Recent years have seen a growing number of U.S. states legalize the use of cannabis. To date, 37 states have legalized marijuana for medical use, with 19 also permitting recreational use. It’s a trend that has gathered pace in recent years and has resulted in numerous second-order effects.
The growth of the legalized cannabis industry presents all kinds of challenges, particularly in a financial and accounting sense. Cannabis producers, distributors, and retailers must navigate a complex, unclear operating environment and deal with challenges that those in more traditional industries don’t have to consider.
Cannabis businesses are largely unable to access conventional financing and are subject to higher levels of scrutiny than those in more loosely regulated industries. Building a successful business doesn’t just require operational excellence: it also demands a robust financial infrastructure that’s capable of handling the regulatory complexities of the industry that vary on the federal and state level.
Working with a dedicated, trusted advisor enables these businesses to capitalize on growth opportunities, act as efficient stewards of investor capital, and stay in compliance with the regulatory complexities of the legal cannabis sector.
As cannabis legalization garners support in more states, new opportunities are emerging. These opportunities lie not just in the production and retailing of the product itself, but also in the ancillary industries that support the legal cannabis industry.
For investors in the commercial real estate and construction industries, legalization represents a new wave of demand for industrial and retail property. Unlike many of the digital-first businesses that have emerged in the past ten years, a cannabis business demands physical space. In commercial real estate markets that are already tight, legalization increases demand for manufacturing, warehousing, and retail locations.
There are plenty of reasons for real estate investors to be optimistic. In states where cannabis has been legalized, 36% of commercial real estate owners reported an increase in their property values since legalization.
The emerging cannabis industry is also fueling significant regeneration in formerly depressed manufacturing communities around the country. Warehouses that had sat empty are rapidly becoming indoor cannabis farms, bringing new jobs, attracting workers to the area, and increasing tax revenues.
Securing a license is a daunting process, but successfully capitalizing on the opportunity it offers demands operational excellence. Here is a brief overview of the additional complexities marijuana business owners must overcome to build a successful business.
The first difficulty many entrepreneurs face is in accessing financing. Cannabis businesses are capital-intensive, requiring investments in production facilities, retail stores, and more. Conventional bank financing tends to be unavailable. Most banks are federally regulated, and while some state-chartered financial institutions may be able to bypass these regulations, they’re often unwilling to risk operating in a gray area.
This inability to access conventional bank debt means that many new cannabis businesses accept loans from private investors. While traditional nonrecourse loans allow losses to be deducted, nonrecourse loans from private investors don’t offer this special tax treatment. For a business that already operates on tight margins, this can be challenging.
With state legalization of cannabis, obviously the primary impetus behind the legalization is generation of additional tax revenue in the form of sales / excise taxes on these transactions. The difficulty is how do businesses handle the reporting and filing obligations with these taxes, as they can be voluminous and difficult to manage. Designing the appropriate reporting system and process is essential for capturing the necessary information at the point of sale and we can assist with this system design. Marijuana businesses and their reporting will be highly scrutinized for accuracy and compliance, just like alcohol, given the nature of the item being sold. Audits are going to be frequent and detailed, and your reporting processes and documentation need to match the scrutiny you’re going to face.
Even though in business legally in certain states, Federal law still considers cannabis an illegal substance. Therefore, the businesses are limited by Section 280E of the Tax Code which prohibits access to federal tax credits and deductions. Ironically, owners of legal cannabis businesses must still pay federal income taxes related to the business. While deductions are allowed for the cost of goods sold, they’re not permitted for non-product expenses. This includes overhead expenses like salaries and advertising that could easily make up 50% of the business’s total costs.
Determining which expenses are eligible to be deducted demands experience and a keen focus on compliance. Marijuana businesses are held to a higher burden of proof than those in more loosely regulated sectors. As such, marijuana businesses must have highly accurate accounts and filings.
The majority of the cannabis industry continues to operate in cash. While cannabis-based businesses can have merchant bank accounts, these are traditionally only available through smaller regional banks and credit unions, and the compliance burden is heavy.
Running a cash-based business brings all kinds of additional challenges, from running payroll to physically securing the tens of thousands of dollars a dispensary might take in each day. These processes are often inefficient and force cannabis businesses to incur additional expenses that further depress margins.
As momentum continues to progress toward seemingly inevitable federal legalization, the industry will mature and processes will standardize. However, none of the challenges outlined above will disappear overnight. Successfully capitalizing on the opportunities of today requires discipline, operational excellence, and the support of capable strategic advisors.
Partnering with an accounting firm with expertise in multi-state, sales and federal tax rules is a crucial step toward building a successful cannabis business. The right firm will partner with you to create a robust financial infrastructure, navigate complex tax issues, and help you build a business that flourishes over time.
Smith and Howard is a nationally recognized tax, advisory, and accounting firm. Our team brings rich industry experience and works with a diverse client base spread across multiple industries.
To learn more about working with Smith and Howard, contact us today.
This article was created with valuable input from Caleb Lloyd, Chris Conrad and Beth Margedant.
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