Operational Challenges Cannabis Inudstry

This article originally appeared in the March 2021 issue of Arizona Attorney magazine.

As a result of Proposition 207 passing (Smart and Safe Arizona Act), Arizona became the 13th state to legalize recreational marijuana. According to projections by Marijuana Business Daily¹, the Arizona recreational market could generate as much as $375 million to $400 million in its first year and $700 million to $760 million by 2024. According to the Business Insider, the cannabis industry is set for a wave of merger and acquisition (M&A) activity as a result of five states, including Arizona, voting to approve recreational marijuana.² The U.S. retail cannabis sales are expected to increase 67% in 2020 to approximately $18 billion³ from 2019 and increase to $37 billion by 2024.⁴

Cash flow management and complex tax strategies, coupled with challenging operational and legal issues, can significantly impact the bottom line. The cannabis industry is anticipating a high-speed growth potential. Rapid growth can be an uphill battle if operational efficiencies and financial and risk management protocols have not been established. For investors and business owners, it is about low risk and high returns. Understanding and addressing the challenges is the first step toward mitigating risk.

Tax and Other Financial Challenges

The biggest elephant in the room is still the Internal Revenue Service’s (“IRS”) application of I.R.C. § 280E which indicates that “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.” I.R.C § 471(c) creates further complications as marijuana business operators may unintentionally underreport tax liabilities.

Plant-touching businesses are subject to 280E, i.e. growers, cultivators, wholesalers, retailers, transporters, etc. There are several court cases that address I.R.C. § 280E issues including Edmonson (T.C. Memo. 1981-623), Olive (TC # 144406-08 Opinion) (Decision filed 2015), CHAMP (2017), Alterman (2018), and Harborside (TC # 151TCNo.11) (2018). In the Harborside case, the Tax Court denied Harborside’s deductions from 2007 to 2012 by citing Code Section 280E.⁵

The CHAMP case is frequently cited as CHAMP engaged in two separate businesses including one for caregiving and counseling services and the other for supplying medical marijuana. The Court noted that CHAMP was “regularly and extensively involved in the provision of caregiving services and those services are substantially different from petitioner’s provision of medical marijuana.” As advisors, we emphasize to our clients to establish a clear distinction through different business entities and maintaining separate books and records. It is important to establish and document the stand-alone nature of a non-cannabis business if that is in fact the true nature of the business.

As financial and legal professionals, we are continually seeking clear authoritative guidance to better advise our clients. The Treasury Inspector General for Tax Administration (“TIGTA”) issued a report⁶ back in March of 2020 of their audit to evaluate the IRS’ “examination and education approach to certain cash-based industries with an emphasis on legal marijuana operations.” TIGTA concluded that the IRS lacked guidance to taxpayers and tax professionals in the marijuana industry. TIGTA’s brief summary of findings⁷ included:

High-risk marijuana business tax returns with millions of dollars in potential tax adjustments are not worked.
Marijuana businesses in California, Oregon, and Washington have a high rate of noncompliance with I.R.C. § 280E.
The IRS lacks guidance regarding Internal Revenue Code Section 280E and the uncertain impact from Internal Revenue Code Section 471(c) of the Tax Cuts and Jobs Act.
The impact of I.R.C. § 471(c) of the Tax Cuts and Jobs Act is uncertain.
The burden for marijuana businesses may change based on the tax impact of I.R.C. § 471(c).
The IRS is not using available marijuana state tax return information to identify non-filers and underreported income.
Some unbanked marijuana businesses are assessed Federal tax deposit penalties based on non-electronic funds transfers.

The IRS’ responses and a copy of the detailed audit report can be found on the Treasury website⁸. In addition, the IRS published new guidance and Frequently Asked Questions that are an important read for legal and financial professionals. It would not be a surprise to anyone if the taxing authorities ramped up their audits in this industry. Reinforcing to clients the importance of maintaining timely-prepared and accurate accounting records and applying effective risk management protocols will help to minimize errors.

In Arizona under Proposition 207⁹, contrary to federal restrictions, all ordinary and necessary expenses are subtracted from gross income. However, the accurate and timely payment of sales tax is not given the full attention that it deserves. Business operators will continue to face scrutiny by the Arizona Department of Revenue. It is imperative that a properly implemented point-of-sale system is maintained and tested on a regular basis to ensure accuracy of reporting. A well-documented and tested inventory control process along with detailed accounting records are essential for audit preparedness.

The main tax-reporting concern related to cash intensive businesses is that cash transactions can be difficult to track resulting in unintentional and perhaps intentional unreported revenues. The lack of certain financial discipline, including adequate cashflow management and budgeting is a continued concern for some cannabis operators. According to the IRS, with respect to cash intensive businesses, the “most significant indicator that income has been underreported is a consistent pattern of losses or low profit percentages that seem insufficient to sustain the business or its owners.”¹⁰ When managing such high volumes of cash, accountability and transparency are crucial in maintaining confidence for both the taxing authorities and investors.

Banking continues to be an ongoing challenge. Although analysts are optimistic that the Secure and Fair Enforcement (SAFE) Banking Act will pass the Senate, an industry powered by cash requires stringent oversight and accurate record keeping. The purpose of the Act is to “increase public safety by ensuring access to financial services to cannabis-related legitimate businesses and service providers and reducing the amount of cash at such businesses.¹¹ According to a report¹² published by the Financial Crimes Enforcement Network (FinCEN), fewer banks and credit unions reported servicing cannabis-related businesses as of June 2020 (695) compared to June 2019 (715). The impact of COVID is one of the factors that has been attributed to the decline. According to the TIGTA report previously discussed, “limited access to banking services increases risk associated with cash only businesses and creates barriers with meeting Federal tax obligations.”

Litigation Challenges

Although all industries have their fair share of litigation challenges, the cannabis industry with its evolving licensing, operational and financial difficulties, will most likely continue seeking legal guidance particularly as Arizona transitions to adult recreation. Weaknesses in the internal control structure, particularly as they relate to cash and inventory, can make cannabis operations more susceptible to fraud. Analysts estimate that approximately 90% of theft in cannabis business is employee related.¹³ Establishing proper segregation of duties with a consistent oversight function can assist in the deterrence of fraud. Although investors may be in low-risk mode during the pandemic, the essential status classification has provided a positive impact on the raising of capital. However, capital raises in this industry in particular should proceed with caution. In September 2018, the Securities and Exchange Commission (SEC) issued an Investor Alert¹⁴ providing warning signs regarding the risks of investment fraud and market manipulation in the cannabis sector. In July 2020, the SEC announced charges against six individuals and their companies for “defrauding investors in connection with unregistered securities offerings that raised over $25 million.”¹⁵

The lack of bankruptcy protection for financially distressed marijuana businesses creates its own set of litigation challenges. One alternative utilized has included the appointment of a receiver to manage the operations and perhaps ultimately sell the company’s assets. When other alternatives are not available, this option, although often contentious and adversarial, may be a viable solution.

COVID Disruptions and Other Operational Challenges

Unfortunately for the industry, cannabis companies were not able to benefit from the federal government’s stimulus funding, including the Paycheck Protection Program. To weather the COVID storm and address financial constraints, some cannabis companies have strategically downsized operations and reduced expenses. For both cannabis and non-cannabis businesses, turnaround financial strategy implementation during distressed economic times can add positive results to the bottom line. Strategies may include a deep dive into product margins and the demand for products, raising cash by identifying assets to sell, and possibly re-leveraging of debt terms.

Like many states, Arizona determined that medical marijuana businesses were essential during COVID. Despite the challenges and distress faced by our economy, monthly product sales since March 2020, with the exception of a slight dip in April, surpassed the then record-breaking results in March. Analysts believe that the cannabis industry is somewhat recession proof, similar to the alcohol and pharmaceutical industries, where demand remains relatively steady or increases during economic downturns.

Supply chain issues, particularly due to oversees manufacturing operations in China, became more prevalent as global economies continue to feel the pressure of COVID. The financial viability of suppliers/vendors is a driving risk factor particularly for companies that have not maintained an alternate supplier network. Some companies risk rapid growth without adequate supply chain processes in place. Lack of financial ability to purchase additional raw materials and stock up to survive a supply disruption can negatively impact operations and consumer confidence.

Regulations are continuing to take shape. The Arizona Department of Health Services (ADHS) announced draft rules on December 10, 2020 for the adult-use cannabis program.¹⁶ Although many regulations have yet to be written, the initial draft regulations are similar to the medical cannabis program.

A lack of adequate inventory monitoring has been an ongoing challenge for some cannabis businesses. Documented standard operating procedures, along with a strong system of internal controls, can go a long way in minimizing risk in this area. Operators become complacent as a result of the repetitive nature of checks and balances. We see this throughout many industries, especially during the COVID crisis when businesses are operating with less staff. Although accountability may shift to different individuals due to staff reductions, establishing internal controls that promote accountability is a key business function. Periodic well-documented physical inventory counts are an essential practice. If possible, utilizing an outside group for audit validation on a surprise basis may deter possible shrinkage or theft.

Despite the many unique challenges faced by the cannabis industry, strong growth is expected on the horizon for Arizona and the U.S. overall. Analysts anticipate a wave of legalization in 2021, along with increased M&A and investor activity.