An Ounce of Prevention Can Stop Financial Distress

April 7, 2023 · MG Magazine

It’s a challenging time for cannabis businesses around the country. But for those of us who have been involved since the beginning, what else is new?

Today, legal markets exist at some level in the majority of American states. However, they operate amidst a mess of restrictive and confusing regulations that can make it difficult for businesses to survive, let alone operate profitably.

Numerous factors affect profitability in the industry, including state regulatory structures, federal prohibition, taxes, lack of access to financial services, and much more. It’s critical for cannabis businesses to understand these challenges and learn how to navigate the rocky terrain to avoid devastating financial outcomes.

It is true momentum is building behind efforts to reform federal cannabis laws. At the end of October 2022, Senate Majority Leader Chuck Schumer (D-NY) announced bipartisan efforts are underway on a bill that would expunge criminal records and allow financial institutions to engage with and lend money to cannabis companies—along the lines of the Secure and Fair Enforcement (SAFE) Banking Act, with revisions being called “Safe Plus”—but no further progress has been reported.

As it stands, the oppressive fist of federal prohibition sadly dominates how cannabis works (or doesn’t work) in states with legal markets. And one of the most financially challenging aspects of current federal law is how the Internal Revenue Code impacts business taxes under Section 280E. This section defines all “plant-touching” businesses, regardless of state legality, as criminal enterprises “trafficking in a controlled substance” under federal law. State-legal but federally illegal businesses cannot deduct “ordinary and necessary” business expenses after reducing gross receipts by the cost of goods sold, which creates a massive federal income tax liability calculated on gross income instead of net income as in other business sectors.

Additionally, cannabis businesses cannot use standard credit card processing services and have trouble acquiring traditional loans and setting up bank accounts. Most cannot access conventional lines of credit or banking services. They remain underbanked in many states because fees—often considered non-deductible by the Internal Revenue Service—make banking cost-prohibitive. To make matters worse, businesses cannot file for bankruptcy protection under federal law, and the remaining options can be expensive. Their best option for salvaging assets from a collapsing company often is receivership, which is simply a way to appease lenders and creditors, not to restructure.

Cumbersome, heavy-handed regulatory systems in legal markets are another prominent reason why so many businesses are financially distressed. In Colorado and California, for example, the cost of doing business is so high—owing largely to onerous regulations and taxation—that business closures and mass layoffs are becoming commonplace.

Other regulatory requirements, such as the inability to transfer products between states, also are detrimental. Products must be produced in the state where they are sold. Another unfortunate byproduct of overregulation and oppressive tax regimes is legacy illicit markets that continue to thrive. Consumers don’t want to pay for legal cannabis if it’s more expensive than illicit cannabis—which it absolutely is in states like California, where legal businesses face particularly high costs associated with regulatory and taxing structures. The sad truth? Overregulation is creating a barrier to success for much of the industry, and punitive tax provisions like 280E are subsidizing the illicit market.

Don’t be surprised if your state’s regulations are poorly thought out and economically inefficient. If you feel like you’re spending way too much time and money simply trying to reach and maintain compliance, you’re not alone. It’s a common issue owing, in large part, to the fact the vast majority of lawmakers who actually draft state regulations don’t know much about cannabis cultivation, manufacturing, or consumers. Beyond that, many legal states still have lawmakers or regulatory “stakeholders” hostile to legalization, who often insist on enacting strict rules and regulations intended to hamper the growth of the industry.

Many people enter the industry without a solid understanding of its unique challenges, what resources they need for success, or any realistic understanding of production. Like anything else that sounds too good to be true, the narrative of a “green rush” overflowing with an abundance of cash is far from true. Sure, some companies are turning solid profits, but many of them are not. And many businesses don’t realize they haven’t actually made any profits until the state or the IRS audits them years later and finds a substantial tax deficiency that may exceed revenues.

And let’s not forget the inflationary and supply-chain issues that have plagued the industry more recently. With the costs of essential goods like food and gas rising, consumers have less disposable income to buy cannabis, and sales have dropped as consumers feel the pinch of inflation. Meanwhile, many cannabis companies are dealing with increased operating costs associated with post-pandemic supply-chain issues.

The bottom line: Always remember cannabis is a commodity with varying, uncertain returns. Better yet, make sure your leadership team includes qualified, experienced professionals who understand the financial risks of running a cannabis business. At the end of the day, the companies that manage to survive economic downturns are the ones best positioned to prosper when the economic picture improves. (Full Story)

In category:Finance
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