The Risks of Cannabis Business And Related Legal Advice

Rinat B. Klier Erlich

Cannabis business varies from state to state and in most cases is in disagreement with federal laws. This article discusses the California state laws, which pioneered the field, and analyses the risk for professionals.

By way of background, in 1996 the Compassionate Use Act was implemented in California authorizing the use of medical marijuana. In 2003 the Medical Marijuana Program Act (MMPA) established guidelines for its lawful cultivation, use, and distribution. In 2015 the Medical Marijuana Regulation and Safety Act (MMRSA) established a regulatory structure for medical marijuana businesses. In 2016 the Medical Cannabis Regulation and Safety Act (MCRSA) was enacted. Later in 2016 the Adult Use of Marijuana Act (AUMA), Proposition 64, passed, allowing for recreational marijuana use and sale. More recently, on June 27, 2017 the Medicinal and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA) was passed, and it combined commercial medicinal and adult-use licensing requirements.

I. Taxes

The taxes for cannabis business are very high and they are also constantly changing. Cannabis businesses are not eligible for California franchise and income tax exemption. Even if they are incorporated as nonprofits, they do not meet the requirements for income tax exemption described in Internal Revenue Code Section 501(c) or California Revenue and Taxation Code (R&TC) Section 23701.

Because California is serious about collecting tax revenues from cannabis businesses and the tax calculations are extremely complex, there are many challenges. This also opens the door to a high volume black market of cannabis business.

An example to constant changes, beginning on January 1, 2018, the California Bureau of Cannabis Control allowed the sale of untested cannabis and product for a limited time. During this transition, the emergency regulations clarify that the distributor collects the cultivation tax when the cultivator sells or transfers cannabis or cannabis product to the distributor. With a few exceptions, cannabis removed from a cultivator’s site is presumed to have been sold and is taxable.

Every six months, the California Department of Tax and Fee Administration must determine the markup. Recently, the CDFTA has determined that the markup from January 1, 2018, to June 30, 2018, is 60%.

II. Licensing

The licensing depends on the business itself. The Bureau of Cannabis Control licenses testing laboratories, dispensaries, distribution and even transportation.

The California Cannabis Cultivation Licensing and the California Department of Food and Drug Administration licenses cultivation.

The California Department of Public Health licenses manufacturing.

In order to determine if a tenant is properly licensed a landlord or property manager would want to have some understanding of the licensing requirements and know what the tenant’s business is. A tenant can be engaged in several businesses at the same time. For example, cultivation and manufacturing.

III. Compliance With The Law

A. Federal Prosecution

Cannabis is a crime under federal law. Marijuana is described as a drug and therefore, cultivation, distribution or possession of any amount of marijuana for any purpose other than scientific is a criminal offense.

The criminal offense includes, landlords and property managers. The controlled Substances Act specifically states that it unlawful to “knowingly open, lease, use or maintain any place, whether permanently or temporarily for the purpose of manufacturing, distributing or using any controlled substance.” Therefore, this includes managing or controlling any such place as an owner, agent, employee, or mortgagee.

Even if cannabis business is approved by the State, a landlord and property manager must adhere to both federal law and to the licensing requirements discussed above. This suggests that property owners should know who they are leasing their space to.

Under the Obama administration, in 2009, the Ogden Memo drafted by the deputy Attorney General reaffirmed the illegality of marijuana however, it noticed that the prosecution of individuals who were in clear and unambiguous compliance with existing state law was an ineffective use of the limited federal resources. The Memo confirmed however, that marijuana related business remained a priority for federal enforcement, even if the business complied with state law. The later Cole Memo confirmed this approach. It stated that the Ogden Memo was not intended to shield such activities. That is, state laws were not a defense to violation of federal laws.

Attorney General Jeff Sessions rescinded those Memos and their perception as adopting a policy of non-interference with marijuana-friendly state laws. Sessions’ move essentially shifted federal policy from the hands-off approach adopted under the previous administration to unleashing federal prosecutors across the country to decide individually how to prioritize resources to crack down on pot possession, distribution and cultivation of the drug in states where it is legal. Sessions directed that federal marijuana prosecution decisions be governed by the same principles that have long governed all prosecution decisions.

B. Forfeiture

The history of forfeiture was to remove the guilty property from the community. It was used as a form of punishment for negligent owners. Under federal law, the Attorney General of the United States can seize real property any time the government has probable cause to believe that the real property is being used to commit a felony violation. This forfeiture has been used as a powerful weapon in the war against drugs since the 70s. The courts’ interpretation of the Comprehensive Act of 1984 has been that no real property may be forfeited, if the activity took place without the knowledge or consent of the property owner. The regulatory scheme of
cannabis through licensing and also through Internet business advertising, made the cannabis distribution more visible. A simple Internet search can identify a property’s use and this would typically satisfy the probable cause requirement for the government. It can also make the landlord or manager’s claims of lack of knowledge less credible.

Forfeiture does not have to be criminal. Civil forfeiture outpaces criminal forfeiture by 83%. It is easier and more effective to purse.

Notwithstanding, some states like Arizona, Maine and Delaware have laws that prohibit discrimination against medical marijuana patient on their status of alone. Those states are less likely to see civil forfeiture. Based on the foregoing, a major risk for a landlord leasing a property to a cannabis business is civil forfeiture, despite the more rare criminal prosecution.

IV. Economic Considerations

A. Insurance

While there are a few insurance companies that insure cannabis operations, the policies are far from perfect. Partially, because cannabis is still illegal under federal laws. If a property owner leases a property to a tenant engaged in cannabis manufacture or distribution there may be gaps in insurance for the risks. Also, the tenant many not be able to obtain renters insurance. Further, the owner’s insurance may exclude certain types of losses. For example, there is no insurance against forfeiture.

B. Banking Institutions

The Bank Secrecy Act requires banks to conduct diligence on their customers and report suspicious activity. Such activity includes cannabis activity. For this reason, many banks do not wish to work with cannabis businesses. Since many institutional lenders do not work with cannabis businesses, this makes it difficult to obtain checks for deposits and security. Dealing with cash payments also puts the landlord at a risk of audit (especially if the rent is over $10,000 a month). Leasing to a cannabis business may also be a violation of the owners’ mortgage agreement.

V. Leases

A. Lack of Control

Once a property owner leases the property, it is more difficult to evict the tenant based on violation of federal law. This means that a property owner will have a difficult time complying with a government cease and desist letter. Other issues landlords may have include, the inability to inspect the premises and ensure compliance with state licensing laws.

B. Modifying the Lease Language

Below are examples to lease clauses that should be considered to better tailor to cannabis rental. It is not suggested that a property manager draft a lease, but many managers and owners use standard lease agreements, which may not be advisable when leasing to cannabis business.For example:

COMPLIANCE WITH THE LAW: Because the main defense to forfeiture is being an innocent owner, a landlord may want to use a provision in the lease that requires a tenant to use the premises “in any manner that complies with federal, state, county, municipal and other governmental statutes and laws, rules, orders and regulations affecting tenant’s use of the premises.’ This boiler plate language alone however, may be insufficient to comply with state laws. A more precise language should be used from the state regulation perspective to include the changing regulations of each state and county regarding licensing and discrimination laws.

PERMITTED USE: Landlords are hesitant to identify any cannabis use in the lease, but because of strict licensing requirements it may be impossible to determine if the tenant violated the lease unless a specific provision is stated by identifying the use. Whether cultivation (what type and what amount), distribution etc.

RIGHT TO INSPECT: A property owner must insure compliance by being allowed to enter and inspect the premises. State laws typically limit access to leased property, so the right to inspect should be modified to allow landlords to inspect and confirm compliance.

INDEMNIFICATION: Standard indemnity agreements may not be enough because they usually only protect damage to the property itself rather than violation of cannabis laws. Indemnity language should also protect landlords from forfeiture.

EARLY TERMINATION CLAUSE: Risks in cannabis operation include, fines for smoke, odor, and loitering. Civil claims for nuisance, foreclosure by the mortgagor and criminal prosecution. An early termination clause is a must, to insure that if the owner needs to terminate the lease it should be able to do so. Ultimately there is a catch 22 that needs to be analyzed by counsel. That is, while the above clauses are suggestions to protect a landlord in cannabis leases, the downside is that they will clearly show that the landlord was aware of the cannabis operation. A landlord should consider the risks with either approach.

Ultimately there is a catch 22 that needs to be analyzed by counsel. That is, while the above clauses are suggestions to protect a landlord in cannabis leases, the downside is that they will clearly show that the landlord was aware of the cannabis operation. A landlord should consider the risks with either approach.