesses involving most professional services and some other personal services, business involving farming, mineral-extraction, restaurant and hotel activities, and certain capital-intensive financial activities. Section 1202 requires that a business owner hold his or her QSBS for five years, and this timeframe could present operational, capital, or durability challenges to the small business.

Business owners should also consider anticipated dividends and working capital needs of the business. Dividends may give rise to a second layer of taxation, and additional cash infusions in exchange for new shares may not meet the section 1202 requirements. It also may be better to enable owners to take advantage of any losses generated in a flow-through structure. Losses in a corporate entity may be trapped (subject to applicable carryforwards), with limited value to a potential buyer. Worthless stock of a corporation may generate an ordinary loss for the stockholders if the stock meets the requirements in IRC Section 1244.

Ultimately, business owners should work with experienced tax advisors or tax counsel to ensure they are fully educated about the short- and long-term consequences of both options. While flow-through entities may be the more attractive option at first glance because of the lower tax burden, there are significant long-term advantages that a business owner can realize by electing taxation as a C Corp.

There are other important distinctions and nuances that a business owner must consider when selecting entity form and taxation structure for his or her business. Issues of corporate governance and plans for fundraising must be considered, along with advice from experienced business counsel, when forming any entity. The owner must ultimately decide if the tax burden and administrative burden that comes along with operating as a C Corp is worth the reward of a future potential sale of QSBS without incurring capital gains tax.

Contact the corporate attorneys at Hoban Law Group to discuss entity selection, taxation issues, or any of your business needs.

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