Marijuana-related companies raised nearly $13.8 billion globally in the first 11 months of 2018 compared to just $3.5 billion in 2017[efn_note]Reported in Fortune.com, December 20, 2018, source: Viridian Capital Advisors.[/efn_note]. Most of these monies are not invested in U.S. marijuana businesses, yet venture capital investment in U.S. marijuana businesses is greater than ever and increasing rapidly, in spite of the U.S. federal prohibition of marijuana cultivation, distribution, sale and use. This paper will summarily discuss the anatomy of the U.S. private venture capital market for investment in marijuana businesses as of March 2019, and the legal issues driving both the reticence to invest on the part of the traditional venture capital community and the willingness to invest by a developing group of mostly small cannabis sector specific venture capital firms.
Public confidence in marijuana investment appears to be growing, probably caused in part by brewing legislative changes, including the U.S. Farm Bill’s federal legalization of hemp in December 2018[efn_note]See P.L. 115–334, December 20, 2018, 132 Stat 4490. The 2018 Farm Bill defines hemp as the plant Cannabis sativa L. and any part of the plant with a delta-9 THC concentration of not more than 0.3 percent by dry weight. Hence, hemp is a variety of the cannabis sativa plant, non-psycho-active, with many traditional uses including dietary products, skincare and clothing. Previous to the Farm Bill’s passage, many states had already legalized the plant. Marijuana is often referred to as “Cannabis,” but after the 2018 Farm Bill was passed federally legalizing the hemp plant, for the purposes of this paper there is a distinction between: (i) “marijuana” for which the production and sale remains federally illegal; and (ii) the broader term “cannabis,” which technically includes marijuana as well as the now federally legal hemp plant. This article primarily concerns investment in “marijuana,” the production and sale of which remains federally illegal.[/efn_note] and Canada’s federal legalization of cannabis in October 2018. During 2018, investors invested about $9.7 billion in marijuana-related public companies and about $4 billion in marijuana-related private companies. Large alcohol and tobacco companies provided heavy investment in Canadian marijuana companies, for example, Constellation Brands (the international producer and marketer of beer, wine and spirits) invested $4 billion in Canada’s Canopy Growth, Molson announced a joint venture with Canada’s Hydropothecary Corporation and Altria (one of the world’s largest tobacco businesses) said it would invest $1.8 billion in Canada’s Cronos Group. Strategic mergers and acquisitions (M&A), in particular Canadian M&A, has increased public company valuations and expectations in the private investment community that returns will skyrocket, if the United States changes its federal law so as to legalize the production and sale of marijuana generally. Marketplace expectations are reflected in the increasing number of consolidation acquisition transactions, representative examples being announcements in October 2018 of iAnthus’ $835 million deal for MPX and Medmen’s $682 million deal for PharmaCann; and the Canadian Stock Exchange’s November 2018 report on financings whereby 20 new listings in November alone involved capital raises of more than $1 billion and a pipeline of 55 issuers stood in the queue[efn_note]For an apt description of the current M&A environment, see the Cannabis Business Times, January 31, 2019: https://www.cannabisbusinesstimes.com/article/cannabis-mergers-acquisitions-playing-field-constellation-brands/,Cannabis M&A Momentum Will Continue to Surge in the Wake of Constellation’s Watershed Deal, by S. Lenn.[/efn_note].
M&A activity has driven increased private venture capital and public investment in marijuana companies. In 2017, 32 private company and 121 public company marijuana transactions closed. In 2018, M&A activity increased markedly to 74 private and 245 public marijuana company transactions closed, a 208 percent total increase from the prior year[efn_note]Source: Viridian Capital Advisors.[/efn_note].
U.S. Venture Capital Markets
The value of total venture and private equity fund (VC fund) related marijuana investment, mostly in young and emerging companies, through 2017 was $373 million and through September 2018 was $643 million[efn_note]Reported in Business Insider.com citing PitchBook.[/efn_note], another marked increase from 2017. Almost all existing VC investors are marijuana sector specific, and their limited partner investors are individuals and family offices, with a few exceptions. By and large, traditional VC funds with pension fund, university, regulated and endowment investors have not entered the marijuana venture capital market. Of the marijuana sector specific VC funds, many of them currently do not invest in marijuana cultivators, producers, distributors and retailers who “touch the plant,” what we will call “primary” marijuana businesses. Rather, these sector specific VCs have largely made investments in “ancillary” marijuana businesses that are service providers and vendors to primary marijuana businesses. Examples of ancillary businesses are software companies, security and compliance, payroll services, equipment lessors, research and development and testing companies, that is, those companies that do not “touch the plant,”[efn_note]See, https://420intel.com/articles/2018/03/09/highest-valued-marijuana-companies-2017-reveal-2-key-insights-about-booming[/efn_note] but whose products or services are vital to an entity that cultivates or distributes marijuana products.
The apparent principal reasons for many marijuana VCs’ preferences for investments in ancillary businesses are: (i) a perceived lower level of legal, tax and regulatory risks as explained below, and (ii) what VCs would sometimes argue is a more compelling business opportunity[efn_note]See Salveo Capital October 11, 2018 reprint of Business Insider.com listing of top 12 VC firms servicing the marijuana industry and investment characteristics of each firm. https://www.salveocapital.com/press/2018/10/11/the-top-12-venture-capital-firms-making-deals-in-the-booming-cannabis-industry-thats-set-to-skyrocket-to-75-billion[/efn_note].
Marijuana VC funds attracting private investors include groups such as Poseidon Asset Management, Merida Capital, Phyto Partners, Salveo Capital, Arcview Investor Network, Hypur Ventures, Tuatara Capital and Casa Verde Capital. All are small in size compared to traditional VC funds that attract institutional investors.
Cultivating, producing, distributing, selling and consuming marijuana are violations of U.S. federal law. But the momentum among marijuana VC investors is building nonetheless. Thirty-three states and the District of Columbia now have regulatory schemes in place making the cultivation, production, distribution and retail sale of medical marijuana legal; ten of which states have also made recreational, adult-use marijuana legal, the latest being Michigan as of this writing. Slowly but somewhat concertedly, many of the legal and regulatory risks for ancillary and primary marijuana businesses are being addressed, and the path to mitigating these risks and overcoming the investment hurdles presented by such risks is becoming clearer. Although marijuana investment is growing rapidly and investor sentiment eagerly awaits (and expects) U.S. federal legalization, the prospect of such legalization is elusive and fraught with complexity.
Perceived Risks of Investment Generally
Traditional VCs with no prior experience in marijuana investing often have one or more of the following reasons for not investing in the space:
- There is still too much regulatory risk and uncertainty due to the continued illegality under U.S. federal law of marijuana and the continued illegality of certain products containing hemp or cannabidiols (CBDs), which makes it hard to predictably buy and plan to sell a marijuana business, so as to navigate the risk in an acceptable manner.
- Contract enforcement – whether of insurance contracts, real estate leases, limited partnership documents or other commercial contracts – often becomes problematic (especially in federal courts) when the purpose of the contract is deemed to be illegal or relates to a business purpose that is illegal[efn_note]Note, however, there appears to be a shift of such contractual defenses in states where marijuana production and sale is legal, and the parties knowingly entered into such agreements. See e.g., Mann v. Gullickson, Case No. 15-cv-03630-MEJ (N.D. Cal. 2016) and Tarr v. USF Reddaway, Inc., Case No. 3:15-CV-02243-PK (D. Or. 2018).[/efn_note].
- Only a small percentage of roughly 13,000 U.S. banks and credit unions will take deposits from marijuana businesses – which constitutes money laundering under federal law – thus inducing many such businesses to hoard and store cash, enhancing the prospects for illegal laundering issues and robbery. Federally insured deposit institutions will not knowingly accept funds derived from marijuana sales. At the least, this makes cash management extremely difficult, expensive and inefficient.
- Federal tax law – specifically Internal Revenue Code Section 280E – prohibits marijuana producing and selling businesses that traffic in the drug from deducting operating expenses from income for federal tax reporting tax purposes, dramatically lowering profit margins[efn_note]Although “ancillary” businesses that don’t touch the plant are generally exempt from Section 280E, such businesses have their own tax complexities, which is a separate subject not covered in this article. See Bloomberg Tax, News Insight: Navigating the Cannabis Industry tax Landscape After the 2017 Tax Act, by M.A. Clayton CH Sasaki, D.L. Strong, July 26, 2018 (https://www.bna.com/insight-navigating-cannabis-n73014481454/). Primary marijuana businesses have available measures to mitigate the problems caused by Section 280E by creating separate businesses with different purposes other than the production or sale of marijuana. Californians Helping to Alleviate Med. Problems, Inc. v. C.I.R., 128 T.C. 173 (2007).[/efn_note].
- Investing in marijuana still carries a moral stigma among certain groups of traditional investors.
Most sector specific marijuana VCs are of the view that some or all of the above risks can be mitigated by investing in ancillary marijuana businesses that don’t touch the plant for one or more of the following reasons:
- Ancillary marijuana businesses are one step removed from the cultivation and sale of marijuana and the laws prohibiting trafficking in marijuana, and provide a greater level of comfort to investors[efn_note]Although different contexts and circumstances may produce different results. For example, in In re Way To Grow, Inc., Case No. 18-14330-MER, Dkt. No. 370 (Bankr. D. Co. Dec 14, 2018), a Colorado federal district court ruled that an ancillary business supplier of gardening equipment to a marijuana grower (which was in compliance with Colorado state law) could not use the federal Bankruptcy Code to reorganize or liquidate because, among other reasons: (i) the ancillary business had a sufficient level of knowledge that it was aiding in the manufacture and distribution of a controlled substance, in violation of the CSA; and (ii) under federal law (18 U.S.C. Section 2), giving aid to one who commits a crime, with the intent to facilitate the crime, amounts to the commission of a crime in and of itself. These principles, particularly under federal law generally, would seem to threaten the theory that an ancillary marijuana business is sufficiently remote from touching the plant to avoid liability. Having said that, all the Colorado bankruptcy court is doing is asserting the primacy of federal over state law – which the U.S. Justice Department has not been willing to conclude so starkly. See reference to the Cole Memo, infra.[/efn_note].
- Ancillary marijuana businesses are not subject to local and state licensing requirements and regulations that exist for primary marijuana businesses.
- Ancillary marijuana businesses are likely not subject to federal prohibitions on interstate transfers of illegal drugs and the proceeds of the sales thereof because their products are not drugs, although money laundering laws still may apply, and there is a risk that the business will be treated as an aider and abettor of a crime under federal law.
- Ancillary businesses are generally not subject to Internal Revenue Code Section 280E denying marijuana businesses that touch the plant the ability to deduct operating expenses for federal tax reporting purposes.
- The size of the market for primary marijuana products is limited to a particular state and locality pursuant to state and local licensing regulations; whereas the ancillary businesses’ market is unlimited in scope, subject of course to other states’ laws, federal law and international treaties.
- Ancillary marijuana businesses have more traditional economic models with valuations that are more dependable and easily determined.
We will now examine some key legal and regulatory hurdles that do exist for marijuana businesses under federal law, factors potentially mitigating the risks and hurdles they present for investors and marijuana businesses, and the status of measures on the horizon to overcome those risks and hurdles.
FDA and Money Laundering under Federal Law
All prescription drugs marketed in the United States must first be approved by the U.S. Food and Drug Administration (FDA). The FDA will approve a drug only if it is demonstrated to be safe and effective. Marijuana is a “controlled substance” regulated by the Drug Enforcement Administration (DEA) pursuant to the Controlled Substances Act of 1970 (CSA). Controlled substances are divided into five categories. Schedule I drugs, which include marijuana, are determined to have a “high potential for abuse,” “no currently accepted medical use in treatment in the United States” and “a lack of accepted safety for use of the drug…under medical supervision.” 21 U.S.C. Section 812(b)(1). As a Schedule I controlled substance, like heroin and LSD, it is a federal crime to possess or distribute marijuana. Schedule II controlled substances such as cocaine and oxcycodone, however, are substances with an accepted medical use but with a high potential for abuse. The DEA has the authority to reclassify a drug if new evidence is presented.
To date, marijuana advocates have tried to urge the reclassification of marijuana. In 2016, the FDA found that although marijuana has no current medical use, it recommended the federal government support further clinical research into therapeutic and medical uses for marijuana and marijuana-derived drugs and the DEA adopted the FDA’s recommendation. Then in 2018, in an important decision, the FDA approved the first marijuana-derived drug, GW Pharmaceuticals’ oral solution, Epidiolex, stating: “This approval serves as a reminder that advancing sound development programs that properly evaluate active ingredients contained in marijuana can lead to important medical therapies.”[efn_note]https://www.fda.gov/newsevents/newsroom/pressannouncements/ucm611046.htm[/efn_note] It would seem that this action is a valuable first step toward reclassification because, for the first time, the FDA recognized the efficacy of a marijuana-derived drug. To continue to posit that marijuana should be classified as a Schedule I drug, that is, with “no current accepted medical use,” would appear to be more difficult after this FDA approval.
The message to investors, whether intended or not, is that the FDA may slowly be rethinking its traditional views as to the efficacy of medical marijuana.
Money Laundering Issues
For marijuana businesses, depositing funds derived from the cultivation or sales of marijuana in a bank account constitutes money laundering under federal law and is a violation of the U.S. Bank Secrecy Act (BSA). Receiving a payment of more than $10,000 from a marijuana business may be a federal crime punishable by up to 10 years in prison. (18 U.S. C. 1957). Engaging in a financial transaction for the purpose of promoting or furthering a marijuana business is a federal crime punishable with up to 20 years in prison (18 U.S.C. Section 1956). So, in accordance with the statutory language, any vendor or service provider, including a lender, financier, landlord, software or other product provider receiving funds from a known marijuana business may be committing a federal felony. In an additional wrinkle, the federal government can take the operating assets of a marijuana business in a civil forfeiture, as well as any property traceable to the proceeds of such operations, for example, cash from operations and investor capital still in the business (18 U.S.C. Sections 981 and 983).
Accordingly, as of March 2018, only 411 out of approximately 13,000 U.S. banks and credit unions knowingly accepted deposits obtained from ancillary and primary marijuana business sales pursuant to the guidelines stated below[efn_note]FINCEN.gov[/efn_note]. Federally insured banks will not accept deposits that derive from the production or sale of marijuana, even in states where the sale or production of marijuana is legal. In a confusing and “untenable” situation according to Attorney General William Barr[efn_note]Testimony before the U.S. Senate, confirmation hearings January 15, 2019.[/efn_note], the fact that severe penalties can be imposed under federal law on marijuana businesses belies the fact that detailed regimes allowing legal cultivation, production, distribution and retailing of marijuana have been put in place in 33 states plus the District of Columbia as of this writing. For the reasons cited above, many marijuana businesses don’t currently use bank accounts and conduct their businesses in cash, giving rise to security and other risks, not to mention cumbersome attempts to manage cash payments made by consumers.
Attempts of Federal Authorities to Accommodate State Laws
So one might ask: what solutions or accommodations to the legal hurdles expressed above have been made so that marijuana businesses are able to operate and are able to attract investors? The answer is that the federal government has come up with a set of guidelines and practices that have the practical effect of accommodating state laws sometimes, but are not clear in their interpretation or consistency of enforcement – and which depend upon the discretion and priorities of the federal attorneys and officers charged with federal law enforcement in the given states, as well as the political machinations of other organs of the federal government.
The foremost example of the federal attempt to accommodate state law is the approach taken by the Cole Memo, last revised in 2013 by the U.S. Justice Department. It dictates enforcement priorities for regional U.S. attorneys, which do not include the sale of marijuana in states that allow for the production, sale and use of marijuana products in accordance with the states’ regulatory schemes. When the Cole Memo was in effect and untouched, states had the confidence that local U.S. Attorneys’ offices would not enforce federal law where state law allowed for such production and sales. In early 2018, Attorney General Jeff Sessions effectively rescinded the Cole Memo and made it known that he opposed the legalization of marijuana by the federal government. However, even under Sessions, there was little if any funding of budgets to enforce marijuana laws, especially with respect to marijuana businesses operating legally under applicable state laws. To further complicate matters, Sessions resigned in November 2018, and the fate of enforcement priorities now rests with Attorney General William Barr. At a confirmation hearing on January 15, 2019, before the U.S. Senate, Barr said the current system regarding marijuana laws is “untenable” and that while he personally supports prohibiting marijuana production, sales and consumption across the United States, he would not “go after” marijuana businesses that comply with state regulations in accordance with the rescinded Cole Memo. So while Barr is not a proponent of federal legalization, it appears he will not act to disrupt the production and sale of marijuana under existing state laws upon which producers, sellers and consumers have relied to date. Barr’s position does not remedy what he describes as the “untenable” situation created by contrary federal and state laws – it only perpetuates it. Barr has further stated that he wants Congress to act to clarify the matter. Not surprisingly, after Barr’s comments, the ETFMG Alternative Harvest ETF, which includes a basket of the largest marijuana stocks, fell roughly 3 percent, perhaps reflecting the realistic fear that, during Barr’s tenure, federal legalization is not by any means assured.
The message to investors is that the U.S. Justice Department under Barr will probably not alter the status quo, effectively following the now rescinded Cole Memo, and it will take an act of Congress to alter federal law in this regard.
Banking Issues and FINCEN
Another example of how the federal government has tried to accommodate state laws is a policy put in place by the Financial Crimes Enforcement Network (FINCEN), an agency of the U.S. Treasury Department seeking to address the problem created by the deposit of funds derived from federally illegal marijuana sales in a commercial or savings bank that currently is considered money laundering under the BSA. Consequently, federal depository institutions will not knowingly accept deposits from marijuana businesses.
However, under a February 2014 U.S. Treasury Department Guidance (Guidance), FINCEN requires the periodic filing by a depository institution of Suspicious Activity Reports (SARs) reporting suspected illegal money laundering activities, including a special “Marijuana Limited” filing when the bank (or often a credit union) becomes aware of marijuana-related funds being deposited. The Guidance was issued to clarify how “financial institutions can provide services to marijuana-related businesses consistent with their BSA obligations, and [align] the information provided by financial institutions in BSA reports with federal and state law enforcement priorities.” The Guidance requires a financial institution to file a Marijuana Limited SAR if it has a reasonable belief that the marijuana business in question does not implicate the Cole Memo priorities and does not violate state law.
So, as long as full disclosure is made on the Marijuana Limited SAR regarding marijuana sales proceeds deposited and the Guidance procedures are observed, an actionable violation of the BSA can be avoided, until FINCEN decides otherwise. This conclusion gives little faith to a large number of depository institutions that are wary of the Guidance changing with the political winds or simply failing to be a model of clarity. Then there is the question: if the Cole Memo was rescinded, where does that leave us with the interpretation of the Guidance, which requires that a determination be made under the Cole Memo that its enforcement priorities are not implicated? Given Attorney General William Barr’s statements in his January 15, 2019, testimony before the Senate to not disturb the status quo by effectively acting in accordance with the Cole Memo, the FINCEN Guidance would seem to continue to have the force it had before the Cole Memo was rescinded, but with an additional layer of ambiguity and uncertainty.
Most recently during the week of February 18, 2019, the U.S. House of Representatives, realizing the lack of clarity and comfort given to depository institutions regarding marijuana-related deposits, held hearings on the lack of banking availability for state-legal marijuana businesses, highlighting a need to address the problem and increasing momentum toward finding a solution. But the lack of clarity and consistency in the regulations remains. The U.S. Senate has pending additional legislative action described below.
The message to investors appears to be that they may take some comfort that the status quo will be maintained under Attorney General Barr, although Barr’s testimony before the Senate does not particularly clarify the issue.
Potential Congressional Action
In addition, there are federal legislative measures put in place that attempt to accommodate state law regarding medical marijuana in particular. The Rohrabacher Blumenauer (previously Rohrabacher-Farr) amendment, sometimes referred to as the Joyce Amendment, is a budget rider prohibiting the U.S. Justice Department from spending funds to interfere with the implementation of state medical marijuana laws, first implemented in 2014. The amendment does not affect the federal law regarding marijuana generally and must be renewed every year with the most recent extension effective until December 21, 2018. Subsequently, President Trump signed into law H.J. Res. 31, the “Consolidated Appropriations Act of 2019,” effectively extending the protection of the Rohrabacher Blumenauer amendment until September 30, 2019.[efn_note]”Congress extends state-legal medical cannabis programs’ protections timing.” Marijuana Business Daily. February 19, 2019.[/efn_note] To be clear, the effect of the budget rider is simply to withhold money from the federal government to prosecute state-legal producers, sellers and users of medical marijuana. It does not change federal law making it illegal to produce, sell or use marijuana. The renewal of the budget rider of course depends upon political considerations, not legal decisions, and therefore is only as effective as the latest renewal or extension. But one can see how this has given comfort in the past, and would give some comfort in the future if continued, to actual and prospective investors in medical marijuana businesses.
Furthermore, numerous marijuana-related bills have been introduced in Congress in 2017–2019, but none have been acted upon. There exists pending potentially historic federal legislation introduced in June of 2018 by Senators Cory Gardner and Elizabeth Warren, which, if passed, will amend the CSA to exempt from federal enforcement individuals or entities who are in compliance with the law of U.S. states’ territories’ or tribal law on marijuana. It is called the Strengthening the Tenth Amendment Through Entrusting States Act, S. 3032 (the States Act). A companion bill was introduced in the House of Representatives by Earl Blumenauer and David Joyce. Although numerous spokespersons, newspapers and other official sources (including President Trump) appear to support the goals of the proposed States Act, it is unclear how much of an uphill battle is posed to enable passage. Other legislation has been introduced by, among others, Senator Cory Booker (the Marijuana Justice Act) and Senator Chuck Schumer (which relegates regulatory authority to the states), both attempting to remove marijuana from the CSA list of banned substances.
Another example of the Senate’s legislative initiative effecting banking for marijuana businesses is the Secure and Fair Enforcement Banking Act (sometimes called the SAFE Act), introduced by Senator Jeff Merkley in May of 2017, proposing to block the U.S. government from punishing banks and lending institutions that serve marijuana businesses in states that allow legal marijuana sales. Senator Merkley’s intent is to stop forcing state-legal businesses to operate on a cash basis thereby decreasing the likelihood of money laundering and criminal activity. The SAFE Act has yet to be acted upon.
As of this writing, the most recent three bills pertaining to marijuana introduced in the U.S. Senate are those labeled “Path to Marijuana Reform which were introduced by Ron Wyden (D. Oregon), and supported by Earl Blumenauer in the House of Representatives.” The three bills represent a comprehensive legislative package comprising an amendment to the Small Business Tax Equity Act, the Marijuana Revenue and Regulation Act and The Responsibly Addressing the Marijuana Policy Gap Act of 2019[efn_note]S.420 (R. Wyden, D.-Oregon)[/efn_note]. The latter proposal is comprehensive and, among other things, decriminalizes marijuana cultivation, production, sale and use; exempts marijuana businesses from Section 280E prohibition on deducting operating expenses for federal tax purposes; sets forth advertising guidelines, relieves banks of liability for accepting marijuana business deposits when the businesses are operating legally within their states; relieves banks of the requirements of FINCEN to file “Marijuana Limited” SARs in return for maintaining internal records; confers conventional bankruptcy protection for state-legal marijuana businesses; and exempts state-legal marijuana businesses from civil forfeitures under certain conditions.
The message to investors is mixed with regard to potential federal legalization, although much of the private investment market seems to think that legalization is inevitable at some time (and sometime within the near future), thus the increasing pace of investment. The voluminous efforts at drafting legislation seem to give a hint of what’s around the corner but have not exhibited enough political momentum to effect federal legalization yet.
Interestingly, the Canadian federal legalization of marijuana in October 2018 has spurred a lot of Canadian investment opportunities for U. S. investors and has inspired U.S. marijuana interests but has not engendered concrete steps to hasten U.S. federal legislation. The effect of the Canadian federal legalization, however, is to spur M&A activity as referenced above. The effect of increased M&A activity has been to increase interest in VC investment.
Section 280E Limitation
A real deterrent to investing in a marijuana business, and what has negatively impacted profitability of marijuana businesses, is the federal tax impediment related to marijuana cultivation, production, distribution and retail sales in Internal Revenue Code Section 280E. But the tide seems to be turning slowly.
Section 280E of the Internal Revenue Code of 1986, as amended (the Code) prevents state-legal sellers of marijuana products who traffic in Schedule I or II controlled substances from deducting ordinary trade or business expenses from company income for federal tax purposes. Marijuana businesses can only deduct the cost of goods sold from taxable income, but not any of their considerable operating expenses. The IRS considers marijuana sales illegal under the CSA, but the producer/seller owes taxes from those revenues in any event and may pay such taxes with apparent impunity on a legally filed return in conformance with Section 280E. While most corporate businesses have historically paid a 35 percent corporate tax rate, because of Section 280E, marijuana sellers have paid an effective tax rate of 70 percent or more on products sold.[efn_note]https://newfrontierdata.com/marijuana-insights/death-taxes-and-cannabis-how-to-keep-280e-from-killing-you/[/efn_note] The lowering of the federal corporate tax rate to 21 percent made possible in the Tax Cut and Jobs Act of 2017[enf_note]The Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, Pub.L. 115–97, introduced as the “Tax Cuts and Jobs Act.” See https://taxfoundation.org/final-tax-cuts-and-jobs-act-details-analysis/[/efn_note], has alleviated some of the tax burden on primary marijuana producers and sellers. However, the burden still exists for marijuana companies that do not or cannot deploy legal tax avoidance strategies[efn_note]For example, the case of Californians Helping to Eliminate Medial Problems (CHAMP) v. Commissioner, 128 T.C. 173 (2007), the court found that Section 280E does not preclude a taxpayer from deducting operating expenses attributable to a separate business other than illegal trafficking in controlled substances simply because it is also involved in illegal trafficking. Also, various states allow for the deduction of operating expenses for state tax reporting purposes. Tax rules and regulations in this area are complex and should be analyzed by cannabis tax professionals.[/efn_note].
To that point, on November 29, 2018, a California-based marijuana dispensary lost its case to end the application of Section 280E to law abiding, state-licensed dispensaries before the U.S. Tax Court in Patients Mutual Assistance Collective Corporation, d/b/a Harborside Health Center v. Commissioner, 151 T.C. No. 11. As a partial mitigation of that decision, on December 26, 2018, the Tax Court ruled that the Harborside Health Center dispensary was not liable for penalties under Section 280E, because it acted “reasonably and in good faith” when taking its tax positions for the years at issue. This ruling could save the marijuana industry millions of dollars if the principle is successfully argued by other dispensaries under similar circumstances. Having said that, the dispensary’s case on the issue of whether Section 280E should apply to marijuana dispensaries is on appeal to the U.S. Court of Appeals for the Ninth Circuit, and until a definitive legal ruling is obtained, legislative solutions will need to be pursued. Proposals by U.S. Congressional legislators to end the prohibition by amending Section 280E have failed in the past under Republican control. Incoming Democrat Rules Committee Chairman James McGovern is thought to favor consideration of the issue.
The original Section 280E was implemented as a result of a U.S. Tax Court decision involving cocaine distribution, Edmonson v. Commissioner, 42 T.C.M. 1533 (1981). Although the sale of cocaine is clearly in violation of federal and state laws, and the sale of marijuana is not illegal in the states where its sale is legal, the IRS has continued to apply Section 280E to licensed marijuana businesses conforming to state law. This logical inconsistency is clear, but to no legal avail so far. Section 280E is still on the books and is still hurting state-legal marijuana businesses.
The message to investors is that there currently is some hope that the effect of IRS Section 280E may be mitigated or eliminated by pending federal legislation or the courts. Having said that, although there are steps being taken to mitigate the overall tax burden by the states in which the production and sale of marijuana is legal, Section 280E is still a negative factor for investors and operating primary marijuana businesses that touch the plant.
Are we at a tipping point where the cultivation, distribution and sale of marijuana products will finally become a legal business under federal U.S. law opening the market to traditional VCs and other investors who have heretofore sat on the sidelines? There is an air of inevitability about it, but the answer is not clear because the outcomes are so rife with politics, and are unpredictable and potentially complex.
To quote an over-used phrase: “The arc of history bends toward justice.” As far as marijuana investment is concerned, one might also say that the arc of history bends toward rational economic behavior. The momentum created by already favorable public opinion, the recent Canadian federal legalization, steadily increasing numbers of state legalizations, Congressional initiatives and the likelihood that investors eventually will respond positively as the production and sale of marijuana becomes more accepted – may be finally turning the tide in the march toward federal legalization, albeit slowly and at an unpredictable rate. It seems that these brewing changes are causing private and public investors to accelerate their investment activity in the faith that rational economic behavior is taking hold and that the current momentum will reach an inevitable climax.
2019 may very well be a pivotal year for the federal legalization of marijuana in the United States, which will, whenever it actually occurs and in whatever form, presumably open the pockets of previously reluctant investors. Currently, those pockets are busting at the seams.