Management Companies – Cannabis Operations

Management Company – Cannabis Operations

Management Companies - Cannabis Operations
Management Company – Cannabis Operations

Management Company – Cannabis Operations – there has been quite a bit written over the past few years relating to the use of management companies in the organization of the structures for the operation of legal cannabis businesses. A substantial portion of the discussion has focused on three primary topics:

  • The potential for allocation of expenses to multiple businesses through common ownership as a consequence of the decision in Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner (CHAMP)[1]
  • The potential reduction in exposure to the disallowance of “trafficking expense” classification under IRC Sec. 280E, the details of which is beyond the scope of the discussion herein.[2]
  • The juxtaposition of a management company as a technique for facilitating access to the commercial banking system for a cannabis business.[3]

We note that FinCEN issued an announcement in January 2018[4] which reaffirmed its intent to continue following the guidelines provided in FIN-2014-001 after Attorney General Jeff Sessions announcement which severely curtailed the ability to rely upon the Cole Memorandum[5] [See AG Sessions – DOJ Abrogate Cole Memo].

Management Company – Cannabis Operations

The issuance of new guidance by the Department of Justice [“DOJ”] in January 2018  [the “2018 Guidance”, a one-page memorandum] emphasizes Congress’s determination that marijuana is a dangerous drug and that “marijuana activity” is a serious crime. Criminal marijuana activity, per the 2018 Guidance, includes certain federal financial statutes that cover money laundering, unlicensed money transmission and the Bank Secrecy Act. The 2018 Guidance indicates that the DOJ’s general principles of prosecutorial discretion for all federal investigations and prosecutions, as stated in the U.S. Attorney’s Manual, render unnecessary a separate statement of priorities for relating to prosecutions relating to marijuana activities. Based on this analysis, the 2018 Guidance rescinds the Cole Memo and the 2014 Guidance, among other items of DOJ marijuana-specific guidance. The 2018 Guidance does not address any federalism or preemption issues that may arise from the disconnect between federal and state law in this area

Banks, credit unions and other financial institutions that have – or are considering — marijuana-related businesses as their customers must carefully reevaluate their compliance with the various federal laws regarding transactions related to marijuana. As long as the FinCEN Guidance remains in force, financial institutions with marijuana-related businesses as customers should continue making required SAR filings and maintaining their Cole Memo compliance programs. Under the 2018 Guidance, however, financial institutions may not be able to accurately assess and address their compliance risk and potential legal exposure associated with doing business with marijuana-related businesses, unless further guidance is provided.  This could be particularly true if the 2014 FinCEN Guidance is also repealed.

Management Company – Cannabis Operations

The 2018 Guidance leaves all marijuana businesses at the mercy of the exercise of prosecutorial discretion of the U.S. Attorney for the jurisdiction in which the marijuana business is operating. From the standpoint of potential criminal prosecution, the use of a management company to avoid to facilitate the operation of a marijuana business is evidence of a knowing circumvention of reporting requirements and could even be viewed, and prosecuted, a separate federal financial crime.

The intersection of banking issues, financial crimes, and legal commercial cannabis operations are a serious problem for those businesses that come under the federal cross-hairs.  We are writing to address the civil side of the use of a management company structure and interaction with IRC Sec. 280E. We note from the outset that our greatest concern is that any use of a management company structure must be justified by a standard of commercially reasonable.  The amounts charged by a management company for services must be “commercially reasonable”. Reimbursements and markups must be consistent with the amounts an arm’s length third party would charge the cannabis business. If the charges from the management company are excessive, the IRS has an arsenal of tools that it can use to implode or recast the management company and its charges, starting with IRC Sec. 482 and the “clear reflection of income” principles.

Management Company – Cannabis Operations

The ”management company structure” has been described by numerous commentators, one example appeared in Canna Law Blog.com on June 3, 2015 which described the structure as:

“Management companies developed in the early days of California’s medical industry. Because California does not have a fully regulated state system for medical marijuana, companies that operate there generally need to organize as various versions of nonprofits. These nonprofits face three big obstacles: banking, taxes, and how to pay their nonprofit directors and officers. Many in the industry have seen management companies as the solution. The nonprofit entity pays gobs of money to the management company, which is generally organized as an LLC or corporation. The money is often tied to the revenues of the nonprofit. The management company then opens a bank account by telling the bank that it is a “business management” or “consulting” company, without disclosing its marijuana ties. It also is free to distribute profits to its owners, and the business freely deducts its expenses because it is not subject to IRC 280E. It’s a perfect structure. But not really.

The main problem with this structure is that it works by actively concealing the source of its funds from third parties. It is pure money laundering under federal law, which bars conducting financial transactions with the proceeds of unlawful activity when the perpetrator knows that the transactions are designed to disguise the underlying activity. As I often say when I give presentations on financial matters for marijuana businesses, just because a pot business is violating the federal Controlled Substances Act does not mean that it also has a license to violate all other federal laws. And it is usually its violations of these other federal laws that lead to arrests. Using this sort of structure for a cannabis business opens that marijuana business not only to criminal liability but also to massive civil liability from the companies with which it does business. Lastly, state nonprofit regulators can (and do) come down hard on nonprofits that engage in concealing activities to distribute profits, a prohibited act.

Though this exact issue does not crop up as much in states with regulated systems and for-profit businesses in the marijuana space, a subtler version has been cropping up as a purported method for helping on tax payments. The general idea is to create a leasing company with common ownership with the marijuana company and then use that leasing company to purchase capital equipment and real estate that will then be leased to a marijuana cultivation company at above market rates. The marijuana company categorizes the lease payments as a cost of goods sold rather than business expenses, rendering IRC 280E moot. The leasing company, in turn, is able to fully deduct (or capitalize and depreciate) the cost of the equipment and real estate because it is not even subject to 280E. This can lead to big tax savings. As long as everything is run as an arms-length transaction and at market rates, it is not even illegal.”[6]

We note that the situation in California has changed dramatically since the quoted item above was written, in no small part due to the MARCUSA legislation, and its anticipated impact which will sunset the use of “Collectives” and other “not-for-profit entities in California.

With the incentives to deploy management company structures severely curtailed for not-for-profits, and concerns associated with the methodology that is utilized in the structure to calculate the management charges passed from the management entity to the cannabis entity, the access to commercial banking channels remains as a commercial need which can justify the use of a management entity in a prudent fashion.

We believe that the successful deployment of a management company structure requires a combination of common sense and collaboration between counsel and a certified public accountant to craft a structure that will withstand challenge.

Management Company – Cannabis Operations

[1] 128 T.C. 173, (2002 )

[2] We have written extensively about the application of IRC Sec. 280E, and the reader can get an overview from Analysis of IRC Sec. 280E.

[3] The discussion of access to the commercial banking system is a complex analysis in and of itself. The primary source of guidance for banking is FIN-2014-G001.pdf, which was issued on February 14, 2014. to clarify Bank Secrecy Act expectations for financial institutions seeking to provide services to marijuana-related businesses.  We recently received confirmation from FinCEN that financial institutions continue to be required to update their Suspicious Activity Reports (“SARs”) on marijuana-related businesses – a requirement that is being missed by some financial institutions. This Alert addresses the continuing obligation by financial institutions providing banking services to participants in the cannabis industry to regularly update “Marijuana Limited” SAR filings.

FinCEN’s Cannabis Guidance was an attempt to reconcile compliance with the SAR filing requirement for suspicious criminal activity with the Obama Administration’s decision to de-emphasize prosecution of cannabis-related business, provided that the cannabis activity was lawful under the laws of a particular state. Following due diligence by a financial institution, a bank account could be opened for a cannabis-related entity, but a Marijuana Limited SAR was required to be filed with FinCEN.  The Cannabis Guidance reads, in part, as follows:

A financial institution providing financial services to a marijuana-related business that it reasonably believes, based on its customer due diligence, does not implicate one of the Cole Memo priorities or violate state law should file a “Marijuana Limited” SAR. The content of this SAR should be limited to the following information:

  • identifying information of the subject and related parties;
  • addresses of the subject and related parties;
  • the fact that the filing institution is filing the SAR solely because the subject is engaged in a marijuana-related business; and
  • the fact that no additional suspicious activity has been identified. Financial institutions should use the term “MARIJUANA LIMITED” in the narrative section.

[4] Jefferson B. Sessions, III, Attorney Gen., Memorandum for All United States Attorneys: Marijuana Enforcement (Jan. 4, 2018) (the “2018 Guidance”)

[5] James M. Cole, Deputy Attorney Gen., Memorandum for All United States Attorneys: Guidance Regarding Marijuana Enforcement (Aug. 29, 2013) (the “Cole Memo”)

[6] Marijuana Corporate Structures that Break the Rules, Cannalawblog.com, Robert McVay, June 3, 2015

Management Company – Cannabis Operations

 

Author: abizcannabis

Managing Director & CEO of integrated transactional financial advisory, tax, and technology consulting firm - aBIZinaBOX Inc New York, Chicago, and OaklandCPA.CITP.CISM.CGEIT.CGMAExpertise with: Alt. Investments/Private Equity, Real Estate, Professional Services, CA Cannabis, Tech Start-Ups and Distressed Assets/DebtTechnology Certifications including:Advanced & High Complexity Cloud Integrator AICPA PCPS, CAQ,, IMTA, CITP ISACA CGEIT, CISMState CPA Societies in California, Florida, Illinois, New York and TexasExpertise with Regulatory Compliance - US - HIPAA, FINRA, SEC Rule 17(a)(3)/(4), eDiscovery, FINCEN - EU- EBA, ESMA, EIOPA UK - BoE, PRA, FCA