In our May 2022 “Office Hour with SKC”, Sarah Krom hosted a panel discussion on the legalization of recreational marijuana in New Jersey and the impact to businesses. In the second part of this discussion, Melissa Dardani, Founder of MD Advisory Services and Leader of the NJCPA Cannabis Interest Group reviewed the differences between a cannabis operator and cannabis investor, as well as the risks and associated costs involved with investing in the industry.
If you are considering investing in the cannabis space, there are risks and due diligence to be aware of. First, we'll review the difference between a cannabis "operator" and a cannabis "investor". Although these terms are used somewhat interchangeably, there is a difference to be drawn especially as it relates to constructing a cannabis team.
Operator vs Investor
An operator is crucial to the cannabis team as they are the ones that have the skills and know-how to handle all stages of the supply chain from cultivation to retail - growing, extracting, processing, manufacturing and ultimately selling. This is known as a vertically integrated entity and until quite recently, was the only way to operate in the cannabis space.
As adult marijuana use becomes legalized and more licenses are opening up, it is such that you don't have to be a vertically integrated business. It is possible to invest in specific stages such as a cultivation center, dispensary, etc. and build your own team. However, there are risks associated with becoming a new entry into this market, and the most important factor is obtaining an operator to assist you. Your potential reward and your potential risk are directly tied to what the operators are doing and how they're able to succeed and turn a profit.
The Risks and Associated Costs
It is important to note that, on a federal level, cannabis is still classified as a Schedule 1 controlled substance, and absent the legislation passing to either deschedule it or move it to a lower level of scheduling, there are many business implications to be aware of.
First and foremost, access to banking can be very difficult. There are only a small number of financial institutions that are willing to deal with cannabis clients, particularly plant touching cannabis clients. And, if it is difficult to get banking, it is nearly impossible to get financing. Even though the market has opened up slightly, generally speaking, it is incredibly difficult to find financing. When you do find it, you are paying what many refer to as a "cannabis tax" - higher fees for the necessary compliance reporting that is required.
Section 280E of the Tax Code
A prevalent business issue for cannabis companies is the specific section within the IRS Revenue Code that states if you are in the business of "trafficking" an illicit substance in accordance with the Controlled Substances Act Schedule 1, you are not allowed to take any business deductions, with the exception of your cost of goods sold. In essence, you cannot deduct most of your expenses when you're calculating your taxable income at the end of the year.
If you are a producer, the tax code has a little bit more leniency in terms of what is considered incident and necessary to produce your product. If you are a reseller, however, there is not much that you can identify as incident and necessary to get your goods from the person who produced it to the point that is ready to sell to your customer.
For an investor, the corporate structure and the point in the supply chain that you choose to invest in can have vastly different implications from a tax perspective. While 280E is enacted and in place, you need to make an educated decision about whether to act independently or to attach yourself to an established operator. Remember that operators that have been involved the longest will have first-to-market positioning and be the ones to reap the rewards of this industry.