As operators gain more experience working in the cannabis industry, some trends are becoming clear. The market is very relationship-based; it’s hard to get a foothold in this competitive space if you don’t partner with another cannabis operator, either directly or indirectly.
When you find a company with which you want to partner, it’s critical to have the right agreements in place. A handshake isn’t an agreement; you need a formal contract or letter of engagement when collaborating with anyone, especially in the cannabis industry.
This is a big-time, big-money business; although someone may be a close friend, our experts say it’s imperative to have a signed, written agreement in place before conducting sales or any other business operation.
Here’s what you need to know about partnership agreements in the cannabis industry, as well as how to cover your taxes under a partnership arrangement.
What is a partnership agreement?
A partnership agreement is a contract – vetted by experienced professionals or lawyers – that sets the terms and conditions of a business relationship between two or more parties. The partnership agreement should cover topics such as:
- Distribution of profit and loss
- Length of the business relationship
- Description of roles and responsibilities for each partner
- How the partnership can be terminated
- How (or if) the partner can buy their share of the partnership
Lawyers should definitely review your contract to make sure the terms are enforceable and reasonable.
In addition, you should work with CPAs and industry tax professionals to really break down the financial implications of the agreement. Especially in the cannabis industry, it’s important to know who will be responsible for taxes.
Why are partnership agreements important?
Partnership agreements are beneficial both from a management standpoint and to protect your business in case anything goes wrong. The cannabis market is still relatively immature, so it’s important to safeguard your investment.
Partnership agreements are important for the following reasons:
- Set roles and responsibilities. Your agreement should clearly delineate who is responsible for what services. Who is the managing partner? When and how do roles and responsibilities change?
- Avoid legal and liability issues. Use the agreement to spell out who takes on the liability and what happens to the other partners if one partner experiences an issue.
- Manage dispute resolution. Hopefully, nothing goes dramatically wrong during your partnership. But, the reality is that not everything is great all the time, and sometimes partnerships have large disputes that need to be handled. Set out the procedures for how to vote on issues and what recommended resolutions are.
- Address tax issues up from the start. Cannabis has many layers of taxes along the supply chain, and partnerships collapse often when two parties fail to assess who is paying what tax when. Don’t let excitement of getting started hurt you in the future. Whoever gets stuck with the tax burden will see their margins begin to tank, especially if they didn’t know they were liable for the taxes.
- Establish a profit distribution methodology. Spell out how profits will be distributed that’s based on generally accepted tax principles.
Basically, any partnership agreement must cover every possible situation where there might be confusion, disagreement, or change.
There’s a lot that can go wrong in this industry – take the time to make your partnership agreements thorough, specific, and mutually beneficial for both parties.
Partnerships and Taxes
An operating agreement is slightly different from a partnership agreement. It is used to describe the operations of an LLC, similar in the way the by-laws of a corporation work. Like a partnership agreement, the operating agreement sets out the terms and conditions for all the members of the LLC.
Where things get complicated, in this instance, is in calculating the tax liability. With a multi-member LLC, tax liability is calculated in each member’s personal income.
For example, if you have income from a multi-member LLC (or partnership) on a K-1, investment income from a rental property and W-2 income from a normal day job then it becomes very difficult to accurately describe future tax liabilities because any movement in one of those three types of income will increase or your tax brackets. Note that we are talking about personal income tax liability.
How should you handle this situation?
Well, there are three options.
The first is to give a rough proxy of tax liability in the partnership agreement (e.g. K-1 partner of the new partnership will receive 15% on top of their distribution to pay taxes). We use 15% since that is the cannabis excise tax amount in the state of California.
The second is to designate which specific partner is liable for which taxes along the supply chain of the cannabis products. For example, a distributor needs to be liable for collecting and remitting cultivation taxes from the growing partner.
The third option which our tax experts typically recommend is to make the tax liability the responsibility of the individual, taking the company/partnership out of the equation altogether.
We like this because it makes things a bit cleaner and protects the company from any tax issues that may arise in the future.
One other consideration to reducing your tax liability?
Charge it through to your customers when possible. For example, if the city charges a 15% Cannabis Excise tax, add that to your customer’s final receipt. This tactic will at least cover some of your tax burden, though you may have additional taxes calculated on that since it would increase your gross receivables. Check out the video below for more details on cannabis taxes.
Finally, consider how your partnership agreements will terminated. Cannabis ventures fail frequently; if one of your partners goes out of business, how will you handle the exit?
“Issues your buyout agreement should cover include whether or not a departing partner has to be bought out, what price will be paid and how, and who can buy the departing partner’s share of the business,” write the experts at The Balance.
For help in structuring a partnership or operating agreement, get in touch with our experts.