Pass-Through Entities in the Cannabis Industry: Structure Smart, Stay Compliant, and Save on Taxes

Structuring a cannabis business as a pass-through entity is—at least on the surface—an excellent way to reduce the tax burden for cannabis businesses. When a company is structured this way, it is not subject to federal income tax as the tax burden is passed on to the owners, who report the income on their personal returns and pay the applicable taxes, avoiding double taxation. 

However, there is a downside to this. While you may (rightly) assume that the business avoids the onerous challenges of IRC 280E, it becomes the responsibility of the partners to manage the process. It could well be, in the end, that the tax liability exceeds the distribution, so it’s a decision that should not be taken lightly. 

As with many things in the cannabis sector, the devil is in the details, and if those details aren’t handled correctly, the intended savings could be offset—or worse, create new headaches.

The 280E Trap: Shifted, Maybe, but Still a Factor

It’s a common misconception that forming a pass-through entity is a way to avoid 280E. 

Under 280E, cannabis companies can only deduct expenses related to the cost of goods sold (COGS) and are prohibited from claiming expenses that any other business would be able to, like payroll, marketing, or even rent. This law applies regardless of business structure.

With a pass-through entity, the burden simply shifts to the owners; it doesn’t go away. 

Imagine a scenario where your business is growing and your share of the profits far exceeds your personal income. You may end up with a tax bill you can’t possibly pay. If you want to avoid this unpleasantness (and who doesn’t?), meticulous tax planning is essential.

Three Pass-Through Options

Cannabis businesses considering a pass-through model will choose one of three structures: a partnership, LLC, or an S-corporation.

• Partnerships

Partnerships are the simplest and most flexible. You are people doing business together, sharing profits, losses, and responsibilities. You’ve got tons of flexibility in terms of how funds are allocated, which can be a massive advantage for owners with different investment levels or risk tolerances.

However, partnerships don’t necessarily shield owners from liability, and partners can be personally responsible for the debts and obligations of the business. With the level of regulatory and financial risk in the cannabis industry, this can be an issue. 

• Limited Liability Companies (LLCs)

LLCs have become a go-to choice for cannabis operators because they combine liability protection with pass-through taxation. Members (owners) can decide on their preferred management structure and can decide how profits are distributed. It’s much less stringent than a corporation. 

However, LLC members must pay self-employment taxes on their share of the profits. Companies may also have a harder time finding investors as the structure is seen as financially risky. 

• S-Corporations

An S-corporation is, essentially, a corporation that has chosen to be taxed as a pass-through entity. The key advantage here is that owner-employees can pay themselves a “reasonable salary” and take the remainder of the profits as distributions, the latter of which are not subject to self-employment taxes. This strategy can yield significant savings.

That being said, S corporations are burdened with all the formal requirements of a corporation. They must hold annual meetings and maintain meticulous corporate records. They are restricted to 100 shareholders, all shareholders must be U.S. citizens or residents, and only one class of stock is allowed. And, though the business doesn’t pay federal taxes, members are not shielded from 280E. 

S-corporations can be helpful in certain situations, such as if it’s a relatively small company with simple ownership structures and limited investment. However, if you’re operating an investor-driven, multi-owner business, it may be too restrictive and can leave owners liable for massive tax bills. 

Navigating Compliance in a Highly Regulated Industry

Regardless of the type of pass-through entity you choose, all cannabis businesses operate under a microscope. 

State regulators are strict on licensing, reporting, and operational compliance. Noncompliance can result in fines, license suspension, revocation, or even criminal charges.

From a tax perspective, meticulous bookkeeping is essential. Because 280E limits deductions, expenses must be appropriately categorized, especially those related to COGS, as that’s the only thing most cannabis businesses can write off. 

Some states have decoupled from 280E, enabling ordinary expenses at the state level. And while this is good news for operators in those regions, it makes for a complex environment where two different sets of books must be maintained to ensure maximum benefits. 

Cash Flow Management

Despite the issues we’ve outlined so far, the biggest pitfall pass-through entities may encounter isn’t necessarily compliance—it’s cash flow. 

Taxable income is allocated whether or not cash is distributed. Because of this, owners can be burdened with an inflated tax bill. In industries like cannabis cultivation, which have long product cycles and heavy reinvestment, this can be especially painful.

Implementing strict distribution policies is essential to ensure enough cash is set aside to cover the owners’ tax liabilities. Some companies use shareholder agreements that detail how and when profits will be distributed to reduce conflict when tax season rolls around.

State-Level Concerns

State-level and local taxation add another layer of complexity. Some states impose entity-level taxes even on pass-through entities. Others treat cannabis differently from other industries, applying excise taxes or fees that must be factored into the overall tax scenario.

For operators with multiple locations, the complexities multiply. Income may need to be apportioned across jurisdictions, and compliance rules vary. As a result, the right entity type in one state might not be the best choice in another.

Strategic Considerations Before You Decide on a Pass-Through Entity

Before committing to a pass-through structure, here are a few things to consider.

• What is your ownership structure? Will you have multiple investors? Do you expect to bring in outside capital?

• How will you handle profit distribution? Think distributions vs. reinvestment (reinvestment can reduce profits and taxes). 

• Are there liability concerns? Is shielding the owners’ personal assets a priority?

• What does the future hold? Do you plan to sell the business or convert to a different structure later?

• Do you have the administrative capacity to handle corporate obligations? S corps require a lot of admin, while an LLC is more flexible. Think about what you’re willing to take on. 

The Bottom Line: Structure for Today, Plan for Tomorrow

While pass-through entities can offer significant tax benefits for cannabis businesses, they must be structured and managed correctly—and there is no one-size-fits-all answer in terms of what’s right for you.

Working closely with a qualified cannabis tax professional is essential and may help you avoid costly surprises. 

A well-structured pass-through entity can help cannabis operators keep more of what they earn, protect their personal assets, and position themselves for growth. Structure smart, stay compliant, and you’ll always be poised for growth. 

Speak to the experts at Growise today to learn how we can help.