New Cannabis Business Law Practice

We are pleased to announce that we have added a new Cannabis Business Law Practice to our firm. Now that Ohio has legalized the sale of medical cannabis, and California has legalized adult-use and medical cannabis, we have extended our service offerings to this fast-growing segment. Companies and entrepreneurs operating in the cannabis market need legal counsel with the right kind of experience in the business and corporate law issues they face. We already have been representing cannabis companies at various levels of the value chain for several months, including cultivators, manufacturers, processors, and retailers. This hands-on experience gives us the industry-specific insights and knowledge that cannabis companies need.

Our focus on transactional business and corporate law work for startups and small businesses translates closely to this new area of law. Here are some of the areas in which we can help your cannabis business:

  • Entity formation, including choice of entity (LLC vs. corporation)
  • Business financing through private placements
  • Contracts with vendors, suppliers, downstream customers, etc.
  • Commercial lease negotiation for industrial and retail space

If you would like to discuss your cannabis industry business, please contact Paul H. Spitz at

Please note that the cultivation, distribution, and possession of cannabis for any purpose is still illegal under federal law. We can only advise you with respect to compliance with Ohio’s medical cannabis program, and California’s medical and adult-use cannabis programs.


Will Trump Kill the LLC?

There is an interesting provision in Donald Trump’s tax reform proposal. Specifically, he proposes to lower the corporate tax rate to 20%, while setting the maximum tax rate for LLC’s and S-corps at 25%. In essence, his proposal would penalize businesses that elect a pass-through entity structure over the traditional corporate structure. So the question is, will this kill the LLC?

Of course, this is only a proposal, and given the track record of the current administration and Republican-led Congress, there may be no tax reform at all. Or, something will pass, but whatever it is will differ in key ways from the original proposal. It’s still worth considering whether it makes any sense to have different tax rates for different entity structures, and what effect that will have.

If the differential tax rate does pass, I expect many of my existing clients who have set up LLCs to engage in some serious tax planning. They will need to compare their tax bill at the new 25% LLC rate, vs. what they would pay if they were a corporation. This may lead a number of these firms to convert to corporations, to take advantage of the preferential tax treatment. Even more profoundly, it may lead new entrepreneurs to ignore LLCs completely when starting a new business. The LLC form is only about 30 years old, and it has become wildly popular for most kinds of businesses, but this new tax scheme may kill it.

Let’s keep an eye on this issue.

The Myth of the S-Corporation

I often hear potential clients say things like, “I want to form an S-corp,” or “should I form an LLC, S-corp, or C-corp?” This illustrates a very common misunderstanding about the nature of an S-corp. In today’s post, I hope to clear up this misunderstanding, once and for all.

The first thing to understand is this: LLCs and C-corps are things, and an S-corp is a choice. The best way to understand this is to go to any state’s website for forming businesses, and look at the different kinds of business entities available. For example, California allows you to form corporations, LLCs, limited partnerships, general partnerships, and limited liability partnerships. Under the category of corporations, you have for-profit corporations and non-profit corporations. Nowhere is forming an S-corp a possibility. The same is true for Delaware, too. When you are looking at the different kinds of business entities, an LLC is an entity, and a C-corp is an entity (although it will simply be called a “corporation”), but an S-corp is not an entity. So what is an S-corp?

An S-corp is a tax election that you make with the IRS. When you form a business at the state level, you have to choose a kind of entity – for example, an LLC or a corporation. Those two types of entities are taxed in different ways, however, and that’s where the S-corp tax election comes in. An LLC is a pass-through entity, meaning that the LLC’s net taxable income or loss is passed through to the owners in proportion to their ownership percentages, and the individuals report the income or loss on their personal tax returns. In the case of a corporation, the corporation itself must pay taxes on its taxable income, and its shareholders only incur tax liability with respect to corporate income that is distributed to them as a dividend. This is often referred to as “double taxation,” one of the most dreaded things since, well, peanuts in an elementary school.

If a corporation wants to be taxed more like an LLC, meaning it wants to be treated as a pass-through entity, it can make an S-corp election. There are some restrictions – the corporation can only have one class of stock, cannot have more than 100 shareholders, and in general, all shareholders have to be individual persons and US citizens or permanent residents. A corporation that has a stockholder who is a Chinese citizen and resident, therefore, would be disqualified from making an S-corp election. The fundamental thing to understand here is that you have two layers – the entity layer and the tax treatment layer. At the base is the entity layer – that’s the corporation. Laying on top of the entity layer is the tax treatment layer – that’s the S-corp election.

As further illustration of how this all works, an LLC can make an S-corp election too. You might ask, “since an LLC is already a pass-through entity, why on earth would it want to make an S-corp election?” That’s an excellent question. The reason is that when an LLC makes an S-corp election, its owners (the LLC members) can become employees of the LLC, so they can have taxes withheld from their paychecks, saving them the hassle of quarterly estimated tax payments. Also, they will pay a reduced self-employment tax on the money they take out via distributions, vs. if they had not made the s-corp election.

One final note: the S-corp election is not written in stone. You can inadvertently blow your S-corp election, by taking on a disqualifying shareholder or exceeding the 100-shareholder limit, for example. You can also voluntarily give up the S-corp treatment, when it no longer is advantageous, or when it interferes with bigger goals, such as when a tech startup needs to take on venture capital investment.

Ten Common Startup Mistakes – Part 1

Today seems like a good day to tie together a number of subjects I’ve written about in the past, as a list of the Ten Biggest Legal Mistakes Startups Make. Here are the first five:

Number 1 – Choosing the Wrong Form of Entity

All too often, I encounter startup founders and would-be founders that reflexively think they need to set their company up as an LLC (a limited liability company). So I ask them, “are you thinking about getting venture capital funding?” If the answer is yes, then right away I tell them they need a C corporation, because venture capital investors will not invest their money in LLC’s. This isn’t some well-kept secret, either. A simple internet search on the subject will quickly show that VC’s require that the startups they invest in be set up as corporations, and preferably, Delaware corporations. So it is always frustrating to me when someone has wasted time and money setting up an LLC, when he or she really needs a corporation. Even more frustrating is when that founder had a lawyer set them up with an LLC; that’s sloppy lawyering, at best. Aside from the VC issue, I find that the corporate structure is generally simpler and easier to work with than LLCs, which are really jumped-up partnerships with complex tax issues. Many startups want to compensate employees with stock options, but options are a corporate concept. You can’t do stock options with an LLC. Finally, the dreaded “double taxation” you get with corporations is not really an issue for startups, because they generally don’t have profits and aren’t making dividends.

Number 2 – Failure to Split Founders’ Equity Properly

Following fast on the heels of picking the wrong entity is failing to properly split up the equity among founders. I’ve written a full post about this subject, so I’ll just write a brief summary here. Founders often just reflexively split the equity into equal shares. The truth is, different founders contribute differently to the startup. Some of those contributions are more valuable than others. It is an uncomfortable and difficult discussion, however, and while opting for equal shares seems like an attractive, less controversial alternative, the discussion is going to happen sooner or later. Better to have it happen sooner, before issuing founders shares.

Number 3 – No Vesting or Buyout Provisions

It is very common for startups to fail to include vesting and buyout provisions that apply to founders’ equity. This is particularly the case when the founders go cheap and use DIY services like LegalZoom to set up their corporation (or worse, their LLC). Everything might seem warm and fuzzy among the founders when starting out, but over time, frictions arise or someone gets burned out, and a founder leaves. What you don’t want is for that founder to leave with all her shares. By vesting those shares over time, and having the option to buy back vested shares at a nominal price, a startup protects itself against having an ex-founder out there with 40 or 50 percent of the ownership. You can read more about this subject here.

Number 4 – Forgetting the 83(b) Election

When you have founders’ stock or stock options that vest over time, you want to make sure that you do a timely 83(b) election. This is one of those wonky tax issues, and you can read more about it here, but I’ll give a brief rundown. When you receive stock that vests over time, you recognize taxable income as the stock vests, because in theory, that stock has increased in value since it was originally granted. The 83(b) election allows you to recognize income on the increase in value at the time you receive the stock, rather than when it vests. There should be minimal increase in value (if any) at that earlier point in time, so there should be almost no tax liability. You have to make the 83(b) election within 30 days of receiving the restricted stock or stock options, however. Not 31 days later. Not 50 days later but I can pay a penalty. Thirty days. Failing to do this can be a huge and costly mistake. Don’t make it.

Number 5 – Failing to Lock Up Intellectual Property

It is crucial for startups to lock up their intellectual property at every opportunity. When setting up the startup, one or more founders may have developed IP that is important to the enterprise. The startup should have the founder execute an IP assignment agreement in exchange for receiving her founders’ shares. By doing so, the startup now owns the IP, and if the founder leaves, she can’t take the IP with her. In addition, other employees may be developing IP for the company, and they should all execute contracts that specify that the IP belongs to the company, not the employee. Finally, if some of the founders are still working “day jobs” at other companies, it is important to review their employment agreements with those other companies. IP that they think they are developing for the startup may actually belong to the day job.

Those are the first five common startup mistakes. The next five will be in Part 2, which is here. Thank you for reading!

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A Common Startup Mistake (and how to fix it)

When someone is running a startup company, there are all kinds of pitfalls and potential mistakes. A typical mistake many startups make is incorporating as an LLC, rather than a C corporation. In this post, I will describe why that is often a mistake, and then I will tell you how to fix it. 

There is a common perception that it is cheaper to set up an LLC than a C corporation. That really is not true, however. In Ohio, for example, the state filing fee is the same for each: $125. Also, if you go to one of those DIY legal websites (who, like Lord Voldemort, shall not be named), the charge for handling the paperwork and filing is the same.

There is also a misperception that LLC’s are inexpensive to set up and operate. LLC’s are hybrid entities – part partnership, part corporation. The operating agreement for a multi-person LLC can run to 100 pages, with complicated provisions involving capital accounts, allocation of profits and losses, and other tax-driven terms. Also, while LLC’s give you a lot of flexibility in setting up how you want to run the company, if you fail to specify these procedures in the operating agreement, you will be stuck with the state defaults, which may not be what you want. Many people who try to set up an LLC on their own don’t even bother with an operating agreement, or never pay attention to it. That can lead to losing the liability shield that is a big attraction of having an LLC in the first place. Most LLC operating agreements also do not include the vesting and buyout provisions that a startup company needs, to address the situation where one of the cofounders leaves the company.

One justification for LLC’s that I hear all the time is the mantra of avoiding the dreaded “double taxation.” For the typical startup, however, the risk of double taxation is like the risk of being hit by the planet Saturn. First of all, you need profits at the corporate level that will be subject to taxation. Most early stage startups don’t have any profits (and too many don’t even have revenues). Second, you need to make dividends to shareholders, so that you can suffer that second round of taxation. But startups can’t pay dividends if they have no profits, and tech companies traditionally reinvest profits, rather than pay dividends. Microsoft was almost 30 years old before it paid its first dividend. So in truth, double taxation is more urban myth than reality for startups. If pass-through of losses is important – for example, if the founder is keeping his day job and needs to offset employment income – an S-corporation election may be a viable alternative.

Finally, setting up an LLC can be big mistake for any startup seeking venture capital, because venture capital investors do not invest in LLC’s. Venture capital investors will only invest in C corporations, and they will usually require that the company be incorporated in Delaware. While you can set up different membership classes in LLC’s, they are not as easy to create and do not have the body of law supporting them that C corporations have. Coming to a potential VC investor with an LLC, rather than a C corporation, also sends a signal that you are relatively unsophisticated. Surprisingly, there are some attorneys out there who work with startups, and still routinely set them up as LLC’s. I shake my head at this, as I can’t come up with any reasonable justification other than that they want to charge more fees down the road to fix their mistake.

Luckily, if you have made the mistake of setting up an LLC rather than a C corporation, you aren’t doomed. There is a relatively straightforward fix, but it will cost you more money and could delay a Series A closing. The fix is called a “statutory conversion,” and is a mechanism under state law that allows an LLC to convert into a corporation. An LLC formed in one state, for example Ohio, can even use statutory conversion to convert into a corporation in another state, such as Delaware. When you do a statutory conversion, the converting LLC is, by law, the same legal entity after conversion as before, so it avoids transfer taxes and other negative legal and tax consequences that might result from multiple-entity conversions.

To do a statutory conversion from an Ohio LLC into an Ohio corporation, you will have to file a certificate of conversion with the state of Ohio and pay the filing fees. If you are converting an Ohio LLC into a Delaware corporation, you will have to file certificates of conversion in both states, and pay filing fees in both states. Also, you will need to file a certificate of incorporation in Delaware, and pay the filing fee for that. There also may be some accounting and tax issues to deal with, depending on the startup’s assets and liabilities. Of course, there are legal fees involved as well.

As you can see, forming as an LLC isn’t necessarily the best option for a startup that will be seeking venture capital investment at some point, but it can be fixed. The remedy, unfortunately, will end up costing the startup time and money. This is why it is always better to take the time to do things right at the outset.

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