Technically speaking - Cannabis Quarterly insights, Q2 2022
Cannabis stakeholders have a sometimes dizzying array of regulations to keep track of, brought on by the fragmentation of state markets, federal illegality, and resultant unique considerations when it comes to taxes, accounting, and much more.
This quarter’s articles
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- The why’s and how-to’s of developing an effective risk program for your cannabis business
- SALT Shaker: State and local developments and trends in tax and more
- From around the industry: Insights from the Sustainable Cannabis Coalition
These articles are part of CannaQuarterly, our new quarterly email newsletter for cannabis industry stakeholders, developed by a wide array of CohnReznick specialists plus contributors from around the industry. Subscribe now to make sure you receive future issues, and visit these pages to explore the other articles included in Q2 2022: Perspectives on Growth | Future of Cannabis
The whys and how-to’s of developing an effective and value-added risk program for your cannabis business
Regardless of whether a cannabis company is publicly traded or privately held, the SEC has the authority to investigate any business that looks to raise capital from U.S. investors. So, as the cannabis industry continues to expand and the nation looks to move toward federal legalization, more and more cannabis companies – MSOs through to SSOs – are looking toward SEC guidance now in order to prepare for their governance and compliance and reporting needs of tomorrow.
As businesses mature or become subject to public company scrutiny and oversight, they need to increase their focus on establishing effective risk management and controls processes. And while effectively addressing requirements is important in all industries, cannabis businesses face a unique set of compliance challenges due to the plethora of requirements such as strict accounting rules, seed-to-sale tracking, and constantly changing federal and state-specific laws and regulations.
That said, risk management shouldn’t be thought of just as a complex, costly program to put in place in order to avoid penalties. A proactive, robust, and structured yet agile risk management and compliance program, built on strong formal processes and regulatory and industry expertise, can also create competitive advantage and safeguard value by helping companies:
- Effectively identify, assess, and mitigate known and unknown risks
- Reduce the threat of adverse events, material misstatements on financials, and other organizational risks through effective policies and internal controls
- Increase the stability of the organization’s operations
- Improve the organization’s ability to handle and respond to regulatory uncertainty
- Drive accountability across the enterprise
- Increase risk awareness and ethical values among employees
- Improve communication channels between management, the board, and the audit committee
The following components can help organizations protect their assets, ensure records are accurate, enhance operational efficiency, and build a sound corporate and ethical culture – all of which helps to increase stakeholder confidence, bolster and preserve company reputation, and ultimately build value in this unpredictable, competitive market.
Governance and internal controls: Leading practices for every cannabis company
Governance and policies
A proper governance structure clearly identifies your organization’s infrastructure; the roles, responsibilities, and transactional authority limits of your management teams and key process owners; and the policies and procedures required to support your organization’s mission and business objectives. Documented policies should be put in place for key accounting practices and how to handle the accounting treatment for non-routine transactions. A comprehensive set of internal controls around accounting, systems, and financial reporting should also be developed to help ensure timely and accurate financial disclosures. In addition, make sure employees are aware of your company’s code of conduct and know how to anonymously report unethical behavior or misconduct.
Physical routine inventory audits should be conducted for more accurate state-by-state seed-to-sale tracking, and to confirm that your inventory valuation and cost of goods sold is accurate and not misstated. If inventory valuation or usage metrics are not accurate, cannabis companies could potentially lose their license, or could face penalties or fines if the amount is materially misstated. In addition, three-way matching – in which payment to vendors is released only upon matching to purchase order, invoice, and packing slip – should be performed to help ensure accurate payment to vendors and prevent any potential fraud from occurring.
Quality control checks and manufacturing controls must be carried out at every stage of the lab testing and manufacturing process to produce safe, quality products and to be more sustainable in the long run. Without federal oversight, companies are required to maintain compliance with state regulations, which are intended to keep consumers safe and healthy, free from contamination or excessive potency. To do this, companies should establish policies, standard operating procedures, and controls to support good manufacturing processes (GMP) and prevent product liability issues. In addition, companies can stand out by attaining an ISO certification, solidifying the requirements for a quality management system and the principle of putting your customers first.
Financial reporting reviews
Monthly trial balance reviews can be conducted to detect accounting errors, anomalies, and potential segregation of duties issues, maximize depreciation for tax deductions, and improve the month-end close process. These types of reviews may include analyzing journal entry activity, reviewing accounting treatment of significant transactions, and performing account reconciliations of key accounts. In addition, if your company is publicly traded, then disclosure controls and procedures should be in place to make sure that financial statements are complete and accurate.
Robust cash control procedures and physical security systems should be employed to protect against theft, particularly at cash-intensive operations like dispensaries. Similarly, appropriate segregation of duties should be maintained around sales, inventory, cash collections, and accounting. Preventive measures will help protect your company’s assets against – and preserve your reputation and brand in the event of – an adverse public event such as unethical conduct from an employee or a security breach or fraud.
Technology risk management
To mitigate unwanted intrusions, crashes, and other computer-based threats, a structured technology risk management program should be put in place that addresses key risks surrounding technology, record management, privacy, and cybersecurity. Also, if your company’s system data and information is hosted or processed by an outsourced service provider, a System and Organization Controls (SOC) Report should be obtained to confirm that the provider operates in an ethical, compliant, and well-controlled environment. SOC reports establish credibility and trustworthiness for the service provider while providing your stakeholders with confidence in the safety of your organization’s data and technology.
Setting up your program for success
While it’s great to know what should be done, a program will only be successful if there are clearly defined roles, ownership, and accountability across key stakeholders. The Institute of Internal Auditors’ Three Lines Model might be a helpful place to start to make sure your operations management, risk management and compliance, and internal audit teams are working together effectively with your company’s governing body to keep your defense strong.
And the work isn’t done once your governance structure is established: Ongoing monitoring processes should be carried out to confirm compliance and evaluate effectiveness. This provides management and the board with objective assurance that the company’s risk management, governance, and internal control processes are operating effectively.
As growth in the cannabis industry continues to accelerate, the risks, challenges, and requirements – and opportunities – facing the organizations within the industry are increasing, too, and long-term sustainability cannot be guaranteed for any cannabis company. However, organizations can differentiate themselves in the eyes of investors and other stakeholders with strong, effective, agile, and transparent governance structures, risk management processes, and compliance programs.
Daniel Fornelius, CIA, Director, Risk Advisory, Global Consulting Solutions
SALT Shaker: State and local developments and trends in tax and more
Ted Tourian, Krista Schipp, Brett Dunn, and Greg Pelucacci
Like any business expanding into new territories, a cannabis business must keep careful track of the many state and local taxes it will be subject to. But, as is often the case, cannabis’ varying legality can add an extra layer of complexity. In this section, we explore recent state-specific developments and what they could mean for your business.
IN THIS ISSUE:
- Market Updates: New Jersey, California, and Rhode Island
- Food for Thought: Special 280E considerations in New Mexico and Arizona; Sales and Use Tax exemptions in Maryland
Adult-use marijuana sales began in New Jersey for those 21 and older on April 21, 2022. Key regulations to be aware of include:
- Adult-use customers are only allowed to purchase one ounce of marijuana at a time. For example, dispensaries are allowed to sell up to:
- 1 ounce of dried flower, or
- 5 grams of concentrates (or concentrates in a solution), resins, or oils and other liquid forms, or
- 1000mg of ingestible products (ten 100mg packages) like gummies
- Adult-use cannabis will be subject to the state’s 6.625% sales tax as well as a social equity excise fee of a third of a percent.
- Municipalities can establish a local cannabis tax that cannot exceed 2% for a cannabis cultivator, manufacturer, and/or retailer, and 1% for wholesalers.
Furthermore, the sales tax for medical marijuana will be fully phased out as of July 1, 2022.
- Industry eyes are increasingly turning to the tri-state area as New York, New Jersey, and Connecticut embark on adult-use sales. This is a great opportunity for growing businesses to move into a busy new market. But remember that despite their geographical closeness, they will still present three different sets of state regulations to keep track of, including tax rates and policies – not to mention local rules and rates, plus differing treatments for adult and medical use. We will be monitoring the area closely – stay tuned for updates in future issues of CannaQuarterly.
- Want more insights on the tri-state area? Read Simplifiya’s summary of the three states’ regulations, drawn from their Simplifya Market Guide. Plus, hear Precious Osagie-Erese of the Minority Cannabis Business Association share her take on New Jersey’s prospects in our Q2 CannaQuarterly video.
As California continues to develop its 2022-23 state budget, cannabis stakeholders should keep an eye on the proceedings for potential impacts to the industry. The May revision, for example, aimed to reform taxes pertaining to the cannabis industry, in particular, “to greatly simplify the tax structure, remove unnecessary administrative burdens and costs, temporarily reduce the tax rate to support shifting consumers to the legal market, and stabilize the cannabis market with policies that are more transparent and can better adjust to market changes.” As summarized by the state, major changes would include:
- “Setting the cultivation tax rate at zero beginning July 1, 2022.
- “Shifting the point of collection and remittance for excise tax from distribution to retail on Jan. 1, 2023, maintaining a 15% excise tax rate.
- “Setting Allocation 3 funding for youth education/intervention/treatment, environmental restoration, and state and local law enforcement programs at a baseline of $670 million annually for three years. Up to $150 million one-time General Fund is available as needed through 2025-26 to backfill Allocation 3 funding, along with the authority to increase the excise tax rate through 2024-25 if tax revenues fall below the baseline for Allocation 3.
- “Strengthening tax enforcement policies to increase tax compliance and collection and reduce unfair competition.”
- If these provisions pass, cannabis businesses operating or doing business in California will need to note the new excise tax collection/remittance responsibilities for retailers, and carefully monitor and plan for any tighter enforcement policies.
The Rhode Island Cannabis Act, passed May 25, legalizes recreational cannabis growing and consumption for adults over the age of 21. Highlights include:
- Retail adult-use sales are scheduled to begin Dec. 1, 2022.
- Existing medical cannabis compassion centers can participate in the adult-use market by paying a $125,000 fee to obtain a hybrid license.
- Adult-use marijuana retail sales will be subject to the following taxes:
- 10% state-level cannabis excise tax
- 3% local-level cannabis excise tax
- 7% sales tax
- There is a moratorium on the issuance of new cannabis cultivator licenses.
- Municipalities will have the option to opt out of adult-use establishments, unless they currently have an existing medical cannabis compassion center in their jurisdiction.
- Prior misdemeanor or felony marijuana possession convictions will be automatically expunged.
- The law establishes the “Cannabis Control Commission,” a marijuana regulatory board.
- It also creates a “social equity assistance fund” to help social equity applicants establish their own marijuana-growing businesses.
- Existing businesses should evaluate whether they want to take advantage of the new hybrid licensing options.
- Monitor the moratorium on new cultivation licenses, in case new opportunities arise.
- Be aware of any local rules pertaining to adult-use establishments, and local taxes.
FOOD FOR THOUGHT
New Mexico: Is state litigation required for decoupling from Section 280E?
When states conform with Internal Revenue Code (IRC) Section 280E, it negatively impacts a cannabis business for state income tax purposes, because such states, like federal, would disallow ordinary and necessary business deductions in computing state taxable income. There is a trend where, when a state legalizes adult use, it introduces litigation decoupling from Section 280E, thus allowing income tax deductions of ordinary and necessary business expenses at the state level. (New York is one example.) Many in the industry believe that the only authority to allow a departure from Section 280E at the state level is through legislative process.
But a New Mexico Hearing Officer recently ruled that specific legislation was not required to decouple from Section 280E in order for licensed medical cannabis growers to claim ordinary and necessary business deductions in computing New Mexico taxable income.
- The Hearing Officer noted, “The fact that the IRS views the activity contrarily does not circumvent the will of the New Mexico Legislature which is entitled to establish a different policy for New Mexico, ‘to make medical marijuana accessible to those with debilitating medical conditions who might benefit from the use thereof.’”
- He ruled that Section 280E was effectively nullified in the Taxpayer’s case, where the Taxpayer engaged in a permissible business activity under the authority of the Compassionate Use Act, “which was expressly intended ‘to allow the beneficial use of medical cannabis in a regulated system for alleviating the symptoms caused by debilitating medical conditions and their medical treatments.’”
- Although not considered the strongest of authority that taxpayers should rely on, the New Mexico ruling demonstrates that a legislative decoupling from Section 280E may not be necessary in a particular state in order for taxpayers to claim ordinary and necessary business expenses or credits for marijuana growing or selling activities sanctioned by that state to reduce that state’s tax bill. That doesn’t mean that state-legal operators should go ahead and claim those expenses to reduce their state taxable income, as circumstances will vary greatly by state; but monitor your applicable states and talk to an advisor about what options may be available.
Arizona: 280E and for-profit vs. not-for-profit status
(Note: This article applies to non-stock corporations for Arizona state taxation purposes only; this does not apply to or impact federal taxable status.)
Before adult cannabis use became legal in Arizona in 2021, dispensaries would be incorporated as non-stock corporations and own nonprofit medical marijuana dispensaries (NMMDs). NMMDs would file federal taxes on a federal Form 1120 and be subject to federal taxes and 280E; state returns would be filed on an Arizona Form 99M, which is informational only.
Now, dispensaries can hold a medical (NMMD) license, a recreational adult “marijuana establishment” license, or a dual license (both an NMMD registration and a marijuana establishment license) – and, with these options, can elect to incorporate either as a for-profit or a nonprofit. State taxation varies, and notably, those that elect to be for-profit can take 280E-disallowed ordinary and necessary expenses on their Arizona returns:
- Medical/NMMD licenses: Medical sales are exempt from state corporate taxation; file AZ 99M, informational only.
- Recreational licenses: Recreational sales are reported on AZ 120 to pay taxes to the state; 280E may or may not apply in computing Arizona taxable income.
- Dual license holders: Medical sales are reported on AZ 99M, and recreational sales on AZ 120. For AZ 120, income earned from the marijuana establishment portion is taxable, while income earned from the NMMD is subtracted on Form AZ 120 when computing Arizona taxable income.
- Dual license holders who do not elect to operate as for-profit must file both the AZ 99M to report income and expenses from the NMMD portion of their operations, and the corporate form AZ 120 for the for-profit portion. These licensees are not allowed to take any 280E-disallowed ordinary and necessary expense subtractions on their AZ 120.
- Dual license holders who do elect to operate as for-profit still must file the AZ 99M to report income and expenses from the NMMD portion of its operations, and the corporate form AZ 120 for the for-profit portion. These licensees are allowed to take any 280E-disallowed expenses as subtractions on their AZ 120.
Businesses that currently are incorporated as nonprofits may benefit from switching to for-profit, depending on their sales: Though for-profit businesses will have to pay state taxes on all of their recreational sales, not just a portion, they will also get to deduct all 280E-disallowed expenses related to those sales on their AZ 120.
The change would be retroactive: A business can change to for-profit at any time in 2022 and it will be effective Jan. 1, 2022.
- Businesses operating in Arizona should evaluate sales and decide whether operating as a for-profit or nonprofit organization is better. Be prepared for additional administrative work around changing status and preparing or adjusting returns.
- For businesses operating in multiple states, be mindful that this applies only to Arizona taxes, and not at the federal level.
- There may be other considerations when deciding whether to operate as a for-profit or nonprofit in the state of Arizona. We recommend consulting with an attorney in making that decision.
Maryland: Sales and use tax exemptions for medical producers
As the cannabis cultivation process has evolved tremendously over the years, the improvements to technology and equipment have often come with hefty price tags. Fortunately, a number of states allow cannabis producers to take advantage of sales and use tax exemptions for agricultural and/or manufacturing equipment, which can mean critically large savings. Maryland is a prime example.
- Agricultural: Under the state tax code, relief generally applies to tangible personal property used to “prepare, irrigate, or tend the soil,” or “to plant, service, harvest, store, clean, dry, or transport seeds or crops.” Farm equipment is treated as personal property entitled to the agricultural exemption if attached to real property. The purchaser does not have to register with the state Comptroller to claim the exemption. (See the state’s Business Tax Tip #11 for more details, including lists of items that do or do not qualify for the exemption.)
- Manufacturing: In general, relief applies to sales of “tangible personal property used directly and predominantly in the production activity at any stage of operation on the production activity site from the handling of raw material or components to the movement of the ﬁnished product, if the tangible personal property is not installed so that it becomes real property.” No form is needed to claim the exemption.
- “Production activity” includes “assembling, manufacturing, processing, or refining tangible personal property for sale or resale”;
- “Used directly” means the property’s use “must be integral and essential to the production activity, occur where the production activity is carried on, and occur during the production activity”; and
- “Predominantly” means that the equipment is used at least 50% of the time in a production activity. (Read more on the state Comptroller's website.)
We checked with the state Comptroller’s office and understand that licensed growers of medical cannabis – entities that are authorized by the state Medical Cannabis Commission “to provide cannabis to a qualifying patient, caregiver, processor, dispensary, or independent testing laboratory, and either cultivates, manufactures, processes, packages, or dispenses medical cannabis, or processes medical cannabis products for resale” – generally qualify for the sales and use tax exemptions for equipment used in agricultural activity or once products are harvested.
- When purchasing, operating, or selling these types of equipment, consult your tax advisor to confirm what exemptions you might qualify for. These exemptions will vary by state and circumstance, so businesses should not assume their equipment qualifies, but it’s worth checking for potential opportunities to save.
From around the industry
Why measuring and reporting standards in the cannabis industry is vital
In order to provide consumers with products they can trust, standards must be constructed and met across the cannabis industry’s various facets — and while government regulations continue to take shape, the industry has an opportunity to propagate and standardize those best practices. Read more in this article from the Sustainable Cannabis Coalition (SCC). Read article >