Nicole Howell Neubert & Jay Purcell, Clark Neubert LLP

Since January 2018, when it finally became legal in California for businesses to sell cannabis to anyone over 21 years old, the imagination of our state’s entrepreneurs has focused on creating exciting new cannabis products and technologies. Vape pens, edibles, concentrated oils, tinctures, popcorn and other new infused goods abound—there’s no limit to the originality. But entrepreneurs need a few key things to enter the market, including a Type 6 or Type 7 license from state regulators; a local permit; and manufacturing equipment.

But acquiring and operating equipment is very expensive, a situation compounded by the fact that cannabis companies remain locked out of commercial lending.  If an entrepreneur wanted to open a bakery, Wells Fargo might loan them money for industrial mixers and ovens—but not so in cannabis. To fill this gap, many cannabis companies either rent equipment, or rent out their own manufacturing equipment when it’s not in use. In each case, the typical contract is an equipment lease between the lessor (like the landlord) and lessee (like the tenant). To cement these deals, many companies use simple leases, often derived from real estate leases. This approach has its pros and cons. The pro is that it’s fast and inexpensive. The cons are complicated, but they need to be understood by anyone involved in a cannabis equipment lease:

1. If you’re leasing out your own property (meaning you’re the lessor), make sure your lease fits rules for a True Tax Lease and a True Lease. If your lease includes a handful of True Tax criteria, you can maximize your tax deductions and credits, instead of your lessee getting the tax breaks. And, if you include some True Lease terms, you can be sure that your lessee’s bankruptcy doesn’t swallow your equipment (which happens if your lease isn’t a “True Lease”). These rules are important when it comes to pricing renewal terms, or options-to-buy, at the end of a lease.
2. If you’re renting-in equipment (meaning, you’re the lessee), special rules apply if the equipment lessor is helping you with financing. If you need to have a security interest in the equipment, pay close attention to Finance Lease rules.
3. The core difference between a Finance Lease and a True Lease is what happens to the equipment if the Lessee goes bankrupt. If it’s a Finance Lease, the lessee’s creditors have a claim on the property. If it’s a True Lease, lessee’s creditors shouldn’t have any claim on the property. For a lessor, this distinction is huge.

What’s a True Lease? If you own the equipment and lease it to a cannabis company, ensure your lease is a True Lease, because it entitles lessee’s creditors to zero claimon the equipment. True Leases are based on this concept: The property’s value comes back to the lessor someday (just like in an apartment rental). Because the value comes back to the lessor, the assets shouldn’t be imperiled by anything lessee does, including bankruptcy. To determine if it’s a “True Lease,” courts look for four things:

(i) in the actual document, both lessor and lessee represent that it’s a True Lease, not a Finance Lease;

(ii) the lease can be terminated, meaning that it can be cancelled by lessee for defects or other problems, in contrast to a “Hell or High Water” condition common to Finance Leases;

(iii) the lease term is shorter than the equipment’s useful life; again, this is because the property’s value comes back to lessor someday;

(iv) renewal terms or options-to-buy must be for real money, not token prices; this is another way of saying, “at the end of the lease, the property still has value.” A True Lease can be underscored by lessor making a UCC filing for the equipment (while it is in lessee’s hands).

So, bottom line: in a True Lease, the lessor gets the valuable equipment back at the end and can rent the equipment again (for significant value), and there are numerous points in the lease confirming this; and most importantly: the lease isn’t eternal, renewals and buy-out options are expensive, and when the lease ends, the equipment is not beyond its useable life.

What’s a Finance Lease? In a Finance Lease, the lessor puts up the money to buy equipment, and rent payments are designed to repay lessor for the expense. In this case, all equipment value is captured by lessee, and in the case of lessee’s bankruptcy, their creditors can try to claim the equipment. In a Finance Lease, leases can’t be terminated, because they should extend for the entire useful life of the equipment; in a finance lease, unlike a True Lease, renewals or options-to-buy can be priced for token prices, because the assumption in a Finance Lease is that valuable equipment stays with lessee. To confirm a Finance Lease, the parties should:

(i) acknowledge it’s a Finance Lease;

(ii) indicate that lessee instructed lessor to buy the equipment, and lessee selected the equipment;

(iii) price renewals or options-to-buy for little to no money;

(iv) have long terms, or renewals that extend to the equipment’s useful life; and,

(v) be almost impossible to terminate, leading to the idea that the lease will persist, even come “Hell or High Water.”

Finance Leases are like layaway terms – the lessee makes payments and intends to capture the equipment’s whole value. Courts will look for long, unbreakable lease terms, inexpensive renewals or options-to-buy, and evidence that the lessee selected the equipment and instructed lessor to purchase it.

In summary:

For property owners who are leasing out property, the True Tax concept is important as well. If a lessor doesn’t include these terms, they may lose valuable tax benefits (like depreciation and expensing). In a True Tax lease, five concepts should present:

(i) when buying the equipment, at least one fifth (20%) of the equipment’s cost comes directly from the lessor;

(ii) the lessor has a profit motive when it leases the equipment;

(iii) at the end of the lease, at least twenty percent (20%) of the equipment’s value remains (in other words, the lease is shorter than the equipment’s life span);

(iv) the lessee doesn’t help finance the equipment’s cost; and,

(v) if the lessee has an option to purchase the equipment, the price is at least fair market value.

If any of these five points isn’t true, the lessor could lose the tax benefits of owning the property, because the IRS sees the lessee as the true owner when, for instance, the lessee can purchase the property for nominal consideration.

Here’s a side-by-side of the three: