By Daniel Bugbee & Dominique Scalia
Eager entrepreneurs are sometimes tempted to take the fastest and cheapest route to starting their business, which is operating as a sole proprietorship. This route, however, is often extremely expensive in the long run. Because owners of a sole proprietorship are personally liable for the debts of a business, creditors of the business can go after an owner’s home or personal savings and retirement funds if the company is unable to pay its debts.
For state-licensed marijuana businesses, there are additional risks associated with a sole proprietorship. As discussed in Part I of this series in the November issue of Marijuana Venture, owners of state-licensed marijuana businesses are likely not afforded bankruptcy protection under federal law. In addition, the assets of a state-licensed marijuana business are at risk of federal seizure and forfeiture because such activity may violate the federal Controlled Substances Act.
When it comes to business entities, no two are exactly alike. General partnerships, for example, do not protect the personal assets of general partners from the partnership’s debts and creditors, and in that sense, are no better than a sole proprietorship. The entities that offer the most protection for owners and investors are corporations and limited liability companies (LLCs).
With regard to protecting your personal assets from liabilities of the entity, corporations and LLCs are more alike than different. A choice between these two structures should be based on the business needs, specific tax considerations, and goals of the company. Corporations are owned by shareholders, with management vested in a board of directors that appoints officers to run the daily operations of the corporation. A corporation’s board of directors makes policies and takes major actions like issuing dividends to shareholders. LLCs are owned by “members,” and can be managed either by all members collectively, by a single manager-member, or by a third-party manager. In general, LLCs tend to provide more flexibility in ownership and management structures than corporations.
Doing business as an LLC or corporation, however, is not the end of the story. A legal remedy referred to as “piercing the corporate veil,” allows creditors, in certain circumstances, to pierce through the entity and access personal assets. To avoid this, entities must engage in good governance practices, including observing corporate formalities, executing and abiding by controlling organizational documents, and adequately capitalizing the company.
Good governance also means meticulous management of assets. Owners and managers of LLCs and corporations should not commingle their personal assets with those of their businesses. This can be especially difficult for businesses dealing primarily or exclusively in cash. As a result, it is necessary for companies to have clear policies in place for tracking assets, including capital contributions by investors. Entities that do not stringently adhere to corporate formalities may find themselves later subject to “veil piercing” proceedings, in which individuals will be held personally liable as though the corporate form did not exist.
Entrepreneurs should consult with counsel knowledgeable about entity formation and corporate structure and governance. Also consider seeking advice about other methods of asset protection, such as the use of trusts that might further segregate business and personal assets. (For more on this subject, see the “Strategic planning for businesses” series by Hal Snow in the May and June issues of Marijuana Venture or online at www.marijuanaventure.com.) Most importantly, make sure to implement strong corporate governance policies before taking action in order to minimize, to the extent possible, personal liability and other risks unique to state-licensed marijuana businesses.
Daniel Bugbee and Dominique Scalia are attorneys with Garvey Schubert Barer Law Firm who specialize in bankruptcy, creditors’ rights, commercial litigation and real estate transactions.