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How Section 280E is Still Hindering the Cannabis Industry

By Jay Jerose
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The cannabis industry is an unprecedented industry and one under constant review and control. Following the November 2020 elections, fifteen states and Washington DC have legalized adult use cannabis, a number that will continue to grow as legalization slowly becomes more widely adopted in other states. Beyond that, a continuously growing number of states allow residents to purchase legal medicinal cannabis, and many have also decriminalized adult use. However, it still remains a Schedule I substance under the Controlled Substances Act and is therefore illegal on all accounts at the U.S. federal level, which creates a number of issues for businesses in the cannabis industry duly operating in states where it has been legalized.

Not only is it difficult for cannabis companies to avail themselves of alternative banking solutions, but there are also obstacles in place preventing these companies from taking advantage of notable tax deductions. The primary obstacle being Internal Revenue Code (IRC) Section 280E.

What is Section 280E?

Section 280E is a relatively short code section, only 77 words to be exact, but it carries significant weight and can have a debilitating effect on the taxable income of marijuana [sic] related businesses (MRB). Section 280E of the IRC prohibits taxpayers who are engaged in the business of trafficking certain controlled substances, including cannabis, from deducting typical business expenses associated those activities. Section 280E, which was enacted in 1982 during the “War on Drugs” era, has become increasingly relevant for cannabis businesses. The cannabis industry has grown substantially in recent years with annual market values expected to reach $30 billion by 2025.

However, while Section 280E greatly restricts the tax deductions of state-legal cannabis businesses, there is some reprieve. Current IRC provisions permit state-legal cannabis businesses, including growers, producers, wholesalers or retailers, to deduct the Cost of Goods Sold (COGS) in computing their US federal income tax liability, despite the application of Section 280E.

Impact of Section 280E on Businesses

 What does Section 280E mean for cannabis businesses today? It is intended to prevent dealers from claiming tax deductions for their business expenses, interpreted to include state-legal cannabis businesses, reduced deductions that result in increased taxable income and MRBs will face higher federal tax rates. 

The IRC disallows any deductions or credits paid or incurred during a tax year if those deductions or credits relate to trafficking controlled substances. The courts have taken the position that the term “trafficking” in this case means “engaging in a commercial activity – that is, to buy and sell regularly.” Simply, the law denies cannabis businesses any U.S. federal income tax deduction for ordinary and necessary business expenses, despite being duly licensed as a legal business in their state of operation.

Typically, the ability to deduct ordinary business expenses means that a business is subject to federal tax on its net income (i.e., gross receipts minus expenses). However, the definition of Section 280E and the classification of cannabis as a Schedule I substance severely hinders legal cannabis companies from taking advantage of tax deductions for actual economic expenses incurred in the ordinary course of business, which results in a significantly higher effective tax rate as compared to other businesses.

Legal Actions and Challenges to Section 280E

There have been court challenges and concessions made to Section 280E. Specifically, the 2007 court case Californians Helping to Alleviate Medical Problems, Inc., v. Commissioner. This court case reinforced the precedence that Section 280E does not apply to cost of goods sold. The Internal Revenue Service (IRS) defines cost of goods sold to be “expenditures necessary to acquire, construct or extract a physical product which is to be sold.” Generally, for a retail MRB, this means that the direct cost of acquiring cannabis products for resale. Deductions for rent, utilities, wages, insurance and other operating costs common to ordinary businesses are generally disallowed. New York State has specifically indicated that it intends to follow Section 280E for its own income tax calculations, disallowing these same deductions against New York taxable income

Tax Court and Section 280E

The Tax Court has also been aggressive in tamping down efforts by MRBs to separate cannabis related and non-cannabis related activities. The courts argue that these separate activities constitute a single trade or business when they share a close and inseparable organizational and economic relationship. In addition, the risk of cannabis related activities tainting a taxpayer’s other business concerns exists if services or employees are shared between an MRB and a non-MRB. Allocation of expenditures to cost of goods sold, as well as any allocations of costs between MRB and non-MRB entities, need to be well thought out and supported by defensible tax and accounting positions.

The Future of MRBs and Section 280E

All indications point to an increased frequency of IRS audits of MRBs compared to audits of non-cannabis related businesses. Therefore, documenting the methodology behind the calculation of costs of goods sold is even more important for MRBs. It is vital to consult with a tax advisor to ensure you are maximizing your cost of goods sold deductions and preparing the best documentation possible to support your 280E tax positions.


Disclaimer: The information presented in this article should not be considered legal advice or counsel and does not create an attorney-client relationship between the author and the reader. If the reader of this has legal or accounting questions, it is recommended they consult with their attorney or accountant.

Current Trends in Banking for Cannabis-Related Businesses

By Paula Durham, CFE, CCCE
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Cannabis is still federally illegal and is included on Schedule 1 of the Controlled Substances Act (CSA), along with such other substances as heroin, fentanyl and methamphetamines.1 It is a federal crime to grow, possess or sell cannabis.

Despite being federally illegal, 36 U.S. states and the District of Columbia have legalized the sale and use of cannabis for medical and/or adult use purposes,2 and both direct and indirect cannabis-related businesses (CRBs) are growing at a rapid rate. Revenue from medical and adult use cannabis sales in the US in 2019 is estimated to have reached $10.6B-$13B and is on track to reach nearly $37B in 2024.3

Because the sale of cannabis is federally illegal, financial institutions face a dilemma when deciding to provide services to CRBs. Should they take a significant legal risk or stay out of the market and miss out on a significant revenue opportunity? So far, the vast majority of financial institutions have been unwilling to take the risk, resulting in a dearth of options for CRB’s. Until recently, cannabis business operators had few options for financial services, but times are changing.

This piece will discuss current trends in banking for cannabis-related businesses. We will cover differences in legality at state and federal levels, complexities in dealing in cash versus digital currencies, Congressional actions impacting banking and CRBs and how banking is changing. The explosion of state legalization of cannabis over the past several years has had a strong ripple effect across the US economy, touching many industries both directly and indirectly. Understanding the implications of doing business with a CRB is both challenging and necessary.

Feds Versus States

Money laundering is the process used to conceal the existence, illegal source or illegal application of funds.4 In 1986 Congress enacted the Money Laundering Control Act (MLCA), which makes it a federal crime to engage in certain financial and monetary transactions with the proceeds of “specified unlawful activity.”5 Therefore, CRB transactions are technically illegal transactions under the MLCA.

Financial institutions therefore face a risk of violating the MLCA if they choose to do business with CRBs, even in states where cannabis operations are permitted. In addition, financial institutions could also face criminal liability under the Bank Secrecy Act (BSA) for failing to identify or report financial transactions that involve the proceeds of cannabis businesses operating legally under state law.6

Federal authorities continued to aggressively enforce federal cannabis laws

In short, because cannabis is illegal at the federal level, processing funds derived from CRBs could be considered aiding and abetting criminal activity or money laundering. States, however, began legalizing cannabis in 1996, and by 2009, thirteen states had laws allowing cannabis possession and use.7 Despite this legislation, federal authorities continued to aggressively enforce federal cannabis laws.8 That changed under the Obama administration when, shortly after being elected, President Obama stated that his administration would not target legal CRB’s who were abiding by state laws.[9] In an attempt to provide clarity in this murky environment, beginning in 2009, the Department of Justice (DOJ) issued three memos designed to guide federal prosecutors in this area. However, none of the DOJ memos issued from 2009 through 2013 addressed potential financial crime related to the legal sale or distribution of cannabis in states allowing the use of medicinal or recreational cannabis.

To assist financial institutions in navigating potential financial crime implications of banking CRBs, the Financial Crimes Enforcement Network (FinCen) issued guidance in 2014 that clarified how financial institutions could conduct business with CRBs and maintain compliance with their Bank Secrecy Act requirements (2014 Guidance).9 According to the 2014 Guidance, financial institutions may choose to interact with CRBs based on factors specific to each institution, including the institution’s business objectives, the evaluated risks associated with offering such services, and its ability to manage those risks effectively.

The 2014 Guidance requires those who choose to provide services to CRBs to design and implement a thorough customer due diligence review that includes, in part, analyzing the licensing of the entity, developing an understanding of the business operations of the entity, and ongoing monitoring of the entity.9 In addition, financial institutions are required to file a Suspicious Activity Report (SAR) for every transaction they process for a CRB, should they choose to accept the business.

Although the 2014 Guidance does outline a path for financial institutions to engage with CRBs, it does not change federal law and, therefore, does not eliminate the legal risk to financial institutions.10 By its very nature, the 2014 Guidance was a temporary fix, subject to changing views of different administrations, evidenced by the fact that all three of the DOJ guidance documents noted above were rescinded by then Attorney General Jeff Sessions on January 4, 2018.12 The DOJ enforcement posture could change once again in a Biden administration. Biden is on record as favoring decriminalization, and Attorney General candidate Merrick Garland has stated that if confirmed he will deprioritize enforcement of low-level cannabis crimes. Garland also believes using limited government resources to pursue prosecution of cannabis crimes states where cannabis is legal does not make sense.12

Because of the uncertainty and high risk, most banks remain unwilling to serve CRBs. Those that do serve CRBs charge exorbitant fees (fees of $750-$1,000 or more per account per month are not uncommon), pricing many smaller operators out of the financial services market.

Cash is King – Or Is It?

Cannabis operators have discovered the old adage “cash is king” is not necessarily true when it comes to the cannabis space. Bank-less CRBs are forced to utilize cash to pay business expenses, which can be particularly difficult. Utility companies, payroll companies, and taxing authorities are just some of the providers that are difficult, if not impossible, to pay in cash. For example, cannabis operators have been turned away from IRS offices when attempting to pay large federal tax obligations in cash. Likewise, cannabis operators have been unable to utilize payroll processing companies to administer payroll and benefits for their businesses because the processors won’t take cash. CRBs can’t use Amazon or other online retailers because online providers cannot accept cash.

Because dealing in cash is so difficult, CRB operators look for workarounds such as using personal credit/debit cards to purchase business equipment and supplies. This doesn’t eliminate the cash problem, however, because the credit card holder will likely have to accept cash as reimbursement. Such transactions could be considered an attempt to hide the source of the cash, which is, by definition, money laundering.

CRBs often have large sums of money onsite

Some bank-less CRBs try to skirt the system by obtaining bank accounts in the name of management companies or other entities one step removed from the actual business. While operators often choose this route in an effort to streamline business and operate out of the shadows, it again runs afoul of banking laws. Transferring cannabis related financial transactions to another entity is actually the very definition of money laundering – which, as noted above, is defined as the process used to conceal the existence or source of “illegal” funds.

In addition to the difficulties in making payments or purchasing business supplies, operating in a cash-heavy environment poses significant safety risks for cannabis operators. CRBs often have large sums of money onsite and transport large sums of cash when purchasing product or paying bills, making them a target for robbery. In 2017, there was a spate of dispensary robberies across the Phoenix Metro area, including one at Bloom Dispensary that took place during operating hours.13

Managing all that cash increases the cost of doing business as well, in the form of increased labor, insurance, and security costs. Cash must be counted and double counted, which can be time consuming for staff, not to mention the time it takes to deliver physical cash payments to hither and yon. Ironically, lack of banking significantly decreases transparency and clouds the waters of compliance, as operating strictly in cash makes it easier to manipulate reported financial results.

Potential Congressional Solutions

In recent years Congress has undertaken several efforts to pass legislation designed to address the state/federal divide on cannabis, which would likely clear the way for financial institutions to provide services to CRBs, including:

  • R. 1595 – Secure and Fair Enforcement Banking Act of 2019 (“SAFE Act”);
  • 1028 & H.R. 2093 – Strengthening the Tenth Amendment Through Entrusting States Act (STATES Act); and
  • 2227 – Marijuana Opportunity Reinvestment and Expungement Act of 2019 (MORE Act).

The climate in Washington DC, however, did not allow any of these initiatives to pass both houses of congress. Had any been sent to the White House, President Trump was unlikely to sign them into law.

The cannabis industry has new reason to believe reform is on the horizon with shift in political leadership in the White House and Senate. Newly anointed Senate Majority Leader Chuck Schumer recently committed to making federal cannabis reform a priority, and President Biden appears committed to decriminalization, reviving the hope of passage of one of these pieces of legislation.

The Changing Banking Landscape

Even though there is little in the way of formal protections for financial institutions, and with the timeline for a legislative fix unknown, an increasing number of banks are working with cannabis operators.

According to FinCen statistics, there were approximately 695 financial institutions actively involved with CRBs as of June 30, 2020. It is important to note that these statistics are based on SAR filings, which banks are required to file when an account or transaction is suspected of being affiliated with a cannabis business. However, some of these SARs may have been generated on genuine suspicious activity rather than on a transaction with a known cannabis customer.

Number of Depository Institutions Actively Banking
Cannabis-Related Businesses in the United States
(Reported in SARS)14

There are arguably more banking institutions offering services to CRBs than ever before. The challenges for CRBs are (1) finding an institution that is willing to offer services; (2) building/maintaining a compliance regime that will be acceptable to that institution; and (3) cost, given the high fees associated with these types of accounts. 

How CRBs Get Accepted by Banks

The gap between CRBs’ need for banking and the financial services providers’ sparse and expensive offerings to the sector has created an opportunity for third-party firms to intervene and provide a compliance structure that will satisfy the needs of the financial institutions, making it easier for the CRB to find a bank.

These third-party firms perform extensive BSA-compliant due diligence on applicants to ensure potential customers are following FinCen guidance required to receive banking services. After the completion of due diligence, they connect the CRBs with financial institutions that are willing to do business with CRBs and provide checking/savings accounts, check writing capability, and merchant processor accounts. These firms often provide additional services such as armored car and cash vaulting services. Some of these firms also offer vendor screening, pre-approving vendors before any payments can be made.

One such firm, Safe Harbor Private Banking, started as a project implemented by the CEO of Partners Credit Union in Denver, Colorado, who set out to design a cannabis banking program that would allow Partners to do business with Colorado CRBs.15 The program was successful and has since expanded into other states who have legalized cannabis. Other operators include Dama Financial and NaturePay.

While these services offer hope for many CRBs, the downside is cost. These services perform the operations necessary to find, open, and maintain a compliant bank account; however, the costs of compliance are still high, pricing some small operators out of the market.

Is Digital Currency an Answer?

 Digital currency is also making its way into the cannabis world. Digital currency, or cryptocurrency, is a medium of exchange that utilizes a decentralized ledger to record transactions, otherwise known as a blockchain. One of the largest benefits of blockchain is that it is a secure, incorruptible digital ledger used for, among other things, financial transactions.16 Blockchain technology offers CRBs a transparent and immutable audit trail for business and financial transactions. Several cannabis-specific cryptocurrencies have sprung up in the past several years, including PotCoin, CannabisCoin, and DopeCoin, to name a few.

In July 2019, Arizona approved cryptocurrency startup ALTA to offer services to the state’s medical cannabis operators.17 ALTA describes itself as a “digital payment club where cash-intensive businesses pay each other using digital tokens instead of cash.”18 ALTA members purchase digital tokens that are used to pay other members using a proprietary blockchain based system. The tokens are redeemable for US dollars at a stable rate of 1:1, and CRBs do not need a bank account to participate in the ALTA program.

ALTA proposes to pick up members’ cash and exchanges it for tokens, which are then used to pay other members for goods and services. Tokens may be redeemed for cash at any time.18 The company has been approved by the Arizona State Attorney General, and one of the first members they hope to enlist is the Arizona Department of Revenue (ADOR). Enlisting ADOR into the program would allow dispensary members to pay state taxes digitally rather than hauling large amounts of cash to ADOR offices.

Similarly, Nevada recently contracted with Multichain Ventures to supply a digital currency solution to the Nevada cannabis industry. Nevada Assembly Bill 466 requires the state create a pilot program to design a “closed loop” system like Venmo in an effort to reduce cash transactions in the cannabis sector. Like ALTA, Nevada’s proposed system will convert cash to tokens which can then be transacted between system participants.19

While both proposals are promising for Arizona and Nevada CRBs, the timeline as to when, or if, these offerings will come online is unknown. Action on cannabis reform at the federal level may render these options moot.

Looking to the Future

Although states are legalizing cannabis in one form or another in growing numbers, the fact that cannabis is still federally illegal poses a significant barrier to accessing the financial services market for CRBs. While most banks are still reluctant to offer services to this rapidly growing industry, there are more banks than ever before willing to participate in the cannabis industry. Recent changes in leadership in Washington DC offer a positive outlook for cannabis reform at the federal level.

As the “green rush” continues to envelop the country, financial services options available to CRBs are slowly growing. Many new options are now available to help CRBs find a bank, develop compliance programs, and manage the cash related problems encountered by most CRBs. However, these solutions may be out of reach for the budget-conscious small operator. Also, there are a number of cryptocurrency solutions designed specifically for CRBs; however, when, or if, these solutions will gain significant traction is still unknown.


References

  1. Controlled Substances Act, 21 U.S.C., Subchapter I, Part B, §812.
  2. “State Marijuana Laws”; National Conference of State Legislatures, February 19, 2021.
  3. “Exclusive: US Retail Marijuana Sales On Pace to Rise 40% in 2020, near $37B by 2024”. Marijuana Business Daily, June 30, 2020.
  4. Kaufman, Irving. “The Cash Connection: Organized Crime, Financial Institutions, and Money Laundering”. Interim Report to the President, October 1984.
  5. S. Code § 1956 – Laundering of Monetary Instruments.
  6. Rowe, Robert. “Compliance and the Cannabis Conundrum.” ABA Banking Journal, September 11, 2016.
  7. “History of Marijuana as a Medicine – 2900 BC to Present”. ProCon.org, December 4, 2020.
  8. Truble, Sarah and Kasai, Nathan. “The Past – and Future – of Federal Marijuana Enforcement”. org, May 12, 2017.
  9. FIN-2014-G001, BSA Expectations Regarding Marijuana-Related Businesses.
  10. Cannabis Banking Coalition Statement.
  11. Sessions, Jefferson B. “Memorandum for All United States Attorneys”. January 4, 2018.
  12. “Attorney General Nominee Garland Signals Friendlier Marijuana Stance”. Marijuana Business Daily, February 22, 2021.
  13. Stern, Ray. “Robbers Hitting Phoenix Medical Marijuana Dispensaries: Is Bank Reform Needed?” The Phoenix New Times, April 11, 2017.
  14. FinCen Marijuana Banking Update, June 30, 2020.
  15. Mandelbaum, Robb. “Where Pot Entrepreneurs Go When the Banks Just Say No.” The New York Times, January 4, 2018.
  16. Rosic, Ameer. “What is Blockchain Technology? A Step-by-Step Guide for Beginners.” com, 2016.
  17. Emem, Mark. “Marijuana Stablecoin Asked to Play in Arizona Fintech Sandbox.” CCN.com, October 25, 2019.
  18. http:\\Whatisalta.com\
  19. Wagner, Michael, CFA. “Multichain Ventures Secures Public Sector Contract with Nevada to Supply Tokenized Financial Ecosystem for the Legal Cannabis Industry”, January 26, 2021.

Could 2021 Be the Year of Federal Cannabis Legalization?

By Bryan Johnson
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The legalization of cannabis in the U.S. has been long in the making. Back in the early 1970s, states such as Oregon, Texas and Colorado began the process of decriminalizing small amounts of cannabis. Fast forward 50 years or thereabouts, and the momentum toward legalization is undeniable.

True, cannabis remains illegal at the federal level, but state after state is legalizing the substance for medical and adult use. California was the first to do so for medical usage in 1996. Since then, several others have jumped on the medical cannabis bandwagon, and a total of 19 states have legalized cannabis for adult use. It seems, then, that it’s just a matter of time before the federal government follows suit.

A Bit of Background 

There are two key federal laws concerning cannabis that criminalize its use: the Comprehensive Drug Abuse Prevention and Control Act (CDAPCA) and the Controlled Substances Act (CSA), which is part of the CDAPCA. The CSA became effective in 1971 and grouped cannabis along with heroin, LSD and cocaine as Schedule I drugs that are tightly regulated and deemed illegal by the federal government. For its part, the CDAPCA, also enacted in the 70s, was an element of the U.S. “War on Drugs,” and served to significantly restrict manufacturing and distribution of cannabis, among other substances, and amp up related security laws.

Times have certainly changed over the decades, and so has public sentiment about cannabis use. In fact, over 91% of U.S. adults say that cannabis should be legal for adult use or medical use—this according to the Pew Research Center. Clearly, more and more states are hearing this message loud and clear given the uptick in jurisdictions legalizing the substance, be it for medical or adult use purposes.

The Booming Legal Cannabis Market

The legal cannabis business is on fire, with recent estimates suggesting that the size of the global market will climb to $84 billion by 2028. This is a staggering number that spells opportunity for budding (pun intended) entrepreneurs in the U.S. and beyond, not to mention tax authorities. It gets even better when taking into account the popularity of CBD products. CBD, which is derived from the cannabis plant but does not contain THC and is legal in the U.S., has become an integral part of the wellness industry. Experts predict that the global CBD market is on its way to reaching a value of $55 billion in years to come.

What This All Means for the Future of Cannabis at the Federal Level

No doubt about it, legal cannabis is big business. But that business is being thwarted by the failure of the federal government to change course and legalize the substance. With cannabis still considered a Schedule I drug, federal banks are unable to provide access to financial services for companies selling cannabis-related products. As otherwise stated, because federal law makes cannabis illegal, banks cannot do business with cannabis companies, which is problematic for so many reasons.

Sen. Schumer unveiling the Cannabis Administration and Opportunity Act

But good news could be on the horizon. The SAFE Banking Act of 2021, which would provide a safe harbor for banking institutions providing services to cannabis clients, was passed in the U.S. House of Representatives and referred to committee. Whether the legislation passes in its current form is anyone’s guess, though our federal legislature does seem to be nearing the relaxation of existing cannabis restrictions.

This is evidenced as well in the U.S. Senate, where the Cannabis Administration and Opportunity Act was recently introduced and is currently pending. That legislation would, among other things, remove cannabis from the CSA, introduce regulations to tax cannabis products, expunge prior convictions, and maintain the authority of states to set their own cannabis policies.

Of course, there’s no certainty that 2021 will be the year when cannabis is finally legalized (or at the very least, decriminalized) federally. Still, we’re closer to that eventuality than ever before.

Support Grows for Federal Cannabis Legislation with the SAFE and CLAIM Acts

By Jay Virdi
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Things are about to change for cannabis and cannabis-related businesses, as landmark legislation to reform federal cannabis banking and insurance laws is just around the corner with the SAFE and CLAIM Acts now making their way through Congress.

The Secure and Fair Enforcement (SAFE) Banking Act, which already passed in the House, would allow financial institutions to do business with cannabis companies without facing federal penalties. There are high expectations the proposal will make its way through the Senate and onto President Biden’s desk.

The Clarifying Law Around Insurance of Marijuana (CLAIM) Act was introduced in Congress in March and is in the first stage of the legislative process. If it passed, it would allow insurance companies to service cannabis businesses without the threat of federal penalties.

For years, fear of sanctions kept banks and credit unions from working with the cannabis industry, forcing cannabis businesses to operate on a cash basis which made them targets of crime and created complications for financial regulators. This is a significant first step for cannabis businesses toward conducting more legitimate and safe operations.

The SAFE Banking Act: Providing a Legitimate Avenue to Banking and Loans

With 37 states and D.C. having taken action to legalize cannabis in some way, it is clear the federal cannabis regulatory model has shifted and the path forward for the SAFE Banking Act shows promise.

The bill creates a safe harbor for banks and credit unions to the extent they would not be liable or subject to federal forfeiture action for providing financial services to a cannabis-related business.More competition means greater capacity and lower premiums for all. 

The bill would prohibit a federal banking regulator from:

  • Recommending, incentivizing or encouraging a depository institution not to offer financial services to an account holder affiliated with a cannabis-related business or prohibit or otherwise discouraging a depository institution from offering services to such a business
  • Terminating or limiting the deposit insurance or share insurance of a depository institution solely because the institution provides services to a cannabis-related business
  • Taking any adverse or corrective supervisory action on a loan made to a person solely because the person either owns such a business or owns real estate or equipment leased to such a business. 

The CLAIM Act: Backing Cannabis Businesses with the Right Insurance Coverage

Should the CLAIM Act pass, it will protect insurance companies that provide coverage to a state-sanctioned and regulated cannabis business. It would also prohibit the federal government from terminating an insurance policy issued to a cannabis business and protect employees of an insurer from liability due to backing a cannabis-related business.

The CLAIM Act will be a boost for the insurance market and drive more underwriters to write cannabis policies. More competition means greater capacity and lower premiums for all. The act would also have a notable impact on currently hard-to-source policies like Cyber coverage, Directors & Officers (D&O) insurance, Errors & Omissions (E&O) and other management liability policies that have been extremely limited to cannabis businesses.

Cannabis Sales Still Growing Strong Globally 

The cannabis market is not slowing down in the United States or globally. Recent forecasts have U.S. sales reaching $28 billion in 2022.

As was the case in Canada where cannabis was made federally legal in 2018, there’s going to be a steep learning curve industry-wide for financial services and insurance vendors who don’t yet understand the risks and liabilities of cannabis operations, even if the SAFE and CLAIM Acts pass this year. And yet this is one giant step in the right direction toward the safe and equitable sales of cannabis country-wide.

FDAlogo

FDA Issues Warning Letters on Marketing and Sale of OTC CBD Products

By Seth Mailhot, Steve Levine, Emily Lyons, Leah Kaiser, Marshall Custer
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The U.S. Food and Drug Administration (FDA) issued warning letters this month to two companies concerning the marketing and sale of over-the-counter (OTC) drug products containing cannabidiol (CBD) as an inactive ingredient. The letters allege violations of the Federal Food, Drug, and Cosmetic (FD&C) Act related to current good manufacturing practice requirements and marketing of new drugs without FDA approval.

At issue: labeling, NDAs and active ingredients

The companies subject to the warning letters market OTC drug products that contain CBD as an inactive ingredient. In the warning letters, the FDA states that it has not approved any OTC drugs containing CBD. According to the FDA, an approved new drug application (NDA) is required to legally market nonprescription or OTC drug products containing CBD, regardless of whether the CBD is an active or inactive ingredient. The FDA notes that CBD has known pharmacological effects and demonstrated risks, and that CBD has not been shown to be safe and suitable for use, even as an inactive ingredient. As a result, the FDA states that CBD cannot be marketed in OTC drug products.

Further, the warning letters noted the marketing of several CBD products that highlighted the benefits of CBD for a range of conditions in such a manner that, according to the FDA, “misleadingly suggests that [their] . . . products are approved or endorsed by FDA in some way when this is not true.” The FDA also took issue with the way products were labeled, which included callouts on the front label regarding the CBD content of the product (a requirement under most state laws that permit CBD as an ingredient). Similarly, the FDA also noted that some of the products advertised CBD as an active ingredient in a topical pain reliever product. According to the FDA, no company may legally market such a product, since there are no OTC monographs or NDAs that allow the use of CBD in an OTC drug.

What this means for you

These warning letters highlight the FDA’s vigilance regarding OTC CBD products. Regardless of whether the CBD is labeled as an active or inactive ingredient, the FDA has taken the position that nonprescription CBD drugs are in violation of the FD&C Act. Companies marketing CBD products should be careful to ensure their marketing practices, as well as their product formulations, do not present a heightened risk of FDA enforcement.

Learning from the First Wave Part 1: How Law Shapes the California Cannabis Industry

By Todd Feldman
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As a cannabis lawyer, I spend a lot of time thinking about the ways that regulations affect a cannabis company’s bottom line. Since I’m in California, the ways are many.

In late 2017 I became the chief compliance officer for an Oakland startup that carried out delivery, distribution, cultivation and six manufacturing operations. A big part of my job was preparing my company, along with several equity cannabis companies, for California’s First Wave of cannabis licenses.

For the most part, First Wave licensees came from California’s essentially unregulated medical cannabis market, and/or from California’s by-definition unregulated “traditional” market. When California began issuing licenses in January 2018, many First Wavers were unprepared because their businesses practices had evolved in an unregulated market. A big part of my job was to help them adapt to the new requirements. As a result, I saw the regulations, and the effects of regulations, in sharp relief.

Regulation touches virtually every aspect of the legal cannabis industry in California. So anyone who wants to understand the industry should have at least a basic understanding of how the regs work. I’m writing this series to lay that out, in broad strokes.

Some key points:

  • The regulated market must be understood in relation to the previous unregulated (medical) market as well as the ongoing traditional market.
  • Regs define the supply chain.
  • Regs are designed to ensure product safety and maximize tax revenue.
  • Many regulations mandate good business practices.
  • Local enforcement of building, health and safety codes tends to be zealous and costly.

A Tale of Three Markets

California’s regulated cannabis market can only be understood in relation to the medical market that preceded it, and in relation to the traditional market (illegal market) that continues to compete with it.

The Before Times

California’s legal medical cannabis market goes back to 1996, when the Compassionate Use Act passed by ballot measure. One fact that shaped the medical market was that it was never just medical – while it served bona fide patients, it also served as a Trojan horse for adult-use (recreational) purchasers.

Another fact that shaped the medical market was a near complete lack of regulation. On the seller’s side, you had to be organized as a collective. On the buyer’s side, you had to have a medical card. That was it.

Meanwhile, the cannabis supply chain was entirely unregulated. This tended to minimize production costs. It also meant that a patient visiting a dispensary had no way of verifying where the products had been made, or how.

The Regulated Times

Licensing under the Medical and Adult-Use Cannabis Regulation and Safety Act (the “Act”) began on January 1, 2018. It was the beginning of legal adult-use cannabis in California. It was also the beginning of the Regulated Times, as the Act and accompanying 300-plus pages of regulations transformed the legal cannabis market.

 For example:

  • The Act defines the cannabis supply chain (as a series of licensees).
  • Across the supply chain, the internal procedures of cannabis companies are subject to review by state agencies;
  • Cultivators and manufacturers cannot sell directly to a dispensary – they must go through a distributor;
  • All cannabis must be tested for potency and a long list of contaminants by a licensed testing laboratory before it may be sold to consumers;
  • And beginning in 2019, all licensees were required to participate in the California Cannabis Track and Trace (CCTT) program, which is designed to track all cannabis from seed to sale.

Just as importantly, the Act establishes a dual licensing system – that is to say, in order to operate, a cannabis company needs a local permit (or other authorization) as well as a state license. In fact, local authorization is a prerequisite for a state license. And your local jurisdiction will have its own rules for cannabis that apply in addition to the state rules, up to and including a ban on cannabis activities.

Needless to say, operating in the Regulated Times is a lot more complicated and expensive than it was during the Before Times.

Especially when you consider the taxes. For example, in the City of Los Angeles, sale of adult-use cannabis is taxed at 10%, which means that any adult-use purchase in L.A. gets a 34.5% markup:

  • 15% state cannabis excise tax, plus
  • 10% Los Angeles Adult Use Cannabis Sales tax, plus
  • 5% sales tax.

Note that the distributors must collect the excise tax from the retailer, so the 15% markup is not necessarily visible to the consumer. Similarly, consumers are generally unaware that there is a cultivation tax of $9.65 per ounce (or about $1.21 per eighth) of dried flower that the distributor has to collect from the cultivator.

Theoretically, all of this might be unproblematic if licensed retailers were only competing with each other. Which brings us to:

The Traditional Market

The traditional market is the illegal market, which is to say, the untaxed and unregulated market.

Legalization of adult-use cannabis was supposed to destroy the traditional market, but it hasn’t. As of early 2020, the traditional market was estimated to be 80% of the total cannabis market in California. This is not surprising, since the traditional market has the advantages of being untaxed and unregulated.

The traditional market has a pervasive negative effect on the legal market. For example, the traditional market tends to depress prices in the legal market and tends to attract talent away from the legal market. Some of these effects will be discussed in the following articles.

This article is an opinion only and is not intended to be legal advice.

CA Health and Safety Warning Laws Have Changed: Are You In Compliance?

By Megan Caldwell, Lindy Martinez
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A new California Proposition 65 mandate took effect on January 3, requiring health warning labels for all cannabis products sold in the state. Failure to comply with the requirements can and will result in enforcement against cannabis producers and sellers, resulting in hefty penalties. Here’s what you need to know.

Some Background on Proposition 65 and Cannabis

California’s Proposition 65, also known as the “Safe Drinking Water and Toxic Enforcement Act of 1986,” requires various parties in the supply chain for consumer products to provide warnings on products they sell in the state if exposure to certain chemicals in those products will pose a significant risk of cancer or reproductive harm. Proposition 65 applies to any company that sells products in California, regardless of whether the business is headquartered or manufactures products in California.

This is an example of a Prop 65 warning label. They might look familiar because we tend to see them on a lot of common goods and products.

Cannabis (Marijuana) Smoke” was listed under Proposition 65 in 2009 because of the potential that it contains ingredients or emits chemicals known to cause cancer. These chemicals include toxins such as arsenic, benzene, cadmium, formaldehyde, lead and nickel. In January 2020, Delta-9-Tetrahydrocannabinol (THC) was added to the list of toxic chemicals under Proposition 65 because of THC’s potential to cause reproductive harm. Now, both THC and cannabis smoke are listed under Proposition 65 and require warning labels.

What This Means for You and Your Company

The updated chemical list, which includes THC, became effective January 3, 2021, so the clock to come into compliance is ticking if you are not already complying. Many cannabis companies selling in California already comply with Proposition 65 by including warnings on their products that emit cannabis smoke. However, now companies that have previously issued a consumer warning regarding cannabis smoke must expand their warnings to include both the potential risk of cancer and the potential risk of reproductive harm. Additionally, products that previously did not require a warning for cannabis smoke will now be subject to Proposition 65 for exposure to THC.

The listing of THC implicates a broader range of cannabis products because it affects any product that contains detectable levels of THC, including products that contain less than 0.3% THC in compliance with the 2018 Farm Bill. Under the THC listing, a wide range of cannabis and hemp-derived CBD products, including products that do not emit smoke, such as edibles, topicals and other concentrates are subject to the Proposition 65 labeling requirements.

The agency that oversees Proposition 65 has provided so-called “safe harbor” levels for many listed chemicals that allow companies to forego a warning label if exposure to the chemical occurs at or below a certain threshold. However, no safe harbor level has been established for cannabis smoke or THC, and so the burden falls to the business to determine if the levels of the chemical pose a significant risk to the consumer. This determination typically requires extensive and costly testing that is not practical for most businesses. Thus, parties in the cannabis supply chain should work to properly label all cannabis-related products at this time. Failure to do so is risky. Proposition 65 “bounty hunters” team up with individuals to enforce Proposition 65 by sending notice of violation letters and then often filing lawsuits against businesses they believe are in violation of the statute. Many of these demands and lawsuits settle, as the cost to litigate is expensive. Settling, though, can be expensive, too.

An In-Depth Breakdown of Prop 207 in Arizona

By Laura Bianchi, Justin Brandt
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To say 2020 was a historic year is an understatement.

Arizona landed in a solid eighth place among the top ten most successful cannabis states thanks to its expansive medical cannabis program. To close out the year, voters approved Proposition 207, also known as the Smart and Safe Arizona Act (SSAA), making Arizona one of 15 states, plus Washington D.C., to legalize the adult use of cannabis, which is expected to rocket the state’s overall cannabis sales to new heights.

It’s essential to this conversation that we clarify the two sides of this rapidly growing industry. Medical cannabis is a form of treatment, the adult use and consumption of cannabis is a choice. During the pandemic, in many medical cannabis states, the medical cannabis industry was deemed an essential service and allowed to continue providing valuable medicine to patients and caregivers. As medical cannabis programs continue to provide safer therapeutic options which are complementary to or serve as an alternative to many traditional treatments and narcotics, especially opioids, patients can be confident the need for medical programs will continue. Arizona’s adult use cannabis program imposes greater limitations on quantity and potency, while also requiring higher standards for packaging. We saw a trend during the pandemic as again, many states prioritized and allowed their medical programs to continue, while limiting adult use facilities, in the same manner as other non-essential businesses.

It’s also worth noting that we have seen many inevitable changes in patient behaviors during the pandemic, including an increased need for medical cannabis. There was a patient demand for convenience, safety and no-contact services, increased online ordering, scheduling and curbside pick-up or delivery. Many of these services were already on the rise in popularity throughout the various legal states. While Arizona’s recreational program prohibits delivery until at least 2023, retail adult use consumers will expect some of these services to extend to the new market. As life after the COVID-19 pandemic continues on and the need for some of these safer more convenient options also continues, we hope to see them more permanently implemented from a legal and regulatory perspective. For now, here are the highlights we’ll see come into play in the first few months of 2021 as Arizona adopts its new adult use cannabis program.

Smart and Safe Arizona Act (Prop 207):

  • Legalizes the sale, possession (one ounce) and consumption of adult use cannabis for adults at least 21 years old.
  • Adds a 16 percent excise tax on adult use cannabis sales, in addition to the state’s 5.6 percent, totaling a 21.6 percent tax.
  • Allocates an estimated $300 million in Arizona revenue to be divided between community college districts, municipal police, sheriff and fire departments, fire districts, highway funds, public health programs, infrastructure, and a new Justice Reinvestment Fund.
  • Allocates more than $30 million annually for addiction prevention, substance treatment, teen suicide prevention, mental health programs, and justice reinvestment projects.
  • Provides opportunities for expungement of certain lesser cannabis-related crimes such as possession, consumption, cultivation or transportation.

But of course, state law is just one part of the equation. Adult use cannabis facilities must be licensed separately from state to local levels, including counties to cities to local municipalities, all of which may also adopt rules and requirements through zoning and land use ordinances. Swift and certain timelines established by the Smart & Safe Act dictate the speedy launch of this new program, first utilizing the existing medical cannabis infrastructure.

Many Arizona consumers are under the impression that they’ll be able to walk into a dispensary on January 1, 2021 and buy cannabis. But that is not the case. They’ll have to wait until the Arizona Department of Health Services (AZDHS) completes the early applicant licensing process, which begins in January 2021. Currently, local and multistate operators are waiting for AZDHS to complete the rules and regulations for the adult use cannabis program. Here are two of the most significant steps to be navigated in the upcoming weeks:

Smart and Safe Arizona Act (Prop 207) – Step 1: The Rulemaking Process

AZDHS has been tasked with developing the rulemaking process for the Smart & Safe Act. The first draft of the adult use cannabis program rules has already been released, primarily consisting of the application requirements for the early applicant process.  AZDHS collected its first round of public comments for consideration on Thursday, December 17, 2020.  The exact details and parameters of the adult use cannabis program will not be finalized or known for certain until AZDHS completes the rulemaking process. We anticipate the next draft of adult use cannabis rules to be released sometime in early January.

Smart and Safe Arizona Act (Prop 207) – Step 2: The Application Process

AZDHS will begin accepting early applicants under the Smart & Safe Act on January 19, 2021, closing the process on March 9, 2021. Current medical cannabis license holders who apply for and acquire an adult use license in the early applicant process will be authorized to a dual-licensed dispensary (both medical and adult use license), as well as one offsite manufacturing facility (which may later be amended to include both medical and adult use manufacturing license), and offsite cultivation.

Early adult use license applicants are reserved for those that currently hold in good standing at least one Medical Marijuana Registration Certificate (“Medical Marijuana License”) and applicants applying to counties with no current operating dispensaries. Any county with a single operating dispensary (a medical cannabis dispensary) will be allocated an adult use license (dual license) as long as the medical license holder is in good standing for the application.  All adult use licenses allocated to those counties without a current operating dispensary must keep that dispensary within that county.

AZDHS will have 60 days to process each application. Adult use licenses for counties without a current operating dispensary will be allocated through a random selection process, if more than two applications are received for that county. Additionally, upon the conclusion of the early applicant process, any adult use license that has not yet been awarded through that process, will be available to the general public and allocated through a random selection process.

This brings us to later phases of implementation of the Smart & Safe Act: within approximately six months of the adoption of the initial recreational program rules, AZDHS must develop and adopt the rules and regulations for the Social Equity Ownership Program (SEOP). The primary goal of the SEOP is to allocate 26 adult use licenses to “communities disproportionately impacted by the enforcement of previous cannabis laws.” In other words, communities disproportionately and negatively impacted by cannabis criminalization. Smart & Safe is light on the exact manner and process at this point, so Arizona voters and cannabis companies will look to AZDHS for the development and implementation of this important part of the adult use program. Stay tuned.

MORE Act Passes the House – Is Legalization Around the Corner?

By Steve Levine, Alyssa Samuel
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On Friday, December 4, 2020, the US House of Representatives passed the Marijuana Opportunity Reinvestment and Expungement Act of 2019 (the MORE Act), which would effectively legalize cannabis by removing it from the Controlled Substances Act. The bill (H.R. 3884) has several key components:

  • Most importantly, the bill would remove cannabis from the list of controlled substances in the Controlled Substances Act, as well as other federal legislation such as the National Forest System Drug Control Act of 1986. This would effectively end many of the obstacles created by the federal illegality of cannabis such as the lack of access to banking, tax consequences such as 280E, adverse immigration impacts and threats of federal criminal enforcement.

    Rep. Earl Blumenauer (D-OR) donning his cannabis mask as he presides over the Congress
  • Second, not only does the bill preclude future prosecution for cannabis-related crimes, the bill is designed to be retroactive and would provide for the expungement of past non-violent cannabis offenses.
  • The bill creates a prescribed excise tax on cannabis and cannabis products. The funds collected from the taxes would be channeled into opportunity and reinvestment programs.
  • A Community Reinvestment Grant Program would be established aimed at the provision of services for “individuals most adversely impacted by the War on Drugs,” such as job training, education, literacy programs, mentoring, and substance use treatment programs;
  • A Cannabis Opportunity Program would be established providing state funds for small business loans in the cannabis industry targeted at social equity candidates; and
  • An Equitable Licensing Grant Program providing funds for states to implement equitable cannabis licensing programs aimed at minimizing “barriers to cannabis licensing and employment for individuals most adversely impacted by the War on Drugs.”
  • The bill would require all cannabis producers to obtain a federal permit. Cannabis businesses would need to be licensed at the state, local, and federal levels to operate.

This MORE Act is a substantial step in cannabis legislation. Reactions to the proposed legislation have been mixed. While the bill does include some measures aimed at social equity, critics of the bill claim it does not go far enough. Similarly, while the bill includes a federal permitting provision, this would be the beginning of a nascent federal regulatory scheme.

What does this mean for your business? 

While this bill passed in the US House of Representatives, it would still need to pass in the U.S. Senate this term, which by most accounts does not seem likely. However, the passage of this bill signifies the progress that has been made and provides insight on what further legislation may look like.

Congress Passes MORE Act

By Aaron G. Biros
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A little over a year ago, the House Judiciary Committee approved the Marijuana Opportunity Reinvestment and Expungement (MORE) Act by a 24-10 vote, marking the first time in history that a congressional committee approved a bill to legalize cannabis. Fast forward a year, and the bill is making history again.

Rep. Earl Blumenauer (D-OR) donning his cannabis mask as he presides over the Congress

Rep. Earl Blumenauer (D-OR), a co-sponsor for the bill and co-chair of the Congressional Cannabis Caucus, donned a cannabis leaf mask as he presided over the floor debate in the House of Representatives on the morning of December 4. After the debate on the floor, the House of Representatives voted 228 to 164 to pass the MORE Act.

While this vote is historic and should certainly be celebrated, it is unfortunately a mostly symbolic win. During the Post-Election Analysis episode of the Cannabis Quality Virtual Conference, Andrew Kline, director of public policy at the National Cannabis Industry Association (NCIA), told attendees that this bill always had strong support in the House, but not enough support in the Senate. “You know I think there is pretty much a 100% chance of it passing the House,” Kline said back in early November. “I don’t think they would’ve scheduled the vote if they didn’t have the votes.”

The House voted 228 to 164 to pass the MORE Act.

Kline told attendees that Republican priorities are most likely to blame when the MORE Act fails to get enough support in the Senate. “The bigger question is what happens when it reaches the Senate and I think it is all but dead when it gets there,” says Kline. “Mitch McConnell has been reluctant to move any legislation over the past four years. He’s really ignored most legislation and particularly any legislation he doesn’t like. He doesn’t like cannabis and it appears to me he barely even likes hemp. He’s really not even fighting for the hemp industry.”

While the MORE Act likely doesn’t have a chance in the Senate, it passing the House is still a monumental moment in cannabis legalization history. This marks the first time in 50 years that Congress has revisited cannabis prohibition, according to Justin Strekal, political director of NORML. “This is a historic day for marijuana policy in the United States,” says Strekal. “By establishing this new trajectory for federal policy, we expect that more states will revisit and amend the archaic criminalization of cannabis, establish regulated consumer marketplaces, and direct law enforcement to cease the practice of arresting over half a million Americans annually for marijuana-related violations – arrests which disproportionately fall upon those on people of color and those on the lower end of the economic spectrum.”

Along with all of the success that cannabis had on Election Day, including five states legalizing it, the House passing this legislation is a symbol of shifting attitudes toward cannabis and serious progress on the federal legalization front.

The real question that should be asked is what will the 117th Congress do? If Democrats gain control in the Senate following the runoff elections in Georgia, it could reinvigorate the momentum behind this bill and offer a renewed breath of life.