Chapter 2 - § 2.2 CHOOSING A GOVERNING STRUCTURE

• Jurisdiction: Colorado

§ 2.2 CHOOSING A GOVERNING STRUCTURE

§ 2.2.1—Overview

The Colorado Marijuana Legalization Initiative, passed in 2012 (Amendment 64), enabled the State of Colorado to begin regulating the cultivation, sale, and possession of cannabis for recreational purposes.⁸ Following the passage of Amendment 64, the State of Colorado and the MED have enacted various statutes and rules related to recreational cannabis sales within the state.⁹ Since the establishment of the Colorado Cannabis Laws, owners have formed RMBs under a number of different entities to govern their businesses in compliance with the rules and in way that best protects the interests of the owners and the RMB.

As mentioned above, there are a number of governing forms available to businesses in the State of Colorado. There are benefits and drawbacks to each type of governing structure, and no one form is appropriate for every RMB. Ultimately, the best type of governing structure for an RMB depends on the goals of the company, which, depending on changes in ownership of the company and subject to any future changes in law, may change over the life of the entity.

According to the Colorado Cannabis Laws, RMBs may be owned by an entity, which may be organized under any of the following governing structures:

a domestic or foreign corporation, cooperative, general partnership, limited liability partnership, limited liability company, limited partnership, limited liability limited partnership, limited partnership association, nonprofit association, nonprofit corporation, or any other organization or association that is formed under a statute or common law of the state of Colorado or any other jurisdiction as to which the laws of this state of Colorado or the laws of any other jurisdiction governs relations among owners and between the owners and the organization or association and that is recognized under the laws of the state of Colorado or the other jurisdiction as a separate legal entity.¹⁰

Operating under a formal governing structure such as a corporation or a limited liability company allows the business owners to limit their personal liability by taking advantage of the "corporate veil," a legal concept that, except in special circumstances such as fraud or the failure to maintain compliance with corporate formalities, separates the debts, actions, and profits of the corporation or limited liability company from its owners.¹¹ In general, and as will be described in more detail below, corporations and limited liability companies are treated as a legal entity separate from their owners, which owners are then "shielded" from personal liability under the "corporate veil" for the debts of the company. Further, the corporation or limited liability company is capable of owning property or other assets, which means that the owners are not personally responsible for the obligations of the company. The choice of governing structure will also have an effect on how the company is taxed by the IRS. A corporation will generally be subject to a more favorable tax rate than a sole proprietor or a partnership, where the profits and losses of the company pass through to the owners on their personal tax returns. Accordingly, operating as a corporation may provide a significant number of advantages to the RMB owners.

Due to the federal laws affecting the cannabis industry, determining the most appropriate governing structure for the RMB presents a unique challenge. As explained above, the federal prohibition has an effect on the RMB's ability to shield itself and its owners from liability for the debts or actions of the company, to raise equity outside of the owners of the company, and to take advantage of tax benefits that are available to those operating in other industries. However, despite the conflict of state and federal laws related to the cultivation, manufacture, and sale of cannabis, RMBs continue to operate successfully in the State of Colorado. The remainder of this section will provide an overview of several of the governing structures available to RMBs and will explore options for the RMB to ensure compliance with Colorado corporations law and the Colorado Cannabis Laws.

§ 2.2.2—Choice of Entity

The RMB owner must thoroughly evaluate the needs of the entity prior to choosing the appropriate governing structure, which needs and structure are likely to change over time. When choosing the governing form, the RMB owner must evaluate the company's need to raise capital and ability to incur debt to determine how many and what types of ownership interests the company should issue. Other considerations for the choice of entity include flexibility of ownership and the company's ability to take advantage of corporate tax benefits, in addition to the owners' bandwidth with respect to incurring personal liability on behalf of the company.

The body of law governing corporations has remained largely unchanged for hundreds of years; however, Colorado Cannabis Laws have been in place for less than a decade and are continually changing. This means that, more so than owners of other businesses, the RMB owner must continually evaluate applicable law and ensure that the RMB is operating under the most favorable governing structure. Moreover, the RMB owner is responsible for not only ensuring it operates in compliance with corporate law, but also ensuring that the operation of the entity does not violate any Colorado Cannabis Laws. This section will explore a few of the more common structures governing structures available to RMBs in the State of Colorado and the circumstances in which one form may be more advantageous to another.

§ 2.2.3—The Corporation

The corporation is one of the most common types of entity. The purpose of the corporation is to operate an organized business under a type of governing structure that shields its owners from personal liability. The owners of a corporation are known as "shareholders," who contribute capital (such as money, assets, services, or other forms of equity) in exchange for shares of stock in the company.¹² In certain circumstances, the shares of stock may be separated by different classes, if, for example, the owners want some shareholders to enjoy preferential treatment. One common example of this is creating voting shares, which means that the corporation will authorize one type of shares that will give the holders of those shares voting rights, while the holders of other types of shares will not.¹³ This structure is commonly used in corporations that give employees stock options as performance incentives. The classes and number of shares of stock authorized by the corporation must be set forth in the articles of incorporation, which is the primary organizing document filed with the Secretary of State, and which provide evidence of the formal incorporation of the entity.¹⁴ Additionally, the number and type of shareholders may be limited by the tax election made by the corporation.¹⁵

One of the basic tenets of corporate law is that the corporation is seen as a separate entity from its shareholders, officers, and directors. The corporation can own assets in its own name and can itself be liable for debts without incurring personal liability for the shareholders, officers, or directors of the company. This means that the shareholders can invest in the corporation and receive dividends or otherwise share in the company's profits, but will not be held personally responsible for the corporation's debts or other liabilities.¹⁶ In addition, even though the shareholders are the owners of the corporation, they are not responsible for the management or setting the policies of the corporation and are generally not in charge of running the business operations. Instead, most corporations are governed by a board of directors appointed by the shareholders and officers appointed by the board of directors. Depending on the particular needs of the corporation, however, the directors and officers may also be shareholders. The board of directors are usually tasked with governing big picture items for the corporation, while the directors are generally in charge of day-to-day operations.¹⁷ The rights, duties, and obligations of the officers and the board of directors are set forth in the corporation's bylaws, which is the governing document for the company, essentially used as the playbook for the corporation.

Traditionally, corporations were not necessarily seen as an advantageous governing structure for RMBs for a number of reasons. First, while the RMB could organize as a corporation, until very recently, an RMB could not be organized as a publicly traded company (PTC) and could not accept investments from PTCs. In 2019, the State of Colorado enacted House Bill 19-1090 (HB 1090), which permits a PTC to invest in an RMB.¹⁸ HB1090 lessened some of the restrictions of ownership of RMBs that had previously been a barrier to entry for PTCs into the regulated cannabis industry since the passage of Amendment 64. Prior to HB 1090, PTCs were prohibited from owning even indirect ownership interests in RMBs. In addition, HB 1090 relieved some of the disclosure requirements for owners and investors in RMBs who do not meet a certain ownership threshold, which opened up an opportunity for investors who were wary of subjecting themselves to the substantial background checks and disclosure requirements that had previously been required by the MED.

As mentioned above, prior to the passage of HB 1090, every owner of the RMB was required to disclose a significant amount of personal information, including submitting to a background check and financial interest disclosure requirements. Through HB 1090, the Colorado Cannabis Laws created a distinction with respect to the ownership interests of an RMB, differentiating between a controlling owner and a passive investor of the RMB: the first being a "Controlling Beneficial Owner," which is essentially an owner of at least 10...