Investing in medical marijuana is a high risk, high reward venture

In November, Arkansas voters passed the Medical Marijuana Amendment of 2016, which legalized marijuana use for medicinal purposes and created a state regulatory regime for the cultivation, distribution and sale of marijuana through licensed cultivation facilities and dispensaries.

The Arkansas Medical Marijuana Commission is making steady progress toward reaching its July 1 deadline to launch Arkansas’ medical marijuana program. Application fees and annual license fees have been tentatively set, rules and regulations are coming together and medical marijuana supporters, investors and entrepreneurs are jockeying to obtain one of the five cultivation licenses or 32 dispensary licenses to be established in Arkansas over the next six months.

Medical marijuana is expected to have a significant economic impact in the state. In 2015, U.S. marijuana sales reached $5.4 billion, and conservative estimates predict sales will eclipse $11 billion by 2020.

However, operating in the industry is not without risk — marijuana is still classified as a Schedule I drug under the federal Controlled Substances Act, making it illegal under federal law. This conflict between state and federal law has created many unique legal, financial and regulatory obstacles for medical-marijuana businesses and their owners.

• Banking difficulties
At this time, no major banking institutions or credit-card companies are providing financial services to medical marijuana businesses, forcing most of the industry to operate on a cash-only basis and without access to traditional payment-processing services. Medical marijuana businesses generate a lot of cash that banks would love to access — cash deposits increase a bank’s lending capabilities while decreasing overall lending costs.

However, because marijuana is federally illegal, banks simply don’t want to risk criminal liability for aiding and abetting the distribution of a controlled substance. Banks could also face liability under the Bank Secrecy Act for money laundering. Marijuana businesses in other states have found some success with small, state-chartered credit unions, which typically charge higher fees and place caps on deposits in order to limit their exposure.

• Section 280E of the U.S. tax code
Section 280E of the Internal Revenue Code prevents businesses that engage in the distribution of controlled substances from taking certain tax deductions, such as rent and salary payments to employees. Interestingly, Section 280E was originally enacted in response to a 1981 court case where a Minneapolis drug dealer deducted expenses associated with his cocaine distribution business (and then successfully defended the deductions in tax court).

Today, it significantly increases the tax burden faced by marijuana businesses; because they are unable to deduct most customary business expenses, medical-marijuana businesses can end up paying income tax on gross revenue rather than profit. In certain situations, IRS rules allow cultivation facilities to take advantage of some deductions that are unavailable to medical-marijuana dispensaries, and careful tax planning and accounting is key for the long-term success of these businesses.

• Intellectual property
Marijuana businesses also face legal hurdles with respect to intellectual property and brand protection. The U.S. Patent and Trademark Office will not register trademarks for marijuana retailers or for products that contain marijuana. As a result, it can be very difficult for marijuana businesses to protect their brand and to prevent competitors from selling products under their brand. One potential solution, which has not yet been proven, is for marijuana businesses to trademark branding placed on ancillary products, such as T-shirts, hats and vaporizers.

Until the Trump administration signals its enforcement policy with respect to marijuana businesses operating in compliance with state law, cannabis entrepreneurs and investors will continue to face legal and financial uncertainty. Due to the lack of access to traditional financing, many prospective cultivation facility and dispensary operators have turned to private equity for seed capital, and medical marijuana businesses must exercise proper diligence in these discussions.

Businesses and their management team can be held liable for providing potential investors with untrue, inaccurate or fraudulent information, and investment documents should adequately disclose the many legal, financial and regulatory risks associated with the current uncertainty surrounding the marijuana industry.

Editor’s note: Cal Rose is a tax and transactional attorney with Wright, Lindsey & Jennings LLP, a law firm with offices in Little Rock and Rogers. The opinions expressed are those of the author.