Legal and Tax Structuring Considerations for ESOPs in the Cannabis Industry (Including IRS §280E)

The Internal Revenue Code (IRC) Section 280E prohibits businesses engaged in trafficking Schedule I or II controlled substances, including state-legal cannabis, from deducting ordinary business expenses on their federal taxes. This leads to effective tax rates as high as 70–90%, as expenses like payroll, rent, and utilities remain non-deductible, leaving only the cost of goods sold (COGS) as an offset to revenue.

However, a properly structured Employee Stock Ownership Plan (ESOP) can eliminate the burden of 280E entirely. If a cannabis company becomes a 100% ESOP-owned S-corporation, it achieves tax-exempt status, as profits pass through to the ESOP trust, which is a tax-exempt retirement entity. Consequently, no federal income tax is due, neutralizing the impact of 280E. Many states also mirror this federal tax treatment, further enhancing the financial benefits.

Companies such as Theory Wellness have leveraged this model to eliminate federal and state tax liabilities, allowing reinvestment of savings into business expansion and employee benefits. However, businesses must comply with IRS and Department of Labor (DOL) regulations to ensure legitimacy and avoid penalties for tax avoidance.

ERISA Compliance and Governance Requirements for Cannabis ESOPs

An ESOP is a qualified retirement plan governed by the Employee Retirement Income Security Act (ERISA) and IRS regulations. Cannabis companies forming an ESOP must adhere to the same compliance standards as traditional ESOP sponsors, despite cannabis’s federal illegality.

Key requirements include:

Establishing an ESOP trust to hold company shares.

Appointing an independent ESOP trustee or fiduciary committee.

Conducting annual valuations and independent audits.

Ensuring stock transactions occur at fair market value to avoid prohibited transactions.

Meeting contribution limits, nondiscrimination testing, and annual reporting obligations.

Cannabis businesses should retain experienced ESOP counsel and trustees to navigate these complexities. The Department of Labor has scrutinized ESOP transactions in other industries, enforcing compliance through litigation where ESOP stock transactions were mispriced. Given these challenges, ESOPs are most viable for companies with at least 20 employees, ensuring adequate participation and financial sustainability.

Choosing the Right Corporate Structure: C-Corporation vs. S-Corporation ESOPs

Most cannabis businesses operate as LLCs or C-corporations, but ESOPs can only own corporate stock. Consequently, an LLC must convert to a corporation before forming an ESOP. The two main structuring paths are:

C-Corporation ESOP: Owners can sell at least 30% of a C-corp to an ESOP and defer capital gains taxes under IRS §1042. However, corporate taxes (including 280E restrictions) remain in effect, limiting the overall tax benefits. This structure is more advantageous for owners seeking immediate liquidity.

S-Corporation ESOP: The company elects S-corp status, and ideally, the ESOP acquires 100% ownership. While sellers lose the §1042 capital gains deferral, the company itself becomes tax-exempt, as ESOP-owned S-corps do not pay federal income tax. This configuration maximizes 280E relief and cash flow improvements.

Some cannabis businesses adopt a phased approach, selling a portion of shares under C-corp status to take advantage of §1042 and later transitioning to an S-corp for full tax exemption. However, such multi-step strategies require careful tax planning to avoid disqualifying the ESOP or losing S-corp eligibility.

State Cannabis Regulations and ESOP Compliance Considerations

State regulations on cannabis ownership and licensing add another layer of complexity when establishing an ESOP. Many states require disclosure and vetting of individuals who hold significant ownership stakes. Since an ESOP trust can become a majority or sole owner, this ownership transfer may necessitate regulatory approval.

For instance, Massachusetts regulators approved Theory Wellness’ transition to ESOP ownership, but companies in other states should proactively engage with cannabis control boards to ensure compliance. Fortunately, ESOP participants are generally indirect owners (with the trust as the actual shareholder), which can simplify regulatory approval processes. However, businesses must ensure that governance documents, such as bylaws and shareholder agreements, accurately reflect ESOP ownership and voting rights.

Weighing the Legal and Tax Benefits of ESOPs in Cannabis

A cannabis ESOP must carefully navigate federal tax strategies, ERISA compliance, and state cannabis regulations. When structured correctly, the benefits are substantial:

Complete relief from IRC Section 280E, turning a tax-disadvantaged business into a tax-exempt entity.

Enhanced employee retention and motivation, with staff benefiting from long-term wealth creation.

A viable succession plan, allowing founders to transition ownership to dedicated employees while preserving the company’s mission.

Improved financial performance, with tax savings reinvested into operations and growth.

While an ESOP structure introduces complexity, for the right cannabis companies, it can be a transformative strategy, reducing tax burdens and fostering a sustainable, employee-owned future. Business owners should conduct thorough due diligence and collaborate with cannabis tax and ESOP specialists to implement a compliant and advantageous ESOP model.