NYSSCPA Marijuana Symposium addresses risks and benefits of the industry

By:
Chris Gaetano
Published Date:
Jan 26, 2017

With New York state having launched its medical marijuana program in January 2016 and all of its neighboring states administering their own medical marijuana programs, the NYSSCPA hosted its first Marijuana Symposium on Dec. 13, in order to educate the profession and the public, inform local and national decision makers, and host a forum for open and thoughtful discussion on one of the United States’ fastest growing industries. 

The U.S. legal marijuana market grew to $6.7 billion in 2016, a 30 percent increase over the prior year, according to Arcview Market Research, and projections for this year are even higher. These legally established businesses, whose primary product is categorized by the federal government as a Schedule I drug, are now operating in 29 states, requiring the accounting professionals who take on these businesses as clients to know the various business issues that come with operating in this arena. Several speakers at the symposium in midtown Manhattan discussed why it’s not just the purchase of the drug that matters, in this mainly all-cash business. 

Because the industry is so new and fraught with instability, CPAs taking on clients in the marijuana business face no small number of uncertainties, according to Ahava Z. Goldman, the senior technical manager at the AICPA and one of the symposium panelists. While she didn’t want to discourage CPAs from taking on marijuana-related businesses as clients, she said it’s important for them to know what it is they’re getting into. 

Because the sale of marijuana is illegal on the federal level, challenges abound for these businesses, with regard to accessing banking services, going public, paying taxes, valuating the product and undergoing audits. There is also a greater potential for fraud and theft than in other businesses. Complying with state regulations constitutes another major undertaking. New York’s medical marijuana law is the most restrictive in the country, and keeping up with all the state-level regulations can sometimes seem a Sisyphean task. 

In addition, a company doesn’t have to produce or sell marijuana to be exposed to risks associated with it. The landlords who rent to marijuana-related companies, the financial institutions that would handle their money, the insurance companies that cover them—all of them potentially face regulatory risks from being associated with marijuana businesses. 

“If your clients are banks, if your clients are insurance companies, if your clients are landlords, you [must] understand the risks they run by providing related services,” Goldman said. 

She also mentioned that CPAs risk potential licensure issues with their respective state boards, depending on what their codes of conduct are. Mat Young, vice president of State Regulatory and Legislative Affairs at the AICPA, who also spoke at the conference, addressed that issue. He noted that state boards of accounting in eight states have passed guidance on marijuana businesses. These boards generally hold that providing accounting services to a marijuana business is not in itself an act discreditable and that they won’t pursue independent disciplinary action against CPAs based on such an engagement. The AICPA has issued model guidance for state boards, which is available here.

Despite its many challenges, the industry is booming. Data from consulting group New Frontier showed that the medical marijuana market in the United States is estimated to reach $11 billion in 2020, with California making up about 30 percent of that amount. That doesn’t take into consideration recreational use, which could further drive sales of the drug. Voters in California passed a ballot in November to legalize marijuana for recreational use, 20 years after it became lawful there for medicinal purposes. Massachusetts and Nevada also passed a ballot for legalization for recreational use in November. 

Hurdles to banking, going public 

Still, the challenges must be addressed head on. One major hurdle is how difficult it is for marijuana businesses to access banking services. Henry Meier, general counsel of the New York Credit Union Association, noted that banks and credit unions are obligated by the Financial Crimes Enforcement Network (FinCEN) to know their customers and to file Suspicious Activity Reports (SAR) if any of those customers do something that seems suspicious. This requirement can be particularly tricky, he said, when it comes to a substance that is technically illegal on the federal level. While it is theoretically possible for a financial institution to service marijuana businesses, Meier said that doing so would require a great number of SAR filings, as a bank must file SARs each time it suspects that a customer is engaging in illegal activity. is means most banks see this as too much trouble and decide not to offer services to these companies at all. 

“Only the biggest and most sophisticated banks and credit unions can do this. This is not something your average community banks can do, given these restrictions,” he said. 

But even with this hurdle cleared, Meier said that the Federal Reserve has refused to grant banks that deal with marijuana businesses access to its system, which severely restricts a bank’s ability to move money around, and the Federal Deposit Insurance Corporation has refused to insure their deposits. Moreover, if a marijuana business were to go bankrupt, it would not be permitted to reorganize under Chapter 13 or Chapter 11. All these restrictions do not make him optimistic when it comes to the legal marijuana industry. 

“You will not have a viable industry in the long term without allowing greater fluidity and financing from the banking system, and right now, there are too many uncertainties,” he said. 

Because many banks won’t do business with marijuana companies, the industry remains primarily cash-based, which, Goldman noted, carries all sorts of other risks, not the least of which are theft and fraud. 

“Even when dealing with people of integrity ... whenever you have this much cash, there’s always a fraud concern. You want to make sure you know what their controls are over who touches the cash,” she said. 

Another panelist, Duncan B. Will, a loss prevention specialist with the liability insurance company CAMICO, made a similar point and added that it’s better to deal with the kinds of questions surrounding cash sooner rather than later. 

“Cash. How is that being reconciled? How is it being controlled? Who has responsibility for that? ... I don’t want there to be a cash issue down the road and have someone say, ‘Oh, this is what you said for us to do,’” he advised. 

If a marijuana business decides to go public, it faces even more challenges endemic to the industry, according to Ram Mukunda, the president and CEO of IGC, Inc., a company that develops phytocannabinoid-based therapies for pain, seizures, cachexia, and chronic and terminal neurological and oncological diagnoses. While the company is listed on the New York Stock Exchange today, getting there wasn’t easy. 

First, said Mukunda, exchanges themselves take a hard line on deriving revenue from cannabis products, saying that if a company is involved in touching, growing, processing or retailing the plant in any way, the major exchange simply will not list it—so if a marijuana company wants to be listed, it can only deal with the plant itself in indirect ways. Even if the exchange will list the company, though, Mukunda said that the Securities and Exchange Commission (SEC) requires numerous disclosures of risk factors, of which there are many for such companies. He added, too, that the SEC does not allow marijuana businesses to accelerate their filings, which is also an issue. Furthermore, even if a company does manage to get listed, clearing houses may decide they don’t want to deal with its stock. Finally, he noted that federal courts won’t enforce contracts involving these businesses, so companies must limit enforcement to state courts. 

“So, being public in this industry is extremely difficult,” he said. 

Taxation and valuation 

Goldman pointed to taxes as another area in which there’s significant uncertainty for marijuana-related businesses, as the industry tends to generate a lot of uncertain tax positions. Much of this uncertainty, she said, is, again, due to the fact that the federal government still considers the sale of marijuana to be illegal, which can make it difficult to predict exactly what the IRS will do as the client attempts to comply with the tax code. Another reason is that valuation itself is full of uncertainty and estimates. 

“Where are you going to find the experts to value it if you have to value it on anything other than cost? Where will you find people saying,‘ This strand is worth this much?’ It’s an issue to consider,” she said. 

Another panelist, Ronald L. Seigneur, a CPA whose firm, the Colorado-based Seigneur Gustafson LLP, has performed 20 marijuana business valuations so far, acknowledged that valuation is fairly new territory, though he also noted that the rules are pretty much the same as they would be for any industry, and that valuation resources for the marijuana industry, in particular, are starting to become available. He said his own firm, during the course of its valuations of marijuana businesses, has developed a procedure involving site visits, management interviews and facilities inspections. 

Based on things such as the size of the facility and the technology that they use (soil vs. hydroponic, for example), he said he can then figure out about how much marijuana can be produced in a single harvest. en, based on the fact that the average facility will produce 5.5 harvests per year—yielding an average of 40 grams per square foot, according to an analysis from Washington, another state that legalized recreational marijuana—Seigneur can forecast revenue and factor in cost structures and taxes, and discount it back to present value. 

The problem, though, is that he needs to apply a risk-adjusted discount rate out of those projected cash flows, and there are very high systemic risks in the industry, such as the aforementioned issues with regulation, fraud and financing. Because of these risks, Seigneur said his firm uses “really, really extreme” discount rates. He briefly discussed one case done by Seigneur Gustafson in Nevada in which the firm used a 45 percent discount rate. 

“That’s unheard of in the 30 years I’ve been doing this, but I think it’s appropriate in this industry,” Seigneur said. 

Panelist Todd Arkley, a Seattle-based CPA whose firm specializes in marijuana businesses, said that paying taxes, in particular, can be a challenge because of Section 280E of the Internal Revenue Code, concerning expenditures in connection with the illegal sale of drugs, which prohibits any deductions or credits for any businesses trafficking in the sale of such illegal drugs, which—again—includes marijuana, for federal tax purposes. 

Arkley noted, though, that the adjustment of gross receipts, with respect to the effective cost of goods sold, is not affected by this provision. Therefore he tries to fit as many items as possible into this category by using Section 471 of the tax code, which concerns general rules for inventories—something that, he said, the IRS has been shown to tolerate if not exactly condone, given that the technique was outlined in guidance that the service released in January 2015. Arkley’s approach is to treat his marijuana business clients as farmers, because the tax code states that farmers who use the accrual method are required to report inventories, which, in turn, allows them to deduct for cost of goods sold and, in turn, save some money. 

Of course, businesses can’t just indiscriminately move everything into cost of goods sold—items need to be either a direct cost, like labor and materials; indirect costs, like rent, quality control or maintenance; or items capitalized in the financial statement (though Arkley noted that the statement must, however, be in conformance with U.S. generally accepted accounting principles for it to count). 

However, he said that this technique applies only to manufacturers and processors, not retailers, for whom the process is much more difficult. Not as many items can be put into costs of goods sold—mainly just the “cost of the stuff they bought and sold, and that’s it.” While items like the salary of a purchasing manager can be bundled in with this, he admitted that it can be rather meager compared to manufacturers and processors. 

“It’s not a whole lot vs. overall cost of goods sold, but it’s something. As CPAs we have to look at what we can get into cost of goods sold,” he added. 

While difficulties in following the tax code remain, and the ways a CPA can deal with them may be a little esoteric, Arkley explained that, ultimately, these are small businesses just like any other, and they have the same concerns and needs that any small business would have. 

Auditing challenges 

Auditors, too, need to be aware of issues particular to marijuana businesses. Given all the uncertainties and estimates that come with these types of companies, Goldman noted that auditors need to ask themselves whether it’s even possible to get sufficient and appropriate evidence on which to base their opinions. If the uncertainties are material but not pervasive, Goldman said, then the auditor could try giving a modified opinion. But if they are both material and pervasive, then the auditor may need to just disclaim the opinion. Alternately, though it may pain the auditors to do so, they may need to just say that they can’t do the audit given the constraints. 

“Just because a client is required to have an audit doesn’t mean you have to provide that audit. You may [have] decided it is, in fact, a level of risk too high for your firm to take on. I hate saying that because you always try to bend over backwards for your client, but sometimes that’s the right answer for your firm,” she advised. 

The possibility that the government may simply come in and shut a business down is something that needs to be in the back of the minds of CPAs when assessing how confident they are that a client can continue as a going concern.“ This may mean your report will have to disclose, or make an emphasis-of-matter paragraph ... about, substantial doubt; you may need to have disclosures in your statement about it,” Goldman said. 

‘Client naiveté’ 

In addition, many of the risks associated with marijuana businesses can come from what Will called “client naiveté.” Some people, he said, enter the business more because they think it’s cool than because they know how to run a company. He said it’s important to impress upon clients that at the end of the day, they are running a business and cannot afford to go into things with blinders on. 

So, for example, he said to make sure clients use the e-verify process—a database run by the Department of Homeland Security that allows businesses to verify that their workers are eligible to work in the United States, as they do not want to give the federal government a reason to be looking at them for possible immigration issues. Similarly, CPAs should make sure that the client is properly managing things like Forms 1099 and W-9. 

However, Will stressed the importance of CPAs protecting themselves, too. CPAs considering taking on a marijuana business as a client should first perform their own risk assessment to determine whether it’s even worth it having this client. If they do take the client on, he said, the CPA should have a detailed engagement letter written, explaining not only everything they’re doing but everything they’re not going to do. Also, he said, get a retainer up front: This is a risky engagement, and the CPA should get money up front so that her independence and objectivity are not impaired. 

“There’s nothing that exotic about these businesses. They’re just small businesses, and most of the things I deal with [are] not 280E [tax issues], but how do I track sales tax, how do I do payroll, things like that. That has been surprising to me. They’re great clients—I love them,” he said. 

New York and other state regulations 

State regulations present another range of obstacles. Hillary Peckham, COO and co-founder of Etain, LLC, one of the five dispensaries in New York state, said that New York’s medical marijuana law is the most restrictive in the country. For those considering setting up a legal marijuana business, the start-up costs will be high. Even setting up a dispensary doesn’t come cheap. In New York state, anyone interested in establishing a registered organization that manufactures or dispenses approved marijuana medical devices must pay $10,000 for the application fee alone, and then leave a $200,000 check as a deposit. 

In addition, the state regulations make staffing difficult because the law states that dispensaries cannot hire anyone with a criminal record. However, she said, the ones with the most expertise in this field are the people who have been active in the industry prelegalization, meaning that only inexperienced people are available. She pointed out that New York law allows them to make only extracts—her company cannot sell flowers or buds—and so, she can only make things like capsules or tinctures, and she reiterated that the hiring restrictions can make it difficult to find people who know how to do this well. 

“We had to assemble a team of people willing to do something that had never been done before: to make a pharmaceutical-grade product for patients with pharmaceutical standards, and really, there are people starting to do this, but it was difficult to find people with the expertise,” she said. 

Then there’s simply the fact that, given restrictions on patients and doctors, New York dispensaries don’t have a lot of customers. Patients can have marijuana prescribed only for severe conditions like cancer and HIV, and even then, can access it only on the recommendation of a doctor who has taken a course on medical marijuana. Peckham said few doctors have actually taken this course— statewide, only 800 of New York’s 80,000 doctors have done so. Those 800 doctors have little competition, she said, so they are able to charge patients $300 to $1,200 per visit before they’ve even picked up any marijuana. Patients then have to pay for it out-of-pocket because insurance won’t cover it. She also pointed out that, given the severe conditions that qualify someone for medical marijuana, roughly 5 percent of patients die every month, which leads to a lot of internal turnover from workers who simply can’t deal with that amount of hardship and death. 

She disclosed that when her business opened its doors at the beginning of 2016, it only had 45 patients statewide, most of whom were in New York City, while her company was based upstate. She said that if the industry is to thrive in New York, then some of the more burdensome regulations need to go and the program needs to expand to allow more people to be eligible. 

“Steps they’re taking to expand the program [are] essential because no one is profitable in New York and no one has proven you can make this a profitable model,” she said. 

By contrast, Colorado, which legalized recreational marijuana in 2012, has a much stronger marijuana industry—data from the state’s Department of Revenue found that tax revenues from the industry total nearly $1 billion dollars. Seigneur said that the state has 1,200 licenses, 573 dispensaries, 470 cultivation facilities and about 100 infused-product testing labs. 

Marijuana businesses there have to deal with the same state-federal split that bedevils similar companies in other states, as well as state-municipality splits. For instance, while Denver has 139 of the 573 total dispensaries in the state, towns just a few miles away have absolutely none and are actively against hosting them. But other municipalities are enthusiastic adopters of the industry—he mentioned a small city called Edgewater, which has two police officers and 24 dispensaries. 

“They are paving their streets with cobblestones because they’ve got so much money,” he said. 

With the recent legalization of marijuana social clubs in Colorado, he said, municipalities are now also wrestling with issues such as where the drug can be smoked—mayors are weighing whether it should be allowed in, say, bookstores or cafes or coffee shops. 

Colorado monitors pesticide and microbial testing, implements packaging controls and has recently started discussing labeling requirements and portion control, Seigneur said. He cited a piece by New York Times columnist Maureen Dowd, who came to Colorado and ate a pot-laced candy bar, unaware that it consisted of 16 portions. He contrasted Colorado, which has a mature industry now, with states like New York, which only recently legalized marijuana for medical use. 

“It’s interesting to see where New York is today, and while I can only imagine [where] it will be next year or after, maybe there’s a lesson to be learned,” he said. 

Some in New York are eager for the state to learn from Colorado. Another of the panelists, New York state Sen. Liz Krueger, a Democrat and a ranking member of the Senate Finance Committee, said that she has a bill that would legalize marijuana for recreational use. She said that she, herself, does not consume marijuana, nor does she drink alcohol or smoke cigarettes, but believes that full legalization is important from a criminal justice angle. 

“The biggest problem with the criminalization of marijuana in our state, as far as I can tell from my research, is it’s destroying young people’s lives, disproportionately young people of color,” she said. She said that the current policy is costing $400 million a year for police time, court time, legal costs and jail costs, all in order to “drag young people, disproportionately of color, through a criminal justice system that has [an] enormously negative impact on their lives, their [families’] lives and may lead to the inability to be eligible for the kind of education and jobs they need,” she said. 

cgaetano@nysscpa.org 

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