On January 1, 2018, California will join states like Colorado, Oregon and Washington in the regulation and taxation of cannabis for both medical and non-medical use. Cities and counties across California are looking to cannabis businesses as a source of additional tax revenue. This strategy is the logical choice for meeting the expected expenses associated with regulating cannabis use at a local level. At a maximum, it has the potential to help ease cost pressures in other areas of the budget. Meanwhile cannabis business owners are seeking to understand how taxes and local ordinances will affect their businesses.

What can we Expect?

The legalized sales and use of cannabis in the U.S. is a relatively recent development that has continued to pick up steam. Currently, there are four states where non-medical cannabis is legal to use, and is being taxed. California is unique in that both its population and economy far exceed comparable situations in Colorado, Oregon and Washington. Examining tax revenue from these states provides some guidance on what California currently expects:

  • Colorado
    Population: 5,500,000
    2016 Cannabis Tax Revenue: $119,000,000
  • Oregon
    Population: 4,000,000
    2016 Cannabis Tax Revenue: $60,200,000
  • Washington
    Population: 7,000,000
    2016 Cannabis Tax Revenue: $185,000,000
  • California
    Population: 39,000,000
    Estimated 2018 Cannabis tax revenue: $1,000,000,000

Opportunities for Revenue

The potential for increased tax revenue, not to mention other benefits to public safety, increases to employment and other economic stimulus, comes hand-in-hand with increased cost to regulate and control the industry. Given that the amount of increased tax revenue isn’t expected to make the state or local agency budgets balanced or net positive, opportunities must be sought to pay for and offset the additional expenses incurred from the regulation, growth, distribution, and use of cannabis. This may come from taxes on cannabis, and can also be looked at through other costs that will be reduced by implementing a robust regulatory framework. Creating a regulatory tax system is critical not only to promote fiscal strategies but it can also be helpful to provide motivation for cannabis businesses to comply with safety and control policies related to the plant, its derivatives and its distribution.

Successful Revenue Raising in California

One successful example in balancing revenue raising and regulatory compliance was the City of San Jose, California. In 2010, after the significant impact on the financial health of state and local governments due to the fallout from the great recession, the City of San Jose was exploring budget balancing strategies. At this time, Scott Johnson (Partner and State and Local Government Practice Leader at partner firm MGO) was Finance Director of the City. Scott participated in the City Manager’s budget balancing Task Force, which initiated a number of teams to explore budget balancing strategies. Scott facilitated a “revenue generation team” (RGT), which developed a number of revenue raising strategies to bridge the city’s budget gap. Scott presented the findings to the Mayor’s General Fund Budget Deficit Task Force and then to the City Council. The City Council directed them to pursue a number of revenue strategies, one of which was to implement a cannabis business tax. After working with the police and planning departments and the City Attorney’s office on regulations and enforcement policies, Scott presented a strategy to the City Council to develop a ballot measure for the voter’s to consider establishing a business tax on gross receipts on all medical and non-medical marijuana related businesses. After working with the City Attorney’s Office in drafting a ballot measure and marijuana business tax ordinance, San Jose’s voters overwhelmingly approved the tax during the November 2010 election (at a rate not to exceed 10% of gross receipts).

Once the ballot was approved, a work plan was put into place to develop an outreach and training program for cannabis businesses. The Council also approved permit and regulatory fees – to recover the City’s costs for the permitting and regulatory efforts. In addition, the finance team developed an audit program for compliance of medical marijuana dispensaries on state and local medical marijuana laws, including the City’s marijuana business tax. The City currently collects over $4 million per year from the tax.

Challenges Created

State and federal governments are conflicting on the legalities of cannabis. In fact, from a federal standpoint, cannabis is still a controlled substance. Under federal law, it is illegal for financial institutions to take money for cannabis sales if they depend on the Federal Reserve. Because of this, banks are avoiding funds earned through dispensation of cannabis. Although there is clear guidance as to how banks can provide services to businesses that service the cannabis industry, leveraging compliance with the Cole Memo and FINCEN guidance, many still remain wary, at a policy level. With few exceptions, the mainstream banking industry has chosen to completely avoid working with such businesses. The lack of banking services forces the business to primarily work in a cash-only system, creating other cash management, transparency and public safety problems. Cash businesses increase the opportunity for fraud and criminal activity as well as creating difficulty for taxing and regulation. Because cannabis dispensary businesses are identified as cash-heavy, they become easy targets for theft and burglary, increasing the cost on a local law enforcement level. In addition, engaging in the enforcement of tax laws associated with cannabis can result in a variety of negative consequences such as loss of revenue, public safety, and threats to other businesses can create problems.

IRS Issues

Although complicated, the IRS has continued to require reporting and payment of taxes from cash businesses, no matter if they are selling magazines at a newsstand or medical cannabis at a dispensary. With dozens of tax audit appeals related to the legal sale of cannabis over the past few years, the IRS continues to be entangled in these contradictory policies, and satisfactory decisions over business deductions and other policies seem to be consistently delayed. Using the IRS as an example of how to handle these issues is probably not going to get anyone very far.

State Legislation

During September 2015, the California Legislature passed MCRSA and establish California’s comprehensive regulatory framework for medical cannabis businesses. In November 2016, California voters approved the AUMA bill, which overlays a separate and different regulatory structure for the non-medical cannabis industry.
California’s legislators are seeking to unify the two laws with a Trailer Bill, which will create a single regulatory framework for cannabis. The Trailer Bill (viewable here) is currently under review and open for public commentary.

Currently, businesses are prohibited from engaging in commercial cannabis activity without processing both a state license and a license or permit from the local governments. Local governments have the authority to enforce provisions in the state law and to adopt ordinances that establish additional standards for local licenses and permits for commercial cannabis activities. With the expanded responsibilities in regulating commercial cannabis activities, local governments also have the opportunity to increase its revenue base by taxing such activities.

One change in the Trailer Bill include an effort to unify conflicts between state and local licensing concerns. With 58 counties and over 480 cities in California, there are expected to be conflicts navigating the different ordinances governing localities. As proposed in the Trailer Bill, local governments will maintain autonomy in establishing zoning and planning decisions and have a responsibility to work with state regulators to maintain a database of all ordinances governing cannabis throughout the state.

Moving Forward

One reasonable goal is to treat enterprises operating in the cannabis industry in a way that is universal and consistent with other comparable businesses, while providing revenue for the localities where it is cultivated, produced, bought and sold. But there is much to be done to get to that place. In the meantime, what is the course of action?

A recent article from the Brookings Institute illustrates that guidance from Washington is getting more conflicted – pushing the industry further away from a banking solution. Municipal governments do not have the luxury to wait for the federal government to resolve these problems. Instead, those responsible for their own local areas need to take it upon themselves to create workable solutions.

The guidance of the Blue Ribbon Commission to “engage the federal government” on the banking issue provides little assistance to business owners and public administrators who have to deal with the dangerous realities of a burgeoning cash business.

As government executives and cannabis business owners continue to tread these murky waters, there remains a need to identify best practices and controls that work in other municipalities–whether related to the cannabis industry or other cash-intensive businesses. Diligent research and candid conversation exist as vital parts of the ongoing effort toward a workable solution. It is clear that additional solutions are needed, at the federal, state and local level and standard “best practices” to be developed that “level the playing field” with well thought out compliance audits and risk assessments to ensure that businesses are in compliance and state and local coffers receive what is due from the industry.

The advisors at ELLO have deep experience working with both cannabis businesses and state and local government entities. Reach out to our team if you are in need of professional guidance navigating, or establishing, cannabis compliance ordinances.

About the author(s)

Evan Eneman
Evan has more than 18 years of experience assisting private and public companies in a variety of industries including Cannabis, Financial Services, Healthcare, Technology, Media, and Entertainment. His areas of expertise include: strategy, compliance, enterprise risk management, business process, internal controls, audit, governance, and IPO readiness. Evan also has experience founding and running an early stage venture capital firm and a branding and marketing agency dedicated to the cannabis industry. Prior to his involvement in the cannabis industry, Evan spent 12 years with a Big Four firm, advising Fortune 100 and emerging growth companies on various aspects of governance, risk, compliance, operations and strategy.