Field of Hemp

Congress has passed the 2018 Farm Bill by an overwhelmingly majority and the President is expected to sign it into law. The Farm Bill has huge implications for the industrial hemp industry because it removes hemp from the federal list of controlled substances and enables farmers to apply for crop insurance. Hemp is a variety of the cannabis sativa plant that contains very low levels – 3 percent or less – of THC found in marijuana, and doesn’t have the psychoactive effects associated with its biological cousin. Hemp has a vast range of industrial uses that include textiles, clothing, plastic substitutes and as an additive to food and drink. Many proponents contend it can also be used to treat conditions such as chronic pain and anxiety. If the President signs the bill, hemp would be regulated by the U.S. Department of Agriculture, much like any other crop, and farmers will legally be able to grow, process and sell the plant and its derivatives such as CBD oil. The Farm Bill presents massive opportunities and a potential boon to the industry that produces and markets cannabidiol, or CBD oil, which has become increasingly popular in recent years. Last year, hemp sales reportedly reached $820 million in the U.S. and that was without it being completely legal. Some analysts now project hemp could grow into a multi-billion dollar industry by 2020 and that the global hemp market could increase to $10 billion by 2025.

In the latest Tax Court opinion addressing the application of Section 280E to cannabis businesses there is no good news. However, there is some new guidance.  In Patients Mutual Assistance Collective Corp. v. Comm’r, 151 T.C. No. 11, the taxpayer made a litany of arguments to convince the court that their business, or a portion of their business was not subject to Section 280E.  These include arguments we have seen before, including (1) that the business was not trafficking in controlled substances, here, because the government had abandoned a civil forfeiture action, and (2) that because a portion of the business involved branding and the sales of non-marijuana products, deductions related to these operations should not be subject to Section 280E.  These arguments failed and only make it clear that similar arguments are likely to be unavailing.  In fact, the Court spends ten pages discussing why the entire business is integrated and subject to Section 280E.  Taxpayers hoping to establish a separate trade or business that is not subject to Section 280E now have clarity, but also an extremely high bar.

New Holdings:  Inventory Accounting Rules

The new developments addressed in this case involve the application of inventory rules to cannabis businesses.  Previous cases focused primarily on the previously discussed arguments and failed to give any detailed guidance on how to apply the inventory rules.  The Court clearly and strongly concluded that the more expansive Section 263A  inventory cost rules do not apply to businesses subject to Section 280E.  The Court reasoned that “if something wasn’t deductible before Congress enacted section 263A, taxpayers cannot use that section to capitalize it. Section 263A makes taxpayers defer the benefit of what used to be deductions-it doesn’t shower that as grace on those previously damned.”  Slip Op. at 53.

The Court’s conclusion is based on the notion that we go back in time to 1982 to determine what is includible in inventory costs.  The Court refers to Treas. Reg. section 1.263A-1(c)(2) which states:

Any cost which (but for section 263A and the regulations thereunder) may not be taken into account in computing taxable income for any taxable year is not treated as a cost properly allocable to property produced or acquired for resale under section 263A and the regulations thereunder. Thus, for example, if a business meal deduction is limited by section 274(n) to 80 percent of the cost of the meal, the amount properly allocable to property produced or acquired for resale under section 263A is also limited to 80 percent of the cost of the meal.

While this reasoning is understandable, if we turn the question on its head, we could also ask whether the section 280E disallowance is determined before or after inventory costs are calculated.  For example, even if there is a meals and entertainment expense that is clearly includible in inventory costs, no one is going to argue that 100% of meals and entertainment is includible in inventory costs.  In this case, you are determining inventory costs and deductions, and then applying Section 274.   So, it is easy to see how those provisions overlap.  However, if inventory costs are determined based on the applicable inventory rules and then Section 280E is applied, then you have a different result because Section 263A expands what can be included in inventory costs, and the remaining deductions are subject to Section 280E.  That result is not inconsistent with the notion that items such as meals and entertainment and penalties are not deducted in determining taxable income regardless of whether they are a deduction under Section 162 or an inventory cost under Section 471 or 263A.

The Harsh Result

It is important to note that the Court analyzed and concluded that the taxpayer was a reseller and not a producer.  Because the taxpayer did not itself grow marijuana, this is not surprising.  The Section 471 rules that apply to resellers do not allow for extensive indirect costs to be included in inventory.  Thus, for businesses that do not produce or manufacture, they will continue to face significant challenges by the IRS if they are including indirect costs in inventory costs.  For cultivators and producers, careful consideration should be given to how the 471 rules apply, depending on the activities of the business.

Still to Come

The Court reserved its analysis of whether penalties apply for a opinion to be issued at a later date.  However, the Court hints that there might be some relief when it states that the overlap between Section 280E and 263A created a “confusing legal environment.”  One can hope that given the lack of guidance addressing the specifics of how the inventory rules apply to cannabis businesses, the IRS and the court will give taxpayers  doing their best to apply Section 280E the benefit of reprieve from penalties.

Other Notes

If you are entertained by Judge Holmes’ opinions, be sure you read the footnotes.  Footnotes 3 and 6 are my favorites.

Jennifer Benda, a Partner in Fox’s Denver, CO office, is an experienced tax attorney who handles tax controversy and income tax planning and compliance matters. She has significant experience assisting companies in the cannabis industry with tax planning and compliance matters.

Tax and calculator buttons

On December 5, 2018, Jennifer will present “Legal Cannabis and Taxes,” a primer on tax issues facing cannabis businesses, including Section 280E, IRS regulations and audits, and related litigation. To find out more about this event and to register, click here. The event will offer important guidance for businesses, attorneys, and accounts alike.

If you can’t make the event, check out Fox Rothschild’s Cannabis Industry State Tax Guide, a comprehensive breakdown for cannabis businesses of the relevant tax provisions in the 50 states and the District of Columbia.

On Tuesday, November 27, Fox Rothschild attorneys Joshua Horn and Joseph McNelis will present “Employment Compliance in the Age of Legalized Marijuana”

This webinar will discuss the conflict between the federal prohibition of marijuana and state marijuana legalization to provide employers with guidance on how to navigate this changing area of the law, develop policies that will comply with both federal and state law, and avoid missteps that can lead to litigation.

Topics will include

• Hiring, Firing, and Reasonable Accommodations
• Zero Tolerance Policies
• Drug Testing
• Federal Contractors, Federal Grantees, and the Transportation Industry

For more information, check out our website and to register, click here. (CLE is available in several states).

You can also review a guide we created (and periodically update) that provides an overview of this topic and practical tips for employers:

Employment Compliance in the Age of Legalized Marijuana

It is not often when an employer defends a FLSA lawsuit by asserting that it is in an illegal business and therefore immune to suit. Sound funny? Well, that is precisely what a Colorado employer that furnishes security services to legal cannabis growers/sellers has pressed on the Tenth Circuit. The employer’s theory is that the workers are not entitled to allegedly unpaid overtime under the Fair Labor Standards Act because their work is illegal under federal law. The case is entitled Kenney v. Helix TCS, and was argued before the Court of Appeals for the Tenth Circuit.

The Company’s counsel argued that the collective action cannot proceed as the FLSA only applies to legal businesses. The lawyer claimed that all job functions engaged in by the workers amount to trafficking in illegal drugs. This case is fascinating because it highlights the tension between a state legalizing cannabis and its continuing illegality under federal law. The lawyer for the Company argued that this controversy entered the “legally ambiguous” sphere in which legal cannabis businesses operate.

The named plaintiff, an armed security guard who guarded growers and sellers, claimed he worked overtime many weeks and was not paid properly. He sought class certification for all such guards, going back three years. The Company moved to dismiss, arguing that the employee’s work (as he was dealing with a Schedule 1 drug under federal law) violated the federal Controlled Substances Act and was thus outside of FLSA coverage.

The district court Judge denied the motion and observed that other courts have not endorsed this concept. The Judge noted that in other cases involving businesses that violate federal laws, e.g. immigration, courts have ruled that these violations did not mean the businesses could not comply with other federal laws. However, the Judge certified the ruling for immediate appeal and thus it went (quickly) to the Tenth Circuit.

The lawyer for the plaintiff asserted that the FLSA does not have a requirement that employees subject to its jurisdiction must be engaged in “only” legal businesses. There was no outright mention of “lawfulness” in the law and there was nothing in the state statute that voided the dictates of the FLSA.

The Takeaway

Maybe Congress should make an exception to the FLSA for this industry, but it has not done so. Consider the implications of granting the employer’s motion to dismiss—it would be giving a business illegal under federal law an advantage over legal businesses by sanctioning the avoidance of paying overtime.

Hmm. Food for thought…

On November 14, 2018, I will be presenting a Seminar entitled “Cannabis: We Are Not in College Anymore” at the Double Tree Hotel in Reading, Pa. I will be joined by Kevin McGinn, CPA, MST of HBK CPAs and Consultants.

Light bulb symbol composed of cannabis, illustrating concept of cannabis-related patents

The event is co-sponsored by the Berks County Bar Association and the Reading Chapter of the Pennsylvania Institute of Certified Public Accountants, and offers both CLE and CPE credit. At the Seminar, Kevin and I will present an overview of Pennsylvania and federal cannabis law, and provide attendees with both practical and ethical advice on representing cannabis businesses and businesses affected by Pennsylvania’s Medical Marijuana Act.

Registration is still open! For more information, check it our here (for lawyers) or here (for accounting professionals). Hope to see you there!

J.B. Pritzker (Democrat) won the election for Governor of Illinois and will be sworn into office in January 2019. Based on Governor-elect Pritzker’s statements on the campaign trail and the current acquisition market in Illinois, the cannabis industry appears to believe that legalized adult use recreational marijuana is a foregone conclusion and that Pritzker will sign a marijuana legalization bill shortly after taking office, which will legalize recreational marijuana in Illinois.

Pritzker has stated that adult use recreational cannabis could generate as much as $700 million per year in annual taxes. Because Illinois has one of the strictest medical marijuana programs in the country, it is uniquely situated to have an explosive recreational market while also avoiding the perceived negative costs of legalization. Illinois has a real opportunity to become a leader in the industry and to also positively address the unfortunate reality that minorities are disproportionately arrested and incarcerated for marijuana possession.

Assuming Pritzker keeps his campaign promises, Illinois’ cannabis industry is set to take off and become one of the largest markets in the country.

Voters in four states (Michigan, Missouri, North Dakota, and Utah) cast their ballots on initiatives to legalize cannabis for either medical or recreational purposes. The ballot measures passed in Michigan, Missouri, and Utah, but not in North Dakota. Here are some details on each measure:

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Michigan – Proposal 1 

Michigan’s Proposal 1 will allow adults to possess, use, and grow marijuana for personal consumption. The proposal also calls for the creation of a state-regulated licensing process and a tax on the sale of marijuana. The Proposal passed with an overwhelming 71%, making Michigan the first Midwestern state to legalize recreational marijuana, and the 10th state in the country to do so.

Missouri – “One out of three ain’t bad…”

In a somewhat unusual situation, Missouri had not one but three medical marijuana ballot initiatives. The initiatives differed in how each proposed to tax the sale of marijuana, the qualifications for medical marijuana patients, and provisions regarding home growers. The one initiative that passed is known as Amendment 2, which proposed to tax marijuana sales at 4 percent, with the proceeds funding veterans health care programs. Amendment 2 was the only initiative of the three that allowed for home growing of marijuana.

Utah Passes Medical Marijuana

Utah voters approved an initiative legalizing medical marijuana, making Utah the 32nd state to do so. In the lead-up to the election, groups on opposite sides of the issue came together and struck a deal that they will write and pass legislation establishing a medical marijuana program.  So while that deal transformed the ballot initiative into somewhat of a symbolic measure, its passage all but ensures that medical marijuana will soon be coming to Utah.

North Dakota Measure Fails to Pass

North Dakota voters struck down Measure 3, which would have enacted one of the country’s most permissive recreational marijuana laws, allowing residents to grow, consume and possess unlimited amounts of marijuana. According to the Bismarck Tribune, opponents of the measure said it was “poorly written and lacking rules and regulations.” Medical marijuana is currently legal in the state, so future measures may result in the state also adopting full-scale adult use.


Joseph McNelis works in Fox Rothschild’s Blue Bell, PA office and focuses his practice on labor and employment matters. Joe also tracks legal developments in the cannabis industry in Pennsylvania and nationwide. Joe can be contacted at 610-397-2332 or jmcnelis@foxrothschild.com.

In a long fought battle, a Colorado cannabis cultivation operation won its battle against an adjacent property owner when a jury found on Wednesday that the operation of a marijuana cultivation facility did not cause injury to the plaintiff’s adjacent real property.  The plaintiffs initiated the suit pursuant to 18 U.S.C. §  1964, the RICO statute that provides for a private right of action against anyone engaged in a racketeering activities, which includes federally punishable drug activities.  Manufacture, distribution, and sale of marijuana are racketeering activity by definition.

Injury is an essential element of a civil RICO claim.  18 U.S.C. § 1964(c) provides that “any person injured in his business or property by reason of a violation of section 1962 of this chapter may sue therefor in any appropriate United States district court and shall recover threefold the damages he sustains and the cost of the suit.” The Tenth Circuit had previously determined that the cannabis cultivation operation was racketeering activity under 18 U.S.C. § 1962 and that the plaintiffs had the right to a trial to determine whether there were damages to their property.  Both sides provided testimony by experts about whether odors were detectable on the plaintiff’s property and how those odors might impact the value of nearby property.   The jury concluded based on the evidence presented that the operation of the cannabis cultivation did not cause injury to the plaintiff’s property.

The case is Phillis Windy Hope Reilly and Michael P. Reilly v. 6480 Pickney, LLC, Park Walton, and Camp Feel Good, LLC, case no: 1:15-cv-00349 in the U.S. District Court for the District of Colorado.

This post is authored by Fox Rothschild associate Henry Whitehead:

For marijuana businesses operating in California the rules are still very much in flux, as shown by a new set of regulations proposed by state regulators.  The state Department of Food and Agriculture, Department of Public Health, and Bureau of Cannabis Control (BCC) first proposed a set of marijuana-industry regulations in July 2018 and, after a public comment period, submitted revised proposed regulations on October 19th.  The changes are substantial, and impact topics fundamental to operation of a marijuana business, including the following:

  1. Labeling and Packaging – There are substantial changes to the labelling and packaging requirements for both distributors and retailers. As to retailers, the proposed new regulations state that until January 1, 2020 all packaging containing cannabis goods must be tamper-evident, but does not have to be child resistant.  However, all products must be placed in a resealable, child resistant, and opaque “exit package.”   After January 1, 2020, all product packaging must be child-resistant, and the exit package will no longer need to be child resistant or resealable.
  2. Marijuana Deliveries – The new regulations prohibit marijuana deliveries by companies that do not have state-issued licenses. The regulations do allow for “technology platforms,” like the apps Eaze and Weedmaps, to facilitate sales between licensed dealers and customers, but prohibits profit-sharing based on sales.  This prohibition on profit-sharing could impact Eaze and Weedmaps’ business model going-forward.  The new proposed regulations also make changes to the prior set of proposed regulations relating to marijuana delivery drivers, vehicles, and limit to $5,000 the value of cannabis goods that can be carried by a delivery vehicle at any one time.
  3. Ownership Disclosures – Marijuana businesses operating in compliance with California’s regulatory scheme would be required to disclose substantial information about all parties who have an ownership stake in the business. Under the proposed regulations “all entities and individuals with a financial interest” in the marijuana business shall be disclosed to the BCC, and the proposed regulations include specific definitions of what it means to have a financial interest in a cannabis business.
  4. Licensed Events – The original set of proposed regulations limited temporary cannabis events (where cannabis can be sold and consumed on-site) to county fairgrounds. The new proposed regulations allow such events at other venues that are approved by the local jurisdiction.  This means that, if the regulations are adopted, local authorities will have discretion to determine where cannabis events can be held, which could lead to a higher number of such events.

These are only some of the changes to the original draft set of proposed regulations, which have been sent out for a 15-day comment period that runs through November 5th.  The proposed regulations can be found here.  Fox Rothschild will continue to follow California’s marijuana industry rule-making process, as the state’s regulatory scheme may well become a model for other states considering legalizing adult use of marijuana.