When will California be preaching to the converted?

Twenty years after California voters approved medical marijuana, the state has been slow to provide guidance to the industry regarding the approved forms of corporate structure for cannabis businesses. The most common form of cannabis business in California is the nonprofit mutual benefit corporation, a hybrid model where corporations are formed to serve a defined class of members rather than for the public benefit. As the industry becomes more lucrative, cannabis enterprises will want to move towards a for-profit structure. They can do so by filing amended articles with the Secretary of State or merging into existing for-profit business entities. However, as there is priority license review for businesses that were operational and in good standing prior to certain 2016 dates mentioned in the legislation, merging entities run the risk of losing their corporate history which is vital when seeking licenses.

Introduction: How we got here

Twenty years ago, California voters approved Prop. 215—the Compassionate Use Act of 1996—which legalized the use of medical cannabis throughout the state. But while cannabis possession by medical patients was legalized, the underlying "businesses" serving those patients were not, leading to the proliferation of nonprofit business entities currently occupying California's cannabis market. In 2003, the nonprofit structure became further entrenched when Senate Bill 420 stated that it did not authorize “any individual or group to cultivate or distribute marijuana for profit.”[1]

Now that California has legalized both medical and recreational use, indications from state regulators, especially after the passage of the Adult Use of Marijuana Act (AUMA)[2] on the November ballot, have been that a transition to a for-profit structure is right around the corner. When that happens, businesses from the older nonprofit regime will want to quickly transition to more functional for-profit entities. The rush to convert to a for-profit entity is heightened by the priority licensing review at the state level for businesses that were operational and in good standing prior to certain dates in 2016. The businesses that can most quickly convert and obtain licensing will be the first targets for outside investors looking to break into the California market.

Overview of California Cannabis Business Models

The most common form of nonprofit business entity used by California medical marijuana collectives to date has been the nonprofit mutual benefit corporation (NMBC). Most states have a single type of "nonprofit corporation" which has strict limitations on corporate governance and prohibits equity interests to individuals, but California's second nonprofit option—NMBCs—act as hybrid nonprofit entities which are formed to serve a defined class of beneficiaries (i.e., the corporation's "members") rather than for the public benefit.

NMBCs are different because their corporate bylaws allow any individual to be admitted to membership, meaning that the directors and officers can also be members. Those same directors and officers can also draft bylaws to allow full asset distribution to members on the corporation's dissolution. It is important to note that while these entities are formed "not-for-profit", they are not eligible to receive tax-exempt status from the IRS or Franchise Tax Board.

The ability for NMBCs to distribute corporate assets to its members upon dissolution is a certainly a handy tool, but most nonprofit entities will want to preserve their corporate operating history for purposes of state (or local) licensing priority. In such an instance, dissolution is not an option and some form of corporate conversion or merger will be required.

Converting from a nonprofit to a domestic stock corporation

The simplest method for an NMBC to convert to a for-profit entity is to amend its articles of incorporation with the California Secretary of State. A nonprofit "mutual benefit corporation may amend its articles to change its status to that of… a business corporation."[3] However, any amendment to a corporation's articles or bylaws requires the approval of certain classes of members if such an amendment would materially and adversely affect the rights, privileges, numbers of that class or reclassify that particular class.[4] Nonetheless, if the members' interests are aligned and they vote to amend, a corporation can declare itself to be a California stock corporation by simply saying so in its restated articles and revising provisions related to the distribution of assets upon dissolution. The members of the NMBC prior to conversion will, in turn, hold equal shares of the new stock corporation following the conversion.

A business that converts to a stock corporation will also need to assess the potential tax consequences of such a transaction. Upon successful conversion, the business will, by default, be treated as a California C-corporation which will be subject to "double taxation"—once at the corporate level and a second time when profits are distributed to shareholders. Should the business wish to elect pass-through status, it can file a Form 2553 with the IRS to become an S-corporation. However, it should be cautioned that electing such status then precludes the corporation from offering future equity to non-individual investors because limitations on S-corporations prevent corporations and partnerships from holding shares.

For businesses seeking to convert to for-profit status and obtain funding from early-stage investors, they should retain C-corporation status or explore whether a limited liability company would meet their needs.

Limited liability companies as an alternative corporate structure

A limited liability company (LLC) is a hybrid corporate form that offers pass-through tax status (like an S-corporation or partnership) combined with the limited liability to its owners (like a corporation). LLCs are highly flexible and, with the help of sophisticated legal and tax professionals, can be carefully structured to offer its members multiple classes of ownership, preferred returns, unequal splitting of tax credits, and the option to be taxed as a corporation.

It is worth noting that a cannabis business that was previously operating as an NMBC will not be able to convert directly to an LLC because corporations and LLCs file different types of articles with the Secretary of State. The California Corporations Code does, however, expressly provide for NMBCs to merge into any domestic or foreign corporation "or other business entity"[5] which means that for-profit status can be achieved through a merger transaction with a separate LLC.

Mergers and the challenge with retaining corporate history

In assessing whether an NMBC's merger with LLC or a stock corporation is advisable, one important question arises: will merging an existing nonprofit into a new for-profit entity preserve the operational history and attributes of the NMBC for purposes of state and local cannabis licensing?

The answer remains far from certain. Under California merger law, the separate existence of the disappearing entity ceases and the surviving party succeeds "as to the rights and property of the disappearing entity".[6] If we consider the entity's history as part of their rights acquired by the surviving entity, then it could be argued that the prior incorporation date and other corporate attributes related to that NMBC's operations and good standing may also survive and impute to the surviving entity.

However, the language in the AUMA regarding priority licensing status requires entities to prove compliance with the law prior to September 1, 2016 to the licensing "authority's satisfaction."[7] Additionally, as part of the application process, the Bureau of Marijuana Control will request that local jurisdictions identify potential applicants who have been operating in compliance with state and local laws.[8] It has even been suggested that the regulators may require the Attorney General's office to approve any nonprofit entity involved with a conversion to or merger with a for-profit entity.

The lesson here is clear: there is still much uncertainty in California's transition to a for-profit cannabis market; any corporate structuring being done prior to a full release of the regulations should be done with extreme caution and pursuant to the counsel of an experienced corporate attorney.

Conclusion: When can we expect California to permit for-profit cannabis businesses?

Neither the AUMA, nor its medical marijuana counterpart, the Medical Cannabis Regulation and Safety Act (MCRSA), explicitly provide for a for-profit structure in conducting business, but it is implied. The definition of a "person" which can apply for a license under MCRSA and/or AUMA includes for-profit entities. Furthermore, MCRSA amended California Health and Safety Code 11362.775(b) to state that the "affirmative defense" protections of operating under the older collective model will be phased out one year after the state begins issuing licenses under MCRSA (i.e., January 1, 2018).

This implied reading means that the very latest date that for-profit entities will be allowed to operate cannabis businesses is January 1, 2019. However, a wait that long seems unlikely. The industry gained significant momentum with California's legalization of recreational use, local municipalities are scrambling to adopt viable ordinances, and an entire industry is waiting—paralyzed—until regulators release clear and unambiguous guidance on the path forward for operating a for-profit business. Such circumstances will likely create pressures too great for lawmakers to ignore and California should likely see movement on this subject in the near future.

[1] Sen. Bill No. 420 (2002-2003 Reg. Sess.) § 11362.765(a).

[2] California Proposition 64, as approved by voters, Gen. Elect. (Nov. 8, 2016).

[3] Cal. Corp. Code § 7813.5.

[4] Cal. Corp. Code § 7813.

[5] California Corporations Code Section 8010 expressly permits this type of merger; furthermore, Section 5063.5 defines "other business entity" to include LLCs and partnerships.

[6] Cal. Corp. Code § 8020(a).

[7] Cal. Bus. & Prof. Code § 26054.2(a), added by initiative, Gen. Elec. (Nov. 8, 2016).

[8] Cal. Bus. & Prof. Code § 26054.2(b), added by initiative, Gen. Elec. (Nov. 8, 2016).

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