Counting on Cannabis

How CPAs and financial professionals can navigate the fast-changing world of weed. By Lisa Wilder | Summer 2020



On Jan. 1, 2020, a near-lifetime ago given the explosive health and economic developments since, Illinois became the 11th state to legalize recreational cannabis for adult use. Compared to the COVID-19 pandemic ravaging industries and markets across the globe since March, dispensary-sold recreational cannabis seemed destined for mid- to low-point status in Illinois’ economic yearbook— except for one thing.

All that money.

According to the most recent numbers, in the first four months of 2020—including the April lockdown month where monthly sales were the highest on record yet—Illinois dispensaries sold nearly $150 million of legal recreational cannabis.

That’s $150 million of recreational weed from roughly 50 licensed sellers, with a planned 75 more on the way in the coming months. In 2019, estimates put the size of Illinois’ total recreational cannabis business at $2 billion. Yet, for Illinois accounting firms, there’s much more to serving this industry than simply taking on a rich new vein of business. Even though two-thirds of Americans support marijuana legalization, in accounting, cannabis is complicated.

“Even as federal legalization has gotten closer, ethical, cultural, and promotional dilemmas have always defined cannabis work within the accounting industry,” explains Nathan M. Summers, CPA, principal with Miller Cooper & Co. “Cannabis is still illegal on the federal level as it is classified as a Schedule 1 substance, and while any businesses touching the plant itself may be completely legal in Illinois, they’re currently breaking federal law. That has tax implications, and most importantly, it means federal banks still can’t get involved for business or payment services, so these are primarily cash businesses.”

Add a complex tax and regulatory framework that’s still in flux, potential PR risk to firms, and a considerable need for cannabis industry expertise within the accounting industry itself, and Summers concludes there are “real challenges for firms new to the cannabis industry.”

However, whatever the obstacles in this fast-moving industry, firms shouldn’t rule out a business with a controversial history. Besides the current boom in recreational weed, cannabis businesses may open opportunities in agriculture, textiles, food, beverage, and consumer products, and eventually a more conventional financial and supply chain ecosystem for such businesses to operate in. And it should be noted that many of the dispensaries now in Illinois’ legal recreational cannabis business have been selling medical marijuana since late 2015.

In short, Summers says now might not be a bad time to get in on the ground floor.

Right now, the market for state-by-state legal recreational cannabis is eye-popping. In 2019 alone, the industry jumped nearly 46 percent to $14.9 billion in sales after a relatively modest 17 percent jump in 2018, and global consumer spending for cannabis flower (the smokable part of the cannabis plant) as well as extracts from other parts of the plant are projected to hit $32 billion by 2022, according to a January report from Arcview Group and BDS Analytics. With those projections and the shifting political landscape, 2020 could be a pivotal year for cannabis.

“With this being an election year, we’re not likely to see any major changes to cannabis legislation in the next quarter,” Summers predicts. “But if you get a new regime in Washington, I think things could change very quickly.”

Even so, there are several developments—some very recent—that could have a wide-ranging impact on new and future cannabis industry clients.

WHAT TO WATCH

Increased Federal Scrutiny

In late March, the U.S. Treasury General for Tax Administration released a report with a straightforward title: “The Growth of the Marijuana Industry Warrants Increased Tax Compliance Efforts and Additional Guidance.” In it, the agency recommended that the IRS develop a “comprehensive compliance approach for the marijuana industry” that zeroes in on how cannabis companies have been improperly reporting business deductions and credits under Internal Revenue Code Section 280E covering “expenditures in connection with the illegal sale of drugs.” In other words, cannabis companies can expect more audits.

“This is definitely the biggest hot-button issue in the industry right now, as it potentially may disallow deduction of virtually all cannabis companies’ operating expenses,” Summers says. Under Section 280E, cannabis companies generally are limited to deducting only their cost of goods sold.

Summers notes that there’s “a handful of companies” in the industry that may be found to have significant tax liabilities as a result of not understanding this rule: “I think it is critical for CPAs to have a thorough understanding of how 280E applies to the cannabis industry now and to watch for future changes regarding legalization at the federal level, as well as staying current on IRS court cases.”

The Banking Access Problem

Due to marijuana’s Schedule 1 drug status, conventional banks are restricted from taking on cannabis companies as business clients for regular banking services essential to most companies, such as business and payroll accounts as well as credit card acceptance for B2B and B2C sales.

That’s why cannabis remains largely a cash business and a red flag for the IRS. Until federal law addresses the situation, alternative banking solutions remain speculative, with some advocates even promoting cryptocurrency-based systems as a way to manage all that cash.

However, there is action in Washington on the cannabis industry and its access to the traditional banking system, and it’s at the top of the legislative pipeline. The question is whether the political environment will change enough to get it across the finish line.

Michael R. Hartley, audit quality leader at Crowe LLP, points to two key bills that could change everything—the STATES Act, which would recognize legalized cannabis industries at the state level, and the SAFE Banking Act, which would finally allow federal banks to extend services more easily to the cannabis industry.

“Essentially, SAFE would allow cannabis companies to deposit money in a conventional bank, which would be an enormous breakthrough,” Hartley says. “However, unless marijuana gets off Schedule 1, you’re not likely to see a lot of change, either in the Senate or at the IRS.”

Most experts don’t expect movement before January 2021, when an incoming Democratic president could signal federal legalization soon. But even if President Trump wins a second term, Attorney General William Barr signaled during his confirmation process in 2019 that he did not intend to crack down on legal cannabis like his predecessor Jeff Sessions.

COVID-19 Concerns

As all businesses are operating now with some form of pandemic filter, cannabis companies large and small are dealing with common issues that involve access to capital and product shortages. For CPAs seeking insight into pandemic-related challenges, current public cannabis companies offer a high-level view of the industry. These companies are facing a range of issues related to financing, investment, product cultivation, valuation, and availability, as well as M&A interest from established food, beverage, and tobacco conglomerates looking to the future.

The Valuation Vacuum

Hartley and Summers point out that product valuation skills will become increasingly important in the cannabis industry as it diversifies. Summers says there’s never been a call for historical or benchmarking data in this area before, but CPAs will need it. “You have live plants that certainly add levels of complexity to valuing inventory, and there’s a need for expertise,” Summers explains. “The question is, who will become the valuation experts in this now legal industry and how those services will be provided?”

THE RIGHT QUESTIONS

Accounting firms take on lines of business with varying levels of complexity and controversy every day. Yet, even as cannabis goes mainstream, most experts suggest that leadership, rank-and-file, and even key clients should take part in the earliest discussions of whether providing accounting, tax, audit, or other services to this industry is right for the firm.

Here are some questions Illinois CPAs should consider before they take on cannabis clients.

Working With Regulators

As long as marijuana is grouped with cocaine and heroin as a Schedule 1 drug, CPAs should carefully consider the position of state accounting boards, the Drug Enforcement Administration, the Department of Justice, and other regulatory bodies before wading into weed. While Chicago and Illinois might welcome cannabis businesses, oversight isn’t so lenient at the federal level.

Considering the Risks

Accountants should also ask themselves if their firms are likely to face any additional risks for getting into this business. Potential new danger spots include reputational, financial, or legal risk, effects to malpractice or professional liability insurance, and risks of being disciplined or sanctioned.

It can be helpful to take a look around and see how other CPAs are navigating these issues. Accountants can examine the services other Illinois CPAs are offering cannabis businesses, or even reach out to firms in other states to see how they’ve prevented missteps and what growth opportunities they’ve seen.

Considering the Fit for the Firm

Taking on a new and complicated line of business could potentially have major impacts for any firm. Firms as a whole should have an appropriate level of expertise before entering the cannabis industry. Even if taking on cannabis clients is an unmitigated win, it can change the culture of the firm and the kind of future hires the firm needs. Firms should consider the changes even a best-case scenario could bring and enter the field with a strategy for which services they hope to provide and the long-term growth they hope to achieve.

Summers thinks cannabis is a promising business for CPA firms that are willing to build the time, expertise, and human talent necessary to making it a success.

“We’re going to need CPAs who think outside the box, get creative, and adapt quickly. This industry is moving at 300 miles per hour and often the accounting function is in the right-hand lane going 50,” Summers says. “For some firms, this won’t be the right business. For others that keep up with the details and complex nature of it, there will be opportunities.”