What Are ESOPs and MEWAs and Why Might They Trend in Cannabis?

Studies show that comprehensive employee benefits can promote a positive work culture, improve personal well-being, attract talent and increase employee retention. An increasing number of cannabis employers are choosing to offer retirement and welfare benefits to their employees. As the industry matures, businesses grow, and the federal government contemplates cannabis banking reform, we are seeing a spike in cannabis-targeted marketing by insurers, plan providers and third-party administrators. Two trends in employee benefit arrangements that cannabis employers may want to be aware of are: employee stock ownership plans and multiple employer welfare arrangements.

Employee Stock Ownership Plans

Historically the least-utilized form of qualified retirement plan, Employee Stock Ownership Plans (ESOPs) seem to be experiencing a surge in popularity. Simply put, an ESOP is a tax-qualified retirement plan that owns company stock. A sponsoring employer will form an ESOP and fund it, typically via loan financing. The ESOP uses those initial funds to purchase the employer’s stock. The employer makes annual contributions to the ESOP, and the ESOP is able to pay off the loan. Each year as the loan is paid down, a specified amount of stock is allocated to participants’ accounts pro rata based on each participant’s annual compensation. Then, when a participant leaves the company, their ESOP account is cashed out according to the fair market value of the stock in that account.

ESOPs are particularly hot in the cannabis industry because an ESOP that holds 100% of stock in an S-corporation—which is a closely held entity that makes a valid election to pass business income, losses, deductions, and credits through to its shareholders for federal tax purposes—is exempt from federal income tax and often exempt from state income tax. For this reason, ESOPs have been marketed as an Internal Revenue Code Section 280E “loophole.” After all, the inability to take tax deductions is irrelevant and no longer a burden to a business that doesn’t pay taxes.

Despite the appeal of these tax benefits, an ESOP isn’t the right choice for every company. An employer must determine whether it has the capacity to maintain an ESOP; in addition to a loan, other options include contributing newly created shares or cash to buy existing shares to the plan. In states where state-facilitated retirement plans are available to cannabis businesses, some employers may not wish to take on the financial costs and administrative burdens of sponsoring an independent retirement plan such as an ESOP. Additionally, as a general rule, companies need to have a minimum of 20 eligible employees in order to sustain a compliant ESOP and avoid a lack of liquidity. (Companies with fewer employees may not have sufficient resources to set up and maintain an ESOP.)

As the industry continues to grow, however, we could see more cannabis businesses turning to the ESOP model. For those interested in creating an ESOP or contemplating the acquisition of an ESOP-owned business, here are two key points to remember:

1. ESOPS are highly regulated.

   ESOP assets are held in trust, which means that ESOP trustees are bound by significant fiduciary obligations imposed by the Internal Revenue Code and the Employee Retirement Income Security Act of 1974 (ERISA). Further, ESOPs are subject to annual reporting requirements, periodic audits and vigorous discrimination testing rules to ensure that the plan does not benefit highly compensated employees more than non-highly compensated employees. The Department of Labor (DOL) oversees the examination and investigation of ESOP transactions and trustee activities, and recent guidance from the Internal Revenue Service (IRS) indicates that the IRS intends to increase its enforcement focus on S-corporation ESOP-related tax avoidance schemes. ESOP-owned companies (and their potential buyers) must ensure that both the plan and company management comply with all applicable rules to avoid losing S-corporation status and potentially becoming subject to plan disqualification, unbelievable financial penalties, and cascading excise taxes.

2. ESOP participants still have rights.

Although ESOP participants are deemed to own the stock allocated to their ESOP accounts, they don’t actually own that stock. The true “owner” of stock held by an ESOP is the ESOP trust, which is managed by the ESOP trustee for the benefit of plan participants and beneficiaries. That being said, ESOP participants have the right to instruct the ESOP trustee on how the trustee should vote their allocated shares in certain transactions. Under Internal Revenue Code Section 409(e), participants have the limited right to direct the trustee with respect to whether to approve or reject a merger or sale of substantially all assets (among other corporate transactions). Section 409(e) does not require the same “pass-through voting” in a stock sale because the stock is owned by the ESOP trust, not the participants. This means that the trustee has decision-making authority. However, because any trustee decision carries fiduciary risk, many plans will provide for pass-through voting even in stock sales; when the trustee merely carries out the participants’ instructions, the trustee is shielded from allegations of fiduciary breach, and the company saves on its fiduciary liability insurance. Particularly in the case of large ESOPs with a significant number of participants, a target company should know which transactions will trigger pass-through voting and notify any potential buyer if the offer will be subject to participant approval in order to prevent unexpected delay.

The tax implications of an S-corporation ESOP aren’t “loopholes,” but rather the result of Congress’s calculated decision to incentivize companies to provide the maximum number of employees with great benefits. With great tax-exemption, however, comes great responsibility. The acquisition of an ESOP-owned company will require extensive due diligence by both the target and buyer as the DOL and IRS keep an increasingly closer eye on ESOP-related transactions. Familiarity with the plan document and plan operations will help weed out inadvertent compliance issues and allow the parties to self-correct noncompliance.

Multiple-Employer Welfare Arrangements

Retirement plans are only one piece of the employee benefits puzzle. Many companies offer other benefits such as medical insurance, vacation time, education benefits, as well as accident, sickness, unemployment, and disability insurance. An employer-maintained plan that offers these types of benefits constitutes an “employee welfare benefit plan” under ERISA. As cannabis companies continue to grow, many may find themselves in acquisition mode and will have to decide when and how to expand health plan coverage to employees of new subsidiaries. These plans are just as integral to the M&A process as retirement plans, and they can pose similar disruptions to a transaction when overlooked.

Enter the MEWA. A Multi-Employer Welfare Arrangement exists when an employee welfare benefit plan offers benefits to the employees of two or more unrelated employers, including self-employed individuals. MEWAs can be formed when multiple unrelated employers agree to pool their resources and purchase better coverage as a group than each would be able to sustain on their own. This can be especially beneficial for small businesses that can't afford to maintain good coverage for their employees under a single-employer plan. MEWAs can also be created entirely by accident in a number of scenarios: For example, when a company maintains a single group health plan for all its subsidiaries and then sells a subsidiary to a buyer, the subsidiary’s employees may remain on the seller’s plan for a period of time post-acquisition. For that period of time, the seller’s plan covers not only its own employees but also the buyer’s new employees, thus creating an accidental MEWA.

MEWAs can be extremely cost-effective, particularly for small employers who wish to share the costs and burdens associated with employee welfare benefit plans, and many employers will continue to opt into MEWAs for these reasons. Employers within a controlled group can realize similar benefits by sharing a single-employer plan without having to comply with additional MEWA rules and requirements. An accidental MEWA, however, can pose significant challenges to employers that aren’t aware that they have become subject to the MEWA rules.

As with ESOPs, the penalties for noncompliance can be extreme; unlike ESOPs, these penalties can come from the federal and state levels. Before undertaking any changes to company ownership, take a look at your ownership structure to ensure you don’t fall into the accidental MEWA trap.

If you sponsor a group employee welfare benefit plan, here are some general MEWA considerations to keep in mind:

1. The controlled group analysis

Corporations in a controlled group (or LLCs under “common control”) can participate in a single plan and reap the benefits of simplified administration and reduced costs without forming a MEWA. The IRS considers three kinds of relationships when analyzing whether related companies exist in a controlled group:

a. If company A owns 80% or more of company B, or is 80% or more owned by company B, they are in a parent-subsidiary controlled group.

b. If five or fewer owners have common ownership of at least 80% of two or more companies and those same owners hold at least 50% effective control of those companies, they are part of a brother-sister controlled group.

c. If companies A and B are in a parent-subsidiary or brother-sister controlled group, but company B is also a member of another controlled group with company C, companies A, B and C are all part of a combined controlled group. 

A MEWA does not exist so long as all participating employers are part of a controlled group.

2. Non-employee directors, independent contractors and leased employees

A MEWA exists when an employer permits leased employees (for example, employees supplied by a staffing company to a business on a temporary or project-specific basis) to participate in its group health plan. Because the ERISA definition of MEWA includes self-employed individuals, this also extends to independent contractors and non-employee directors who participate in a plan. Employers should be aware that offering plan benefits to these individuals may result in a MEWA.

3. State regulation and additional filing requirements

When a controlled group exists, only the plan sponsor must file the necessary DOL forms—participating employers are not required to file. MEWA status can trigger additional filing requirements for not only the plan sponsor but also participating employers. Some of these additional forms must be filed 30 days before the MEWA begins operating. Further, certain MEWAs will also be subject to state regulation; for employers who operate in multiple states, varying states’ laws can lead to compliance confusion.

Employee benefits and the associated rules and regulations don’t need to trigger the financial headaches and managerial burdens with which they are often associated. Cannabis business owners seeking to acquire another business or expand their benefit plans should contact a trusted benefits attorney before entering into a transaction in order to confirm compliance with the law and avoid running afoul of the DOL and IRS. Familiarize yourself with your plan documents and keep an eye on plan operations to maximize early detection of red flags. If you do find yourself in a sticky situation, remember that many noncompliance issues can be self-corrected (and penalties and taxes minimized) with swift action and the assistance of an experienced benefits attorney.

Naomi Tellez is an associate at Frantz Ward law firm. She works with business clients on complex employee benefit matters affecting both tax-qualified and nonqualified benefit plans. She also advises clients on plan administration, Internal Revenue Code and ERISA compliance, and assists employers with the identification and correction of complex plan issues utilizing U.S. Department of Labor and Internal Revenue Service procedures. Tellez’s practice includes the representation of clients in connection with the merger and acquisition of businesses in a variety of industries, including the Ohio cannabis industry.