A Growing Demand for Cannabis
Demand for cannabis and related goods continues to rise as consumers purchase products for medicinal and recreational use.
Because cannabis contains tetrahydrocannabinol, or THC, the chemical that gives it the “high,” it is heavily regulated by the Food and Drug Administration. Cannabis containing THC was first approved for medicinal sale in 1996 in California. Today, 22 states allow the legal sale of medical marijuana, and it is prescribed for a variety of uses, such as to treat chronic pain and anxiety, to ease nausea related to chemotherapy, and to reduce the number of epileptic seizures. In 2012, Colorado and Washington became the first states to license the legal sale of recreational marijuana. Today, 11 states allow the sale of recreational marijuana, and products range from plant buds and oils to edibles such as gummies, chocolates, and snacks.
By contrast, the FDA is less stringent in its oversight of the manufacture and sale of hemp-related products that contain a small amount of THC and the chemical cannabidiol, or CBD, which doesn’t cause a “high.” The 2018 U.S. Farm Bill removed hemp from the list of controlled substances. Since then, sales of CBD products have exploded, and the extract is now found in creams and sprays, squirted into lattes and smoothies, and even used as a topping on ice cream and pizza.
The combined sale of cannabis products containing THC and CBD is expected to reach $59 billion by 2025, according to a report by Global Market Insights, a market research firm.
While more states are licensing the legal sale of marijuana, the federal government still considers cannabis a Schedule 1 drug, in the same category as heroin, LSD, and ecstasy. As a result, federally regulated banks and credit card companies are hesitant to open accounts for cannabis businesses.
The Treasury Department requires banks to file a Suspicious Activity Report (SAR) with the Financial Crimes Enforcement Network (FinCen) for all marijuana-related businesses. These regulations require banks that have marijuana-related businesses as customers to complete SARs every 90 days to update any changes in potential risks. Additionally, FinCen requires banks to report any cash transaction of $10,000 or more. This requirement extends to all banks and businesses that are depositing $10,000 or more in cash into a financial institution. These requirements exist to prevent money laundering and other financial crimes. Because the federal government views the product as illegal and looks askance at the large cash transactions, banks are reluctant to provide services to the cannabis industry.
Any entity along the legal cannabis supply chain faces the same hurdles. Growers, manufacturers, distributors, and shippers all deal in cash and have the same banking troubles. And when one of these cannabis businesses pays the landlord, cleaning service, and other contractors in cash, they, too, encounter similar issues.
The American Bankers Association supports an easing of federal restrictions, and the U.S. House of Representatives recently passed the SAFE Banking Act, which would enable banks to accept deposits from cannabis businesses with fewer restrictions. The Senate has yet to consider the bill. Some state-chartered banks, savings and loans, and credit unions are willing to open accounts, but the legal cannabis industry largely remains a cash-only business.
Cash: Need for Careful Controls
The reality is that because the legal marijuana business deals largely with cash, stringent procedures and controls must be put in place to ensure proper security and compliance with laws and tax regulations.
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) is an organization that provides thought leadership and guidance on risk management, internal controls, and fraud deterrence for business enterprises. COSO encourages management, when developing policies and procedures, to identify the organization’s risks; its business processes, internal controls, and technology; and where control activities may be necessary.
Dispensaries must be careful that there is a detailed record of each cash transaction. The National Association of Cannabis Businesses (NACB) prepared national standards on best practices, with suggested procedures that include point-of-sale systems to track the price and inventory of items sold, the day and time of each sale, and the employee who made the sale. The cash drawer should be balanced for each employee at the end of each shift and at the close of business.
The NACB also provides guidance to management regarding cash controls, suggesting the removal of cash from the register and placing it in the safe. Two people should review and sign off on the deposit slip. Two people should be present to place money into and remove money from the safe. Detailed records must be kept when using cash to pay suppliers, services, and landlords.
The NACB suggests that dispensary operators also should have strong security, including highly fortified doors and windows, surveillance cameras, and computer systems with strong firewalls to prevent hacking. There should be armed security personnel to protect the store and to escort anyone removing cash from the building. Secure transportation should include vehicles with bullet-proof glass, video cameras, and GPS tracking.
The Troubles with Taxes
The federal classification of marijuana as an illegal drug also causes tax complications for cannabis-related businesses. While the IRS requires you to claim any earnings from the sale of illegal drugs, it offers very few tax write-offs. If business owners fail to file income taxes on illicit sales, they could go to jail. Remember Al Capone?
Under section 280E of the federal Tax Code, a business engaged in trafficking of a controlled substance is prohibited from taking most tax deductions. The only exception is a write-off for “costs of goods sold,” meaning the expenses related to purchasing inventory, the cost for shipping, and any other directly related expenses. Cannabis dispensaries and other marijuana-related businesses are unable to write off other routine business expenses, such as salaries and benefits, depreciation, professional services, real estate taxes, mortgage interest, advertising and promotion, office supplies, transportation, travel, and business entertainment.
Cannabis businesses don’t get too many tax breaks on the state side, either, as most states adopt the federal tax rules when shaping their income tax forms. California did recently pass legislation allowing licensed medical and recreational marijuana dispensaries to write off typical business expenses.
Dispensaries and other marijuana-related businesses also are subject to an array of state taxes, mostly in the form of excise and sales taxes. Among the 11 states allowing the recreational sale of marijuana, excise and sales taxes range from 43.5 percent in Washington and 31 percent in Illinois to 22.5 percent in California, 17 percent in Massachusetts and Oregon, and 0 percent in Alaska.
Legal and Insurance Risks
There are any number of legal and insurance-related risks and challenges for marijuana-related businesses:
- There is regulatory uncertainty. The myriad federal and state laws regulating cannabis businesses present legal risks in insurance disputes, including issues related to directors and officers’ coverage and employment-related matters.
- There are risks inherent with the business. Dispensaries, which deal in cash only, are vulnerable to fraud and theft. Growers and manufacturers may use equipment that increase the risk for power outages, fires, or chemical explosions.
- Insurance companies are reluctant to cover property owners who lease to cannabis businesses. Most traditional policies prohibit coverage for violating criminal statutes or engaging in conduct that violates public policy.
- Legal issues include regulatory challenges, especially involving banking; potential criminal issues, such as theft of products or money, employee fraud, or embezzlement; and potential products liability issues.
- Further, if a cannabis business doesn’t utilize the proper policies, procedures, and controls, it could be subject to lawsuits from partners, shareholders, or landlords.
While recreational cannabis dispensaries and related businesses are growing in number and have a huge potential for profit, they also carry many business, regulatory, and legal risks. Common elements of each of these risks are basic compliance and governance components that would benefit from an informed legal perspective. Attorneys need to be equipped to provide sound advice to clients about the regulatory, banking, tax, insurance, and legal challenges associated with a marijuana-related business.
David Benkert is a senior managing director at Ankura in California, focusing on financial accounting and compliance oversight.