Photo by Gracie Malley

In a rapidly expanding industry expected to generate billions, California is the crown jewel, tastemaker and industry leader in cannabis. What the ’90s were to technology, cannabis is to the present. With $2.4 billion in sales recorded in 2014, it does not take a savant to understand the appeal of entering into the cannabis industry fray.

Adding to the escalating fervor pitch of excitement and noise surrounding the cannabis industry, was California’s landmark, historic passage of the Medical Marijuana Regulation and Safety Act in October 2015. This act is helping to close the curtain on the “Wild West” era in California. With that said, the legal landscape is still fraught with peril and the best way to understand the current risks and mechanics of an effective cannabis business in California is to understand the genesis of the current laws while considering the upcoming application and licensing process, scheduled to commence on Jan. 1, 2018.

Legislative and Regulatory History

On Oct. 9, 2015, California passed a comprehensive regulatory framework for the cultivation, distribution, processing, transportation, testing, and retail of medical cannabis and ancillary medical cannabis products. However, the application process will not start until January 1, 2018, with licenses being issued after that date. In the interim, cannabis businesses in California will need to continue to navigate the current laws, which are an amalgamation of the 1996 Compassionate Use Act, the 2003 Medical Marijuana Program Act, the 2008 Attorney General Guidelines for the Security and Non-Diversion of Marijuana Grown for Medical Use, and relevant case law, in addition to local licensing, permitting and zoning restrictions.

Keys to Current Compliance

Collective Cultivation and Distribution

Medical cannabis businesses must be properly formed business entities in order to have an effective affirmative defense in the event of a criminal prosecution and to comply with all of the state’s non-cannabis rules and regulations.

There are several corporate structures that collectives can elect to use, but only one structure is listed as the preferred corporate form in the 2008 Attorney General Guidelines — the California Cooperative Corporation. Cooperatives have the flexibility to operate both as for-profit and as non-profit entities. There are benefits and detriments to the potential different corporate forms a collective may choose as its structure, so be sure to consult with an attorney or professional who specializes corporate formation and who understands the cannabis industry.

Operating Without Making a Profit

The not-for-profit requirement of California medical marijuana law continues to flummox many outsiders, and indeed, is not well understood within the industry. The Medical Marijuana Program Act of 2003 states, “nothing in this section shall authorize… any individual or group to cultivate or distribute marijuana for profit.”

It is important to understand the distinction between operating without making a profit and being structured as a not-for-profit entity. While having the words “non-profit” in the name of your organization could potentially be helpful in presenting a defense, it can be troublesome for business entities down the road, particularly when it comes to distributing assets or taking on investment capital.

Your collective corporation must operate without making a profit, however, members may be reimbursed for the services they provide, and your collective can pay for outside management services and other professional assistance from providers who do not cultivate or distribute cannabis and who make a profit. Make sure that you have a competent attorney or accountant who understands these issues and is able to assist you in properly structuring your business to comply with the not-for-profit requirement.

Closed Loop Collective Model

Additionally, California law requires a “closed-loop” collective model. A closed loop collective model means that no medical cannabis patient in California may legally distribute cannabis or cannabis products to any entity or individual who is not part of their collective. This means that there is no express provision allowing for business-to-business transactions or distribution under California law. Certain methods of compliant structuring combined with exacting accounting measures can provide some solutions, but these need to be done with painstaking care and an understanding of the various points of exposure that remain.

Business Considerations

Running a medical cannabis business in California requires walking the tightrope between following specific compliance and paying attention to traditional business considerations.

The following points are some items to keep in mind:

Honestly Evaluate Your Core Competencies

Ganjapreneurs are entering the cannabis space from traditional industries, bringing important strengths developed from time spent outside the cannabis world. Identify the skill set you bring to the legal cannabis marketplace and focus on how you can leverage and capitalize on that skillset to add value to the market and to generate personal economic benefit. Be starkly honest, even critical, in your self-assessment and determine and map out how your particular strengths are applicable to the cannabis industry.

Build A Strong Team

While great companies require innovative and creative ideas, you must be able to execute on your brainstorming. Setting your business apart and gaining an edge in the marketplace will be dictated in part, by the team you choose to surround yourself with and is involved in the operations of your business. Human capital is your business’ greatest asset; flex that asset and deploy it in a diligent and concerted effort. In our experience, well-constructed teams will outperform individuals in this market. Also, look for opportunities to set ego aside and form strategic partnerships with other businesses and entities.

Evaluate the Competitive Landscape

Know the players working on similar business ideas and projects in the space. We have repeatedly seen business plans that lack a serious analysis of the competitive environment. While we are working in an emerging industry with large upside, it is not a vacuum, and you will have to compete to survive. Indeed, the marketplace will only become more competitive as it draws more entrepreneurs and established corporations. While you do your research to scope your current competitors, keep in mind and be aware of new competitors entering the market. The survival of your business will partly depend upon how aware of current events within the industry you are, so go to events, trade shows, conventions, and read industry blogs and magazines. Be part of the conversation, lend your voice, and expand your cannabis expertise. Because the topography of this industry is still being mapped, and the legal environment remains precarious, we advise you to truly know and understand the business you have chosen.

Tax Considerations

Decisions in 2015 with the Ninth Circuit Court of Appeals have upheld the federal eligibility to preclude and disallow most of the ordinary business expenses that most businesses in the United States deduct. Even if your state has passed law for either medicinal or recreational marijuana sales, and its taxing schematic has followed suit to allow for deductions most people expect on their business return – the federal IRS has disagreed, the United States Tax Court and the court just below the United States Supreme Court have upheld that decision.

In general business, just about every dollar spent for the production of income can find a home in some type of lawful deduction. Not so for the average marijuana business. Under Oliver v. Commissioner and Section 280E the vast majority (if not all) of ordinary business expenses are not eligible for deduction.

When a business is trafficking in controlled substances prohibited by federal law, regardless of policy pursuit for criminal prosecution, IRC Section 280E functions to eliminate eligibility for ordinary business expenses. As such, even a legally operating and state licensed dispensary is still subject to these punitive tax measures because its activity is still federally illegal.

The end result is a very high net tax profile for most industries working with marijuana. That’s the plain fact of it. Some measures are sitting with Congress to reduce the effective tax rate for marijuana businesses to 50 percent and somewhat unimaginably – that would be an improvement. Current schematics frequently render businesses either flat out not viable or in the 70 percent and up bracket.

Understand Compliance and Keep Track of Regulations As They Evolve

The cannabis industry has a long history of criminal prohibition, and while the sun is setting on prohibition, the importance of avoiding criminal liability remains paramount to your ability to work in the industry in the future. Make sure that your business is keeping pace with regulations as they develop, and find a qualified legal team to help you do so.

By Luke K. Stanton, Jeffrey D. Welsh, Lukian Kobzeff and Regina Unegovsky.

Would you consider opening a cannabis business in California?