That can’t be right, marijuana is legal here.” It’s a common refrain from would-be cannabis entrepreneurs, initially filled with enthusiasm—only to run headlong into a brick wall of harsh reality. Or, rather, one of many brick walls facing cannabis businesses even in states that have legalized and regulated production and sale.

    Cannabis legalization is not a binary switch that has been thrown to the “on” position. Systemic disadvantages remain for the state-legal industry on numerous fronts, which translate to inefficiencies and costs for businesses and consumers. And of course, these challenges are particularly severe for potential cannabis entrepreneurs with limited access to capital and relevant professional networks (often people that have been most harshly impacted by cannabis prohibition), despite the emphasis placed by some policymakers and industry figures on social equity and providing opportunities for disadvantaged groups.

    Many of these problems flow from the remaining prohibitions in the federal Controlled Substances Act (CSA). But obstacles go far beyond mere fear of a federal prosecution. And it should be noted that even proposed “fixes” for these issues—ones that could have truly positive impacts—will nonetheless likely require further iterative reforms.

    These challenges include, but are certainly not limited to, the following three areas:

     

    1. Envying the Florist: The Heavy Tax on Cannabis

    Even casual observers of the cannabis industry know of the heavy tax burden it faces. For example, in California two separate cannabis-specific taxes are levied. First, California collects a flat cultivation tax of $9.25/ounce of flower and $2.75/ounce of leaves on any cannabis in the commercial market. Second, California charges a 15 percent excise tax on each retail sale. Of course, that 15 percent is in addition to, not instead of, the normal state sales tax applicable to goods. It is also in addition to any additional local taxes.  

    Whether these tax rates should be reduced remains a hot topic among policymakers and within the industry. There is general recognition that cannabis-specific taxes are unlikely to disappear in the near future. But some licensed cannabis retailers look enviously at the florist next door who does not have to mark up customers’ bills in the same way—and fear competition from an unlicensed drug dealer who pays no taxes at all, and sells cannabis at a price uninflated by the costs of safety testing, licensing fees, or employing a unionized workforce.  

    Of course, cannabis entrepreneurs understand that they are not the only industry that faces excise taxes, and many welcome the opportunity to demonstrate the value of the legal industry to their home states.  

    What potential cannabis businesses are often surprised to learn is that the federal tax code includes a section that significantly raises their tax bills. To simplify, Section 280E prohibits businesses from taking most tax deductions or credits if the underlying business consists of trafficking substances listed in the CSA.  

    A person who sold drugs illegally, Jeffrey Edmondson, successfully challenged the IRS to deduct his “business expenses.”

    Section 280E is blessed with a colorful origin story. Congress enacted Section 280E in the wake of a 1981 tax case in which a person who sold drugs illegally, Jeffrey Edmondson, successfully challenged the IRS’s calculation of his tax liability to deduct his “business expenses.” In 1982, Congress responded by enacting Section 280E to prevent drug dealers such as Mr. Edmonson from being treated under the tax code in the same way as legitimate businesses.  

    Fast forward to the present day, and the IRS applies Section 280E to state-legal cannabis businesses. So while a florist or liquor store may be able to deduct relevant expenses and pay taxes only on their profits, a licensed cannabis business will be forced to pay taxes on its revenue minus a series of limited carve-outs.

    Altogether, cannabis companies face much higher effective tax rates than other businessesestimated as an effective rate of 70 percent or higher by the nation’s largest cannabis trade association.

     

    2. Laughing All the Way to the Bank (If You Can Find One)

    Transacting business—and needing to make payroll, remit taxes, and the like—exclusively in cash is far from ideal. As a result, the federal bank regulator, FINCEN, issued guidance in 2014 designed to detail how banks could service cannabis businesses consistent with their federal law obligations. Treasury Secretary Steven Mnuchin testified to Congress in February 2018 that “we don’t want bags of cash” from the cannabis industry, and that “we want to make sure that we can collect our necessary taxes.”

    Yet many cannabis businesses continue to struggle to find banking services because banks want more guidance than regulators have provided to-date, or because they consider compliance too costly to warrant opening such accounts. Indeed, it recently made major news even outside the industry when CFA Federal Credit Union became the first financial institution to openly serve Massachusetts’ brand new adult-use cannabis industry.

    Just as Secretary Mnuchin does not want “bags of cash,” cannabis business owners don’t either.

    Needless to say, just as Secretary Mnuchin does not want “bags of cash,” cannabis business owners don’t either. Of course, there are security concerns: If large amounts of cash are stored at a business, that business, its employees, and its customers are left vulnerable. There are practical ones, too: Cash must be accounted for, tracked, and monitored.  

    There are also good governance issues. When building a compliance program, particularly in a high-risk industry, one of the first orders of business is implementing cash controls so that funds can be clearly tracked. Limited access to banking makes it more challenging for some businesses to take that step.

     

    3. Whose Crime Is It Anyway? Legal Ethics and Cannabis

    Yet another challenge for potential cannabis entrepreneurs in certain states is the risk that attorneys can face in representing them. The specifics vary by state, but there is a general prohibition on attorneys intentionally assisting a client in the commission of a crime.  

    For example, in the Model Rules, Rule 1.2(d) prohibits a lawyer from “assist[ing] a client, in conduct that the lawyer knows is criminal.” The reasoning is clear: A person should not be able, for instance, to ask a lawyer how to minimize the risk of punishment for a robbery that person is planning.

    That makes sense for robbery. But what does it mean for state-legal cannabis businesses that are trying to comply with heavy regulatory burdens under state law? 

    State bars have split on this issue. The prevailing position is exemplified by the Arizona Bar, which concluded that the complexity of compliance with the state’s medical cannabis law compelled the conclusion that Arizona attorneys should be able to provide advice. In the words of that ethical opinion, prohibiting lawyers from advising Arizona medical cannabis businesses would “depriv[e] clients of the very legal advice and assistance that is needed to engage in the conduct that the state law expressly permits.”

    The minority position is exemplified by the New Mexico Bar. New Mexico law permits medical cannabis. But New Mexico attorneys working with cannabis clients do so at their own risk. The New Mexico Bar concluded that “assistance to these medical cannabis businesses would violate the Rules of Professional Conduct,” though it declined to provide guidance on what constituted “assistance” in this context. Instead, it warned that attorneys must analyze the issue themselves, and warned that an attorney’s conclusion that a given client representation did not constitute assistance “may be tested through a disciplinary complaint.”

    This risk is yet another function of the unique legal status of state-legal cannabis, one which is particularly painful because of the highly regulated nature of the industry. But that advice may come with a price for lawyers in certain jurisdictions.  

    Accordingly, though cannabis is not uniquely highly regulated, it faces a unique threat. In the cannabis industry, in certain jurisdictions (and for lawyers who are licensed in those jurisdictions, even if practicing elsewhere) lawyers must proceed with caution before assisting clients in dealing with the hundreds of pages of cannabis regulation that they face. New Mexico lawyers advising the highly regulated insurance industry do not share these concerns.  

    There is, however, an argument that even lawyers in jurisdictions following New Mexico’s lead need not fear discipline for assisting clients in tightly regulated state cannabis markets. The prohibition is on assisting with conduct the attorney “knows” to be illegal. As I detailed in a recent academic article for the U.C. Davis Business Law Journal, there is good reason to believe that state cannabis markets could exist beyond the federal government’s constitutional grasp.  

    To the extent that attorneys conclude that a given state’s market met those parameters, it would call into question whether the attorneys knowingly assisted in the violation of the law (since they would have concluded the underlying conduct was beyond the reach of the federal government and, accordingly, not a federal crime). But of course, that requires an attorney to take on additional personal risk compared with representing, say, an insurance company. And that risk limits the pool of potential advisors for the cannabis industry.

    The cannabis reform movement has accomplished a great deal, and there is significant positive momentum. That said, the nascent industry continues to face a number of robust, systemic challenges to achieving parity with other legitimate businesses.


    Photo via The Motley Fool

    • Michael Cooper

      Michael is the co-founder and managing member of MadisonJay Solutions LLC (https://www.madisonjaysolutions.com), a leading regulatory advisor to the adult-use cannabis industry. He publishes and speaks frequently on state-legal marijuana regulation. He is a graduate of Harvard College and Harvard Law School, and previously served as General Counsel of MHW, Ltd. and in the litigation department of Cravath, Swaine & Moore LLP.

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