Many ordinary risk management tools are unavailable to cannabis entrepreneurs because of federal prohibition.
Senior Attorney to Hoban Law Group
8 min read
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Envision managing the risk of a volatile, staggeringly lucrative, 100 percent federally illegal enterprise. Toss in ridiculously inconsistent federal, state and local regulations, insanely evolving technologies and efficiencies, and an industry-wide disinclination to ever “play by the rules.”
However, when armed with decent risk management fundamentals, a marijuana related business can diminish most horrible outcomes, fortify the enterprise’s sustained growth, and maybe even get rich along the way.
Risk management is the identification, evaluation, and prioritization of risks followed by coordinated and economical resources application which minimize, monitor, and control unfortunate events’ probability or impact. Although denied many standard “risk management tools” (like credit cards, bankruptcy law protection, and federal patents and trademarks), assembling a “risk management insurance, accounting and legal advisory team” could prevent an insufficiently prepared marijuana related businesses from foundering.
Related: Pay Attention to These 6 Cannabis Industry Trends
Indentifying marijuana related businesses’ loss exposure.
With Corona brewer and Robert Mondavi wine producer Constellation Brands Inc. investing $3.88 billion in grower Canopy Growth Corp, the Wall Street Journal valuing 2018’s US legal marijuana sales at $10.2 billion, and marijuana stocks trading on Canadian exchanges, cannabis is officially big business and in dire need of risk management.
However, due to Marijuana’s 100 percent federal illegality, even more is at risk and fewer, and less effective, risk management tools are available. The Comprehensive Drug Abuse Prevention and Control Act of 1970 prohibits Marijuana’s manufacture, distribution, dispensation and possession and lists it next to heroin as a Schedule I controlled substance having “a high potential for abuse.” Thus, claims may be brought against anyone in the Marijuana industry’s supply chain touching the item prior to sale to the consumer; i.e., anyone planting, cultivating, harvesting, processing/extracting, testing, packaging, disposing, transporting, and dispensing Marijuana (hereafter, collectively referred to as “Marijuana Related Businesses”). Due to this federal illegality, many standard “risk management tools” like credit cards, bankruptcy law protection and federal patents and trademark sare denied to Marijuana Related Businesses.
Risk management is the process of anticipating losses and developing a plan to survive them through: (1) identify each loss exposure (ex., being sued for a defective product); (2) evaluating each loss exposure’s frequency and severity; (3) weighing, then selecting, each exposure-managing-technique; (4) deploying exposure managing techniques; and (5) reviewing evaluating and improving risk-management plan.
A Marijuana Related Business’ “loss-causing-events universe” encompasses: (1) people (owners, investors, employees, customers and vendors); (2) property (buildings, equipment, crops, inventory, vehicles, data, cash, intellectual property); and (3) profits.
Although people are a Marijuana Related Business’ most valuable asset, and their welfare is the first priority, even the most safety-conscious businesses experience job-related injuries costing thousands in medical expenses and lost productivity. Through enacting safety plans and rigorous employee training, accidents’ frequency and severity can be minimized, employee health and welfare can be protected, and workers’ compensation insurance coverage premiums can be stabilized. Similarly, to prevent a dying investor’s ownership transfering to a less than cooperative relative, Marijuana Related Businesses could obligate owners to execute buy-sell agreements requiring their survivors to sell decedent’s portion to the surviving partners.
Unlike people, damaged or destroyed property can be repaired and replaced and its “useful life” can be accurately anticipated and amortized. Unfortunately, due to federal prohibition, Marijuana Related Businesses are denied many standard insurances (like crop or cash exceeding $25,000), federal trademark and patent protection, and banking and credit card services.
Marijuana Related Businesses’ profits and valuation create the greatest vulnerability and regulatory fines and penalties, business interruption, and lawsuits impose the most perilous risk. Because they endure federal, state and local regulations, Marijuana Related Businesses are vulnerable to fines and penalties from federal agencies (including the Drug Enforcement Administration, U.S Department of Agriculture and Food and Drug Administration), state agencies (ex., Pennsylvania Department of Health’s Office of Medical Marijuana), and each municipality and borough in which they operate.
Related: The Politics of Reforming Federal Marijuana Laws Increasingly Favors the Reformers
“Business interruption loss” is where an event halts an Marijuana Related Business’ operations — like a wildfire’s soot and ash wiping out a grower’s crops immediately prior to harvest. Before the ensuing revenue-generating-grow-cycle is completed, employees, utilities and rent still require payment and, unless it has six months of cash to survive a revenue-less 180 day period, a Marijuana Related Businesses could get crushed.
Lawsuits range from a single plaintiff seeking damages to class actions in which an entire group of claimants seek compensation. Each year, defective, faulty or misused products cause serious injuries and property damage. Although primarily seeking remuneration for personal injury, property damage or economic harm, product liability claims may also seek punitive relief to punish the defendant and redress harms allegedly done to society. Defending litigation or settling claims can materially drain a company’s resources requiring additional regulatory requirement compliance, developing/disseminating product warnings, instituting a product recall, deploying employee time to investigate/mitigate claims, investigating/testing products and assessing risk, and hiring expert consultants.
Related: 3 Financial Mistakes Your Cannabis Business Can’t Afford to Make
Assembling your risk management team.
Because even the most standard loss could crash an insufficiently prepared Marijuana Related Businesses, assembling a “risk management insurance, accounting and legal advisory team” is critical.
First, before the business launches, choosing an industry appropriate insurer and coverage is mandatory and, due to the specificity of the regulations governing cannabis production cycles, extraction and infusion, waste disposal, and finished products, managing a Marijuana Related Business’ insurance needs requires understanding the most precarious exposures.
Specialized coverage is needed for growing operations (indoor, outdoor, greenhouse), extractors, product infusers and manufactures, dispensaries (HIPPA compliance and cash management), transporters (product and cash), testing labs, commercial landlords and property managers, and security providers. Additionally, because critical differences exist between the provided coverage (much of which contain troubling exclusions), specialized coverage is required for standard areas like general liability, property, workers compensation, professional liability, directors and officers, employment practices liability, crop, cyber security and data breach, motor truck cargo, stock throughput and crime and employee dishonesty.
Second, choosing a certified public accountant (“CPA”) familiar with the cannabis industry, the thousands of pages of Internal Revenue Service’s (“IRS”) regulations and, most importantly, §280E of U.S. Internal Revenue Code of 1986 is a game changer.
Related: 7 Things You Need to Know Before Becoming a Dope Accountant
Pursuant to §280E, the IRS forbids Marijuana Related Businesses from deducting otherwise ordinary business expenses from gross income associated with “trafficking” Controlled Substance Act’s Schedule 1 substances like marijuana. 21 U.S.C. §§ 801, Et. Seq (1970); 26 U.S.C. §280E (“No Deduction … shall be allowed for any amount paid … in carrying on any trade or business if such business … consists of trafficking in controlled substances …”).
Thus, because it prohibits claiming any tax deduction other than costs of goods sold (i.e., direct expenses attributable to the production of products sold by a company), §280E denies Marijuana Related Business from claiming typical retail business deductions like rent, utilities, and maintenance.
A seasoned industry CPA can offer profitability protecting and 280(e) shielding strategies like: (1) using primary accounting system as the general ledger only for sales, cost of sales and inventory; (2) using primary accounting system’s department classification functionality within a single accounting file and use separate files for each legal entity without commingling a management company or other entities with a dispensary; (3) using the same chart of accounts in each company’s accounting file (making it easier to prepare and confirm financial information); (4) keeping sales, cost of sales and inventory details in the tracking and point-of-sale systems and archive monthly; (5) documenting services and transactions between all dispensary-related entities; (6) following all intercompany contracts and pay/record the intercompany bills monthly; (7) ensuring all inventory is on the balance sheet at the end of each reporting period; and (8) developing, documenting and strictly following a process to determine total cost of goods sold.
Third, because even the most standard claim could derail an insufficiently prepared Marijuana Related Business, having a lawyer on board to avoid, mitigate and defend against liability and claims is essential.
Successfully defending against litigation requires treating all failures as potential claims and quickly reacting to liability issues when they arise. A seasoned cannabis attorney will help launch a “risk transfer program” shielding from claim and damages caused or contributed by third parties’ acts and omissions by documenting these decisions in writing and at a business relationship’s inception. Risk transferring documents include “Hold Harmless Agreements” (ensuring that third parties are contractually responsible for own negligence and/or errors and omissions) and “Statements of Financial Responsibility” like certificates of insurance which confirm both that third parties have sufficient insurance and list Marijuana Related Businesses as an “additional insured”.