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What Professionals Need to Know About the Cannabis Industry

Cannabis is an industry that is of great interest to CPAs, finance professionals, investors, and the public at large. While many have found their way into the industry, there is still a fundamental question to be answered by each professional: should I take on this cannabis client or investment?

Federal Landscape

To understand the cannabis industry, one needs to understand its history and the current environment. Recent polls from Pew and other sources suggest that the majority of Americans are in favor of legal cannabis, both medicinal and adult use. This momentum from the public at large has not gone unnoticed by politicians, as multiple pieces of legislation have been proposed over the last few years to address some of the shortfalls that currently exist in the industry.

While full legalization at the federal level may be some time away, significant issues like maintaining state-level cannabis programs and clearing the challenges around banking can be addressed. Legislation like the STATES Act and SAFE Banking Act aim to tackle these issues. The STATES (Strengthening the Tenth Amendment Through Entrusting States) Act clarifies that the federal government will recognize state-level cannabis programs as being legal and that the federal government would not interfere. The SAFE (Secure and Fair Enforcement) Banking Act seeks to clarify the compliance and service infrastructure for institutions delivering banking and financial services to the cannabis industry. As of the date of this writing, none of this legislation has been passed; however, the momentum is there for a solution to be reached.

Banking is one of the most fundamental challenges to the cannabis industry; to date, FDIC insured banks are not providing banking services to cannabis businesses. Depending on the state and municipality, cannabis businesses must resort to banking with credit unions, community-owned, or non-FDIC insured banks, and other alternatives. All of these solutions come with their own unique challenges, including service limitations and high fees.

State Landscapes

Part of learning about the industry is looking at the individual states and the different programs that are currently in operation. Each state with a legally operating cannabis program has their own distinctive market and evolving compliance infrastructure.

States like California and Colorado are mature markets that many are familiar with. Colorado recently celebrated $1 billion in tax revenue generated from their adult use program, but most key performance indicators point to a market that has about plateaued. California is currently the largest market in the country, but also one of the most complicated to do business in from a compliance and regulatory standpoint.

Washington and Oregon are both currently feeling the effects of being markets with excess inventory, and the negative impact that oversupply can have on prices. Wholesale prices in Oregon dropped to a low of $398 per pound in 2018, which has had detrimental effects on the bottom line for participants in growing, manufacturing, and retail, all key parts of the cannabis vertical.

Michigan is a state with a highly intensive application and due diligence process, but if an applicant is willing to go through the process, they will have access to an incredibly robust and diverse market for all parts of the vertical.

The New York Market 

New York is an exciting potential market, if and when the legislation and framework are properly established. The history of the market is an interesting one and, if anything, is consistent with the typical political process for the state. The medical program in New York was established by the Compassionate Care Act in 2014. This legislation gave the state 18 months to develop the framework of the medical program, and in 2016 the medical marijuana program was opened to the public.

Ten vertical licenses were awarded, however the groups that were successful in their application process were highly capitalized and had already had success in other states. In the time since the program launched in 2016, there have been approximately 82,000 patients and 2,100 practitioners admitted into the program, with up to 40 dispensaries allowed, but not yet operating.

In response to the public’s visible demand for a more expansive cannabis program in New York, a delegation was commissioned by the state and sent to California and Colorado to study their programs. The goal was to determine the strengths and weaknesses of these programs, both medical and adult use, and how best to apply the lessons learned from these other states to any future programs in New York.

In January 2019, Governor Andrew Cuomo added an adult use cannabis program to his fiscal year 2019-2020 budget. This was done as an attempt to accelerate the legislative process—to get the framework of a program approved in less me than the typical piece of legislation in New York. One of the focal points for the program was on social good, to give back to communities that have been disproportionally affected by the War on Drugs. As part of the proposed cannabis program, a portion of tax revenues would be reinvested into these communities.

As of the date of publication, New York has not moved forward with an adult use cannabis program, or even a materially expanded medical marijuana program. New York City Comptroller Scott Stringer published an estimate for what the New York market could look like with a fully operating adult use program. Stringer estimated approximately $3.1 billion in total revenues, which would generate approximately $435 million in total tax revenues for New York. The population of cannabis consumers in New York was estimated to be two million, with an annual spend of $2,100 per consumer. These estimates may be conservative based on studies done by various publications and other groups.

The National Market

In the time since legal cannabis programs have been in operation, there have been an estimated 82,000 “cannabis businesses” established. This includes: growers, manufacturers, retailers, technology and infrastructure, brands, consumer packaged goods, and more. Over the last 18 months there has been considerable market consolidation, through both attrition and an active mergers and acquisition market. This trend does not appear to be slowing down at this time.

Overall, the cannabis market has been expanding year over year. In 2018, the national market was estimated to be approximately $10.8 billion in revenues. Topline revenue figures have been quite attractive given the relatively young age of the cannabis market; however, this does not take into account the unique tax considerations of the cannabis industry.

When discussing taxes and the cannabis industry, the conversation typically starts with Internal Revenue Code Section 280E. IRC 280E states:

“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”

Simply put, this means that because cannabis is a Schedule I drug, any expenses other than those directly allocable to Cost of Goods Sold (“COGS”) are not deductible for federal tax purposes. IRC 280E can cause a significantly inflated federal tax liability and influences how aggressive a business operating in the Cannabis industry allocates expenses to COGS.

IRC 280E is just one important tax consideration for the cannabis businesses, as there are many variables to consider from corporate structuring, 199A deductions, employees and their benefits, and beyond.

Should I Take This Cannabis Client or Make This Investment?

In light of the legislative, market, and tax issues outlined above, the question that has been asked frequently and is the fundamental question to address: Should I take this cannabis client or invest in the industry? There are some key elements when trying to answer this question. First and foremost is considering reputational risk. This can be interpreted in a few ways, as this consideration can be applied to current or potential future clients in other industries, partners, employees, investors, banks, government entities, and more. Are your current clients going to have any objections or concerns about you entering the industry? Will taking on a cannabis client have an impact on future clients? Are my partners comfortable, personally and professionally, with taking on a client in the industry? These are all questions that need to be answered.

A second key element when looking at the industry is your Know Your Customer (“KYC”) process. It is good practice to have a KYC process for any new client, and this is especially true for cannabis. Given the unique nature of many individuals and companies operating in the cannabis industry, one must ensure that any potential client properly represents their background, experience, and business. This can be done via client interviews, background checks, and a detailed due diligence process before accepting a client. Having the client sign an engagement letter and even a representation letter for all engagements, which includes language detailing the nature and risk associated with their business, is also good practice.

A third key element is having industry experience. There is no substitute for having substantive cannabis experience, doing the research, and building up a network of experts before entering the industry.

The best way to answer the question of whether to take part in the cannabis industry is to understand the complicated history of the industry, the current legislative standing at the federal and state levels, and the direction the industry is moving. A professional must consider clients with unique backgrounds, the everchanging landscape, the different frameworks in each state and the fact that there is limited guidance. Ultimately, due diligence is key.

About the Author:
Zachary Gordon, CPA, works primarily in the real estate and cannabis practices at Janover LLC, focusing on family office financial statement compilations and reviews, tax planning and related services, as well cannabis-focused services such as deal and business structuring, 280E tax planning and optimization, and license application on due diligence. He has extensive experience in private equity and the tech startup space, as well as public accounting with a focus on real estate, cannabis, not-for-profits and tech. These startups ranged from early stage to greater than $20 million in annual revenue. He has served as controller, auditor and director of finance & operations for several startups and serves as an adviser for a cannabis-focused technology incubator. He is a stakeholder in several cannabis and non-cannabis companies across multiple vertices including technology, human resources and consumer product goods. Zach is a member of the AICPA and NYSSCPA. At the NYSSCPA, he is the chair of the Cannabis Industry Committee and a member of the Technology Assurance Committee.

 

Originally published by the NYSSCPA’s Online Tax Publication,  Tax Stringer.

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