Counseling a Cannabis-Related Business

The cannabis industry is intriguing and rapidly evolving. With more states and countries legalizing cannabis in varying forms, this industry will continue to expand. Many companies are moving into the cannabis business or expanding already existing businesses to meet the needs of the growing cannabis industry. For example, companies are:

There are also a multitude of ancillary cannabis-related companies, many of which need an infusion of capital from willing investors. The business opportunities in the cannabis world are vast.

However, cannabis remains an illegal drug at the federal level, presenting numerous challenges for cannabis-related companies and their counsel. This article examines the principal legal issues that practitioners must consider when counseling a cannabis-related business, including:

In 1937, the Marihuana Tax Act made cannabis illegal in the United States. In 1970, Congress enacted the Controlled Substances Act (CSA) (21 U.S.C. § 801), under which cannabis was codified as an illegal substance at the highest level, namely, a Schedule I drug under the CSA. Schedule I drugs are defined as those with no currently accepted medical use and a high potential for abuse.

After years of wrangling with prohibition, states slowly began to enact their own laws allowing for the growth, sale, and use of marijuana for medical purposes. The first major step toward broader change came in 2013, when US Deputy Attorney General James Cole issued a memorandum (Cole memo) stating that the Department of Justice (DOJ) did not intend to seek prosecution against any person or company that remained in compliance with existing state cannabis laws. At that time, no fewer than 17 states had laws that legalized some form of cannabis. The Cole memo further identified the eight most important areas where the DOJ intended to focus its prosecution:

The Cole memo was rescinded in January 2018. However, Attorney General Merrick Garland stated in his March 1, 2023 testimony before the US Senate Judiciary Committee that the DOJ’s forthcoming cannabis policy will be “very close to what was done in the Cole memorandum” (C-SPAN: Attorney General Merrick Garland, Testimony Before the US Senate Judiciary Comm. (Mar. 1, 2023)).

In 2014, Congress approved the Rohrabacher-Farr budget amendment, which prohibited the use of DOJ funds to interfere with state medical cannabis laws. This budget amendment was another significant step toward legalization. It has been passed in some form every year since then. The budget amendment has not, however, prevented the DOJ from prosecuting individuals who used their state medical cannabis license as a façade to engage in “blatantly illegitimate activity” (United States v. Bilodeau, 24 F.4th 705, 714 (1st Cir. 2022)).

Another sign of movement toward full cannabis acceptance is the Agriculture Improvement Act of 2018 (Pub. L. 115-334) (Farm Bill), which made hemp federally legal (for more information, see Hemp and the 2018 Farm Bill: Overview on Practical Law). Every legislative session since the Farm Bill has contained renewed discussion and debate over some level of cannabis legalization, beyond hemp, at the federal level.

Similarly, there has been ongoing debate over the Secure and Fair Enforcement Banking Act (SAFE Banking Act), which is proposed legislation that would provide much needed relief to cannabis-related businesses by making banking easier and more accessible. The SAFE Banking Act passed in the US House of Representatives several times but did not pass in the Senate. The most recent version of the bill was introduced in April 2023 by a group of bipartisan lawmakers (S. 1323 and H.R. 2891). Although the SAFE Banking Act would be a small step toward full federal legalization of cannabis, most challenges to the industry discussed in this article would remain.

States are continuing to legalize cannabis in varying degrees and methods. For example, some states:

State cannabis laws vary dramatically and are continuously evolving. Counsel must stay informed on these differing laws and jurisdictions. (For more on state marijuana laws, see Medical and Recreational Marijuana State and Local Laws Chart: Overview on Practical Law.)

Any cannabis-related business operating in the current climate must ensure full compliance with state and local laws. Every state’s law regarding cannabis is different. For each new state law that in some form lifts a ban on cannabis, new regulations must be drafted and implemented for both medical and adult recreational use to execute the new law. These regulations may include:

With differing and changing state laws in the face of ongoing federal illegality, the margin for error is small. However, the opportunities are plentiful for diligent participants to help the industry progress. Effective legal counsel in the cannabis industry is crucial.

A primary challenge when counseling any cannabis-related business is the ongoing tension between a particular state’s law, where cannabis is legal in some form, and federal law, under which cannabis remains a Schedule I illegal drug. The conflict between federal and state laws is likely to remain a high hurdle for cannabis-related businesses to overcome until either:

Cannabis-related businesses of all kinds are faced with various concerns, and some are forced to test the legal waters for clarity. The current unknown legal scenarios are numerous. Some state courts have even determined that federal law preempts state medical marijuana laws. Navigating the new roads being paved in this industry is challenging for cannabis-related businesses and their counsel.

Counsel should monitor the status of pending federal bills regarding cannabis, including proposals that:

These changes, if enacted into law, would remove many legal hurdles for cannabis-related businesses, even without a full de-scheduling of cannabis from the CSA.

Banking is likely the most difficult current issue emanating from the conflict between federal and state cannabis laws. Financial institutions are hesitant to open accounts and provide financial services to customers who conduct business that is illegal under federal law. As a result, companies operating a cannabis-related business face the initial struggle of finding a depository institution and the ongoing challenge of obtaining capital and debt financing. Additionally, they face immediate and continuing issues with the handling of cash, most notably regarding paying employees, taxes, vendors, and other third parties.

Financial institutions have mostly avoided the federally illegal cannabis industry to date for various reasons, including that:

The purpose of SARs is to assist federal investigators in identifying and stopping criminal enterprises. Under the Financial Crimes Enforcement Network (FinCEN) rules, a bank must file one of three types of SARs for each cannabis-related transaction occurring at that bank. SARs reporting is required even where operations are legal in the state. SARs not only create more scrutiny by federal regulators but also significantly increase the costs for financial institutions to maintain the required due diligence and administrative burdens. These costs are most likely passed along to the bank’s cannabis company customer. (For more on SARs filing requirements, see Suspicious Activity Reporting Requirements for Financial Institutions on Practical Law.)

For any financial institution undertaking the challenge of the cannabis industry, avoiding violations and the resulting penalties requires diligent focus on:

Even a company ancillary to the cannabis industry may find that its banking relationships are hindered due to it transacting directly with a cannabis business. This depends on the bank’s concerns with potential money laundering and BSA implications.

A cannabis-related business that operates completely in cash must decide, if the opportunity arises, whether to begin using a financial institution. This presents various concerns, including:

Some state-chartered banks and credit unions have decided to service cannabis-related businesses. They rely on ongoing “assurance” from FinCEN and recent attorney general statements that a bank’s full compliance with the BSA regulations serves as protection. Additionally, FinCEN guidance issued in 2014 supports banking for cannabis-related businesses. However, the FinCEN guidance includes extremely strict due diligence and reporting obligations to the government. Accordingly, most banks still consider the obligations too onerous and the risk too great.

For many current cannabis-related businesses, the only real option is an all-cash business. This unusual operational quagmire results in additional concerns unlike almost every other business, such as:

Addressing these additional concerns always results in greater expense for cannabis-related businesses.

Whether a cannabis-related business is a start-up company (which is common in this industry) or a healthy business with a history of operations, the need for business funding is ever present. Therefore, the lack of traditional banking options is a major challenge for all cannabis-related businesses. Most options for capital are through private funding and non-traditional lending scenarios. The lack of traditional banking makes capital harder to locate and significantly more expensive than through a traditional lending relationship with a bank.

To address banking challenges, counsel for a cannabis-related business should:

Counsel providing legal services to a financial institution doing business with a cannabis-related business should understand the bank’s concerns and identify the additional obligations that the bank has when working with the cannabis-related business.

Cannabis-related businesses have unique challenges arising from conflicting federal and state tax laws.

Under the Internal Revenue Code (Code), a business is entitled to deduct ordinary and necessary business expenses for carrying on its trade or business in calculating taxable gross income (26 U.S.C. § 162). Maximizing business expense deductions is a common tax strategy.

Regardless of the industry, a company can decrease its overall federal tax liability by deducting numerous allowable business expenses, including employee compensation, rent, business interest, marketing and advertising, insurance, utilities, and other taxes. However, these deductions are not available for cannabis businesses. Under Section 280E of the Code, business expense deductions are prohibited for any trade or business that involves “trafficking in controlled substances” (26 U.S.C. § 280E). In light of the current designation of cannabis as a controlled substance under Schedule I of the CSA, cannabis businesses are included in this prohibition. Therefore, these businesses must pay taxes on all of their revenue without the benefit of deducting business expenses, other than the narrowly defined “cost of goods sold” (COGS), to reduce their taxable income (see COGS below).

Some cannabis companies have argued to the IRS that they should at least be allowed to deduct business expenses incurred for separate lines of business not directly related to the sale of cannabis. The IRS and various reviewing courts have consistently held that if any part of the business relates to cannabis, then Section 280E prohibits all business expense deductions, even if the trade or business also engages in other activities. Because of Section 280E, the federal tax liability for cannabis businesses is significantly higher than for other companies. The effective income tax rates for cannabis businesses can easily reach 70 to 90 percent, making it difficult for them to stay in business. To address this challenge, states with cannabis legalization are increasingly enacting laws to “de-couple” from the federal Section 280E prohibition and allow cannabis businesses to deduct business expenses for state tax purposes.

Cannabis businesses are able to take a credit for COGS, which can potentially include these important expenses:

For example, a COGS credit allows a marijuana seller or dispensary to deduct the purchase price of its inventory, which is the wholesale cost of the product. The COGS credit is most helpful as a tax deduction for cannabis cultivating facilities. These facilities can realize more benefit than most other cannabis-related businesses, because they can deduct costs for growing the product, such as:

Cannabis-related businesses and their counsel can seek to address tax-related challenges by taking steps to:

Workplace protections and related employment issues are directly affected by:

These employment issues concern not only cannabis-related businesses but all employers in any state with statutes allowing some form of legal cannabis. For example, some courts have taken the position that off-site use of medical cannabis may be a reasonable accommodation under state law. The vast majority of states do not require accommodations for medical use, even where the medical use is legal. No state requires employee accommodations for adult recreational use, even where this use has been otherwise legalized.

The majority of states allow medical marijuana use. However, the medical conditions that qualify for this cannabis use can differ. For example, more restrictive jurisdictions such as Iowa only allow the use of CBD to treat a debilitating medical condition defined by statute (Iowa Code Ann. § 124E.2). On the other end of the spectrum, California permits the use of medical cannabis for any condition approved by a physician. Although California offers an identification card, all that is required for medical cannabis access is a written recommendation from a physician (Cal. Health & Safety Code § 11362.7(f) (defining “qualified patient”)).

In states where conditions are specifically articulated and a patient qualifies under one of the identified conditions in the statute, generally both:

Some states have enacted a medical marijuana law that protects employees who are registered medical marijuana cardholders (employee-cardholders). Many state statutes regarding medical cannabis specifically address whether the law affects an employer’s treatment of an employee-cardholder. For example, Arizona’s and Illinois’ medical marijuana laws contain language specifically prohibiting discrimination against employee-cardholders.

However, state medical marijuana laws that protect employee-cardholders typically contain exceptions for the employer’s benefit, such as:

Some states, such as Alabama and Ohio, expressly allow employers to provide no additional workplace protections for medical marijuana users, whether in hiring or continued employment. Employee-cardholders in these states do not have employment protections under the medical marijuana law even if they are following state law and limit their use to off-duty hours. (For more on state medical marijuana laws, see Medical and Recreational Marijuana State and Local Laws Chart: Overview on Practical Law.)

Even in cases with very similar fact patterns, state courts have arrived at different conclusions regarding the obligation of an employer to reimburse its employees for the costs of medical marijuana treatment. For example:

Because of the largely analogous fact patterns among these cases, it is difficult to distinguish the legal conclusions. The expectation is that states will continue to disagree and render disparate rulings as long as the CSA continues to identify cannabis as federally illegal.

Courts are increasingly issuing decisions interpreting the various state laws on workplace protections and related employment issues. Employers should carefully review all applicable state laws and interpretive case law when drafting drug-testing and substance-abuse policies.

Businesses that already have drug policies in place should review these policies for potentially necessary revisions based on changing state cannabis laws and court interpretations. While employers may not be required to accommodate on-the-job use, making reasonable accommodations for registered medical users in appropriate jurisdictions is a sound approach that would likely withstand judicial scrutiny. Further, tailored policies for employee-cardholders would decrease litigation risk more than blanket policies excluding marijuana users from employment.

Cannabis-related businesses do not have access to the protections of the Bankruptcy Code because it is a federal statute. Despite the DOJ’s current practice of non-prosecution, cannabis-related businesses are prohibited from obtaining bankruptcy protection until cannabis is de-scheduled from the CSA, because:

Although cannabis debtors cannot generally benefit from Bankruptcy Code protections, hope for reform may lie with the judicial branch. For example:

While the bankruptcy courts are a place to monitor for cannabis-related businesses, there is little question that they have shown significantly more latitude for legal hemp companies. Following the 2018 Farm Bill, most hemp businesses do not face the same federal legality challenges that cannabis businesses continue to face under the Bankruptcy Code.

Failing cannabis companies can take advantage of non-bankruptcy alternatives, which include state-sanctioned assignments for the benefit of creditors or receiverships (for more information, see Assignments for the Benefit of Creditors: Overview and Corporate Receiverships: Overview on Practical Law). A liquidation of assets or a complete sale of the business can occur under these scenarios but without official bankruptcy protection. These non-bankruptcy alternatives help with creditor concerns and are typically a preferable process to an unstructured winding down of a company (which may leave creditors angry and in pursuit of business owners to personally satisfy any outstanding debts).

However, these non-bankruptcy alternatives lack certain benefits that are available in bankruptcy. Under the Bankruptcy Code, the debtor or trustee:

Cannabis companies also cannot benefit from:

Finally, state court receiverships, while potentially the best option, pose their own challenges, including:

Cannabis-related businesses face specific challenges in the areas of real estate, intellectual property, dispute resolution, and business structuring.

Some states, such as Arizona, Illinois, and Oklahoma, expressly prohibit landlords from discriminating against tenants for the legal use of cannabis. However, federal law prohibits knowingly opening, leasing, renting, using, or maintaining any place to permanently or temporarily manufacture, distribute, or use any controlled substance (21 U.S.C. § 856(a)(1)). Despite the DOJ’s policy of non-prosecution, property owners considering leasing property to an entity engaged in a cannabis-related activity should still conduct due diligence before entering into a lease to determine whether the lease violates any state or local laws or other contractual restrictions, including:

There are risks when a landlord leases its property to a tenant that sells or cultivates cannabis, including that the landlord may:

Tenants must also protect themselves against these risks. A cannabis business tenant should:

Currently, US intellectual property law affecting a cannabis-related business differs depending on whether the business is seeking:

Unlike other forms of intellectual property, copyright protection does not necessarily require registration. However, registration for a copyright is beneficial because it provides the cannabis-related business with a basis for:

(For more on patents, trademarks and copyrights, see Intellectual Property: Overview on Practical Law.)

Uncertainty surrounding whether and how federal courts may address disputes involving cannabis-related businesses and cannabis issues will remain while cannabis is an illegal substance under the CSA. When counseling a cannabis-related business regarding dispute resolution, counsel should be aware of the jurisdictional options for hearing the dispute, including:

When drafting and negotiating written agreements for a cannabis-related business, counsel should consider the potential for dispute resolution, including whether to include:

(For more on dispute resolution considerations, see Choice of Law and Choice of Forum: Key Issues and Arbitration vs. Litigation in the US on Practical Law.)

Because transactions concerning cannabis are illegal under the CSA, there remains a risk that courts will not enforce the parties’ rights and obligations on the basis that they violate public policy. By contrast, most arbitral tribunals, applying the separability doctrine, will not decline to hear a case even where the underlying agreement may be illegal or invalid. Courts generally enforce arbitration agreements and awards despite assertions that to do so would be against public policy (for more information, see Challenges to Arbitral Awards in the US Based on Public Policy Violations on Practical Law). Parties should choose an arbitral seat in a state where transactions in cannabis are legal (for more information, see Choosing an Arbitral Seat in the US on Practical Law).

(For more on factors parties should consider when drafting an arbitration agreement, see Drafting Arbitration Agreements Calling for Arbitration in the US on Practical Law; for a model contract clause that requires parties to resolve their disputes by alternative dispute resolution, with explanatory notes and drafting tips, see General Contract Clauses: Alternative Dispute Resolution (Multi-Tiered) on Practical Law.)

When forming any business, the first step is to decide on a strategic business structure. Using an entity to operate a business is desirable because, as a general rule, the equity owners of an entity are not personally liable for the entity’s liabilities.

Similar to other industries, the most commonly used entity types for cannabis-related businesses are:

Particular state cannabis law requirements, however, may drive or even dictate the decision to use another entity type, such as a non-profit or cooperative entity. (For more on the various structure, liability, tax, and management differences among C-corporations, S-corporations, LLCs, and partnerships formed in Delaware, see Choosing an Entity Comparison Chart (DE) on Practical Law.)

The analysis to determine in which jurisdiction to form a cannabis-related business generally focuses on the same considerations as those for other types of businesses, including whether a particular state:

Each of these considerations varies based on the specific nature of the cannabis-related business and the practical goals of the enterprise.

A C-corporation is generally chosen as the entity structure if a business intends to raise funds from outside investors. Given the current difficulty of obtaining financing from banks and other traditional financial institutions, cannabis-related businesses tend to obtain capital directly from investors in exchange for equity interests in the company. Additionally, a C-corporation is a favored investment vehicle because this type of entity:

The primary disadvantage in choosing a C-corporation over either an S-corporation or an LLC is the double taxation of C-corporations. The income of a C‐corporation is taxed both:

Double taxation can be enough to prevent a business from choosing to operate as a C-corporation. However, the reduction in the corporate tax rate from 35% to 21% under the Tax Cuts and Jobs Act (TCJA) has tempered this deterrent. Since the TCJA’s 2017 enactment, it may be more advantageous in some cases to operate as a C-corporation, even with double taxation. The determination hinges on a variety of factors, including the projected combined entity and individual tax rates on business operations as well as other non-tax factors. (For more on the tax treatment of US business operations organized by a group of individuals in corporate versus partnership form, see C-Corporation and Partnership Tax Comparison Chart on Practical Law.)

Other disadvantages of C-corporations include the formal requirements to create and maintain a C-corporation, such as:

These corporate formalities are costly, especially compared to LLCs, which are not subject to these requirements.

The advantages of an LLC over a C-corporation include:

An LLC is typically preferred to a C-corporation if:

(For more on LLC agreements and their principal provisions, see LLC Agreement Commentary on Practical Law; for model LLC agreements, with explanatory notes and drafting and negotiating tips, see LLC Agreement (Multi-Member, Board-Managed) (Private Equity Buyout) and LLC Agreement (Single Member) on Practical Law.)

If a later analysis deems taxation as a C-corporation preferable, an LLC generally can be converted into a C-corporation (for more information, see Partnership to C-Corporation Conversion: Tax Issues on Practical Law).

S-corporations are generally not preferred over either a C-corporation or an LLC due to the substantial limitations on the availability of the S-corporation election. For example, an S-corporation must be an eligible US entity and must have:

(For more on the federal income tax rules for different types of business entities, see Choice of Entity: Tax Issues, Taxation of S-Corporations, and Taxation of Partnerships on Practical Law.)

Calculating business income is basically the same for C-corporations and LLCs. However, special consideration should be given to cannabis-related businesses regarding how Section 280E affects business income, because this can influence how and when distributions are to be made, if at all. Analyzing income projections and distributions may drive the decision on entity type (see C-Corporation, S-Corporation, or LLC above). Counsel should consider the full picture of a cannabis-related business as part of the entity choice and remember that business structuring considerations should factor in:

As discussed above, counsel for a cannabis-related company must fully understand the state and local laws where the client is located and operates. Compliance with the varying statutory and regulatory regimes in all jurisdictions is both challenging and of paramount importance in the cannabis industry.

There is no uniformity among the states that have legalized some form of cannabis. Particular states allow for both medical and adult recreational use, while others allow legal cannabis solely for medical use (for more on the legal status of marijuana in all 50 states and the District of Columbia, see Marijuana State Legal Status Charts: Overview on Practical Law).

Among the states that allow some form of legal cannabis, each has its own regulatory scheme for licensing and cannabis-related activities. Regulations can cover not only the cultivation and selling of cannabis but also related issues such as the testing of products for quality and quantity, packaging, and product branding.

Counsel should also be aware of the ordinances of relevant local municipality and county governments. The local jurisdictions within each state (cities, counties, and villages) can have their own regulations regarding the possession, sale, and use of cannabis that are more restrictive than the particular state’s laws. For example, local ordinances may restrict the location of or even completely prohibit a marijuana cultivator, dispensary, or related business, even if the state’s statute allows medical or adult recreational use.

Compliance with the various laws relevant to a particular location can be challenging. Additional compliance with the diverse rules and regulations of other governing bodies is even more challenging. As a best practice, all cannabis-related businesses should have a dedicated compliance team to focus on the multitude of rules, regulations, and requirements, many of which are likely to be different from business to business, depending on the nature of the cannabis-related business and where it operates.