Medical Marijuana Update: Accounting, Ethics & Tax Issues

Transcription

1 Medical Marijuana Update: Accounting, Ethics & Tax Issues Continuing Professional Education Business Valuation Resources October 24, 2012 Jim Marty CPA,ABV, MS Ron Seigneur MBA, ASA, CPA/ABV/CFF, CVA Overview of Topics Introduction and background of my marijuana practice Ethics issues Industry, accounting and tax analysis Valuation issues: cash flow and risk 2

2 How Did I Get Interested In This Practice Area? In the summer of 2009 clients were asking me to look in to the MMJ industry Landlords wanted to know if they should rent to MMJ growers Clients hurt by the economy were seeking advise about the industry Hydroponics shops supplying the MMJ industry wanted me to be their accountant I agreed to look into the industry 3 How Did I Get Interested In This Practice Area? (cont d) Due diligence trip to California in November 2009 Met with Matt Kumin, attorney in the CHAMP case, Californians Helping to Alleviate Medical Problems Met Hank Levy, CPA in Oakland, CA: In 15 years of MMJ in CA the IRS has never santioned a CPA for preparing tax returns for the industry The IRS wants CPAs to help this industry This has been my experience working with the IRS in Colorado Hank and I formed a CPA firm, Bridge West CPAs and Consultants, LLC, to service this industry in all states that have some form of MM or legal marijuana 4

3 Met With Some Of The Marijuana Attorneys In Boulder And Denver Denver Attorneys told me there was a need for accountants to help this industry I started attending industry meetings MMIG Medical Marijuana Industry Group primarily a lobbying group The Cannabis Business Association 5 What My Marijuana Practice Looks Like Today: Prepare tax returns for approximately 70 Medical Marijuana Centers (MMCs) Provide expert witness and valuation services in MMC ownership disputes Assist in numerous IRS audits (very few where I signed the tax return) No CID referrals or significant penalties even though the IRS is vigorously enforcing 280E in Colorado Participating in the first Tax Court Case to be docketed for a Colorado MMC Providing consulting, accounting and audit services in AZ, NM and WA states 6

4 Unanswered Questions Three and a half years after the Ogden Memo, what are the major unanswered questions for CPAs and Lawyers working in the Marijuana Industry? 1. Can CPAs and lawyers work in this industry without crossing ethical or legal lines? 2. Do IRC sections 280E and sections 263A apply to this industry? 3. How can the Marijuana Industry function without banking services? When the Ogden Memo came out in November 2009, Colorado lawyers and CPAs with Medical Marijuana clients were in uncharted territory. We weren t even sure what questions to ask. Today, we at least know what the questions are, but are a year or two away from getting the answers. 7 Ethics Issues For Attorneys And CPAs: Maine This is especially true under the restated position of the Justice Department in the 2011 Memorandum from Deputy Attorney General Cole, which stated, Persons who are in the business of cultivating, selling or distributing marijuana, and those who knowingly facilitate such activities, are in violation of the Controlled Substances Act, regardless of state law. The attorney also faces ethical concerns in representing a medical marijuana business. Model Rule 1.2(d) provides, A lawyer shall not counsel a client to engage, or assist a client in conduct, that the lawyer knows is criminal or fraudulent. the attorney will have actual knowledge of the client s criminal activity by the nature of its business. 8

5 Ethics Issues For Attorneys And CPAs: Maine (cont d) Maine and its sister states may well be in the vanguard regarding the medicinal use and effectiveness of marijuana. However, the Rule which governs attorney conduct does not make a distinction between crimes which are enforced and those which are not. So long as both the federal law and the language of the Rule each remain the same, an attorney needs to perform the analysis required by the Rule and determine whether the particular legal service being requested rises to the level of assistance in violating federal law. It is worth noting that there is no guarantee that, with a change in policy, administration, or resources, the federal law might ultimately be enforced to the chagrin of lawyers whose conduct enabled the dispensaries. Even under the present policy, it is a situation where potential clients may ultimately, if not initially, use the medical dispensary and state law as a pretext for other more lucrative ventures. 9 Ethics Issues For Attorneys And CPAs: Arizona If a client or potential client requests an Arizona lawyer s assistance to undertake the specific actions that the Act expressly permits; and The lawyer advises the client with respect to the potential federal law implications and consequences thereof or, if the lawyer is not qualified to do so, advises the client to seek other legal counsel regarding those issues and limits the scope of his or her representation; and The client, having received full disclosure of the risks of proceeding under the state law, wishes to proceed with a course of action specifically authorized by the Act; then The lawyer ethically may perform such legal acts as are necessary or desirable to assist the client to engage in the conduct that is expressly permissible under the Act. 10

6 Ethics Issues For Attorneys And CPAs: Colorado 11 Ethics Issues For Attorneys And CPAs: Implications for CPAs with Marijuana Business Clients Currently no State Boards of Accountancy, including Colorado, have taken positions similar to the State Bars The Colorado State Board of Accountancy currently has not taken a position. I believe they should take a position one way or the other so CPAs can feel comfortable servicing the Marijuana Industry or leave it The State and local governments across Colorado are rolling out complex taxes and regulations for the Industry. Many of these models are based on $1b in Colorado sales It is a situation where the cities and states need the CPAs and lawyers involved more than we need the Marijuana business 12

7 Section 50: Principles Of Professional Conduct Of AICPA Code Of Professional Conduct ET Section 57 - Article VI - Scope and Nature of Services: A member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services to be provided..01 The public interest aspect of certified public accountants' services requires that such services be consistent with acceptable professional behavior for certified public accountants. Integrity requires that service and the public trust not be subordinated to personal gain and advantage. Objectivity and independence require that members be free from conflicts of interest in discharging professional responsibilities. Due care requires that services be provided with competence and diligence. 13 Section 50: Principles Of Professional Conduct Of AICPA Code Of Professional Conduct ET Section 53 - Article II The Public Interest Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism.01 A distinguishing mark of a profession is acceptance of its responsibility to the public. The accounting profession's public consists of clients, credit grantors, governments, employers, investors, the business and financial community, and others who rely on the objectivity and integrity of certified public accountants to maintain the orderly functioning of commerce. This reliance imposes a public interest responsibility on certified public accountants. The public interest is defined as the collective well-being of the community of people and institutions the profession serves. 14

8 Section 50: Principles of Professional Conduct Of AICPA Code Of Professional Conduct (cont d).02 In discharging their professional responsibilities, members may encounter conflicting pressures from among each of those groups. In resolving those conflicts, members should act with integrity, guided by the precept that when members fulfill their responsibility to the public, clients' and employers' interests are best served. 15 Colorado State Board Of Accountancy Rules 9.13 Incorporation of AICPA Code of Professional Conduct A. In addition to these Rules of Professional Conduct, the Board adopts and incorporates by reference the AICPA Code of Professional Conduct included in the AICPA Professional Standards effective June 1, 2012, as provided in Chapter 1. These Rules do not include amendments to or later additions of the AICPA Code of Professional Conduct included in the AICPA Professional Standards. All Licensees must comply with the Board s Rules of Professional Conduct and the AICPA Code of Professional Conduct in the performance of Professional Services. 16

9 9.3 Integrity And Objectivity Section Colorado State Board Of Accountancy Rules A. A Licensee shall not engage in fraud, deceit, or any form of dishonesty in connection with or relating to offering or providing a Professional Service, including, but not limited to, knowingly obtaining or exercising control over anything of value without authorization, as a result of, in connection with, or otherwise relating to offering or providing a Professional Service. B. A Licensee shall not engage in fraud, deceit, or any form of dishonesty in relation to the Board, including, but not limited to, any act or omission, any response, representation, application, form, or communication with or to the Board whether oral or written. C. A Licensee shall not knowingly misrepresent facts or subordinate their judgment to others. 17 Recent Legal Articles Published Federal Income Taxation of Medical Marijuana Business Prof Edward J Roche, Jr. Associate Dean and Professor of Law, University of Denver Sturm College of Law Tax Lawyer, Vol.66, No. 2 Practitioners should not run into trouble for preparing tax returns as this assists the MM client in satisfying a legal requirement, but Could giving tax advice leave a CPA or attorney open to an aiding and abetting or coconspirator charge? Prof Roche concludes that this issue is not free from doubt. 18

10 Recent Legal Articles Published Marijuana Lawyers: Outlaws or Crusaders? Sam Kamin & Eli Wald, University of Denver Sturm College of Law, Legal Research Paper Series, Working Paper No , by Prof Edward J Roche, Jr. Associate Dean and Professor of Law, University of Denver Sturm College of Law Tax Lawyer, Vol.66, No. 2 This research paper delves deeply into the aiding and abetting and coconspirator issues U.S. v. Peoni, Judge Learned Hand for aiding and abetting to apply the associate with the venture, wishes to bring it about, make it succeed. Criminal law in the US has long been loathe to use criminal sanctions to enforce ethics, such as non reporting of a crime in deference to American individualism. Similarly for coconspirators, it is not enough that the defendant knowingly associate with others for criminal purposes, it must be shown that she intends to achieve those criminal goals. a majority of states require true intent. 19 Recent Legal Articles Published (cont d) Marijuana Lawyers: Outlaws or Crusaders? Kamin & Wald So where does this leave attorneys and CPAs working in the marijuana industry? Though rare, cases of lawyer prosecution many times involve securities fraud or attorneys working directly for organized crime families. prosecutors may fear interfering with or undermining attorney client relationships. The authors revisit rule 1.2(d) of the ABA Rules of Professional Conduct and the AZ and ME ethics statements and notes the lawyers (and CPAs) are regulated by the states. 20

11 Rule 1.2 A lawyer shall not counsel a client to engage, or assist a client, in conduct that the lawyer knows is criminal or fraudulent, but a lawyer may discuss the legal consequences of any proposed course of conduct with a client and may counsel or assist a client to make a good faith effort to determine the validity, scope, meaning or application of the law. 21 Recent Legal Articles Published (cont d) Marijuana Lawyers: Outlaws or Crusaders? Kamin & Wald The authors believe that a strict reading of this rule fails common sense, The rule fails to define the terms council and assist and the meaning of discuss is less than clear, If all a lawyer can do in criminal matters is discuss the consequences of the conduct It would seem that Rule 1.2 forbids an attorney from drafting contracts for a MM business or assisting in the preparation of a Marijuana license 22

12 Recent Legal Articles Published (cont d) Marijuana Lawyers: Outlaws or Crusaders? Kamin & Wald The Maine rule confronts the significance of risk to an attorney when his client is committing a Federal felony everyday. The Arizona rule is more concerned with access to the law and a lawyer s role and duty to provide services and help clarify the law. 23 Arizona Ethics Committee Holding Legal services are necessary or desirable to implement and bring to fruition that conduct expressly permitted under state law. In any potential conflict between state and federal authority, such as may be presented by the interplay between the Act and federal law, lawyers have a critical role to perform in the activities that will lead to the proper resolution of the controversy. Although the Act may be preempted by federal law or otherwise invalid, as of this time there has been no such judicial determination. 24

13 Recent Legal Articles Published (cont d) Marijuana Lawyers: Outlaws or Crusaders? Kamin & Wald The authors conclude that in a highly regulated society, first class citizenship and the ability to act autonomously under the law requires access to the law and, therefore, lawyers. when a state chooses to regulate a particular conduct, in this case cultivation and sale of marijuana, access to the law becomes a necessary aspect of implementing this policy decision. 25 My Opinion My thoughts are that access to lawyers and CPAs by the Marijuana Industry is a matter of public policy. The IRS, Colorado Department of Revenue and the various cities and local governments across Colorado are rolling out complex taxes and regulations. Implementation will be impossible without the participation of the lawyers and CPAs While State ethics rules don t fix the problem, at the Federal level they do provide some cover. 26

14 Safe Harbor My safe harbor proposal is simple and I encourage all State Boards of Accountancy with legal Marijuana to adopt some form of it. CPAs should not accept any ownership or invest in a Marijuana business No contingent fees No participation in the profits of a Marijuana business Fees for services to assist these businesses with tax and regulatory rules will be allowed including audited and reviewed financial statements as required by several states Consulting services should be allowed for assistance with compliance. Compliance consulting should be broadly defined to include operational as well as financial and tax compliance 27 Brief History Of Medical Marijuana In Colorado Amendment 20 passed in 2000 (Exhibit A) 2009 Holder Memo (Exhibit B) 800 Retail outlets open by 2010 Patients in Colorado increase from a few thousand to 129,000 in June 2011 Currently approx. 103,000 patients registered with the Colorado Department of Health Amendment 64 passes in November 2012 with 55% statewide support 28

15 The Status Of Current Applications There are currently 1,645 active applications for marijuana businesses in Colorado 1,199 have been approved 446 are pending From the Colorado Department of Revenue, Medical Marijuana Enforcement Division website, June Medical Marijuana Registry Program Update (As Of May 31, 2013) Colorado Department Of Health Website Statistics of the Registry include: 220,637 new patient applications have been received to date since the registry began operating in June The total number of patients who currently possess valid Registry ID cards is 105,886 67% percent of approved applicants are male The average age of all patients is 42. Currently forty-one patients are minors (under the age of 18) 59% percent of patients reside in the Denver-metro area (Adams, Arapahoe, Boulder, Broomfield, Denver, Douglas & Jefferson counties), with the remainder of patients residing in counties throughout Colorado. 30

16 Economic Impact Sales tax to the State of Colorado $2.2 million January- October 2011 City of Denver for the same time period $2.2 million Colorado Springs $380,000 November 23, 2011 Denver Post Occupancy needed for over 1600 applications Warehouses for cultivation-not public information Employment: 10-15,000 employees Wages: $15 per hour for budtenders (cannabis consultants) $60-80,000 per year for gardeners Background checks for key person if share in profits and losses 31 Colorado Medical Marijuana Dispensary Retail Sales And State Sales Tax Fy 2012 Sales State Sales Tax Collected Total $199,118,715 $ 5,409,622 Average sales per patient $1,900 Consumption per patient 7.6 ounces per year at $250 per ounce How much will sales increase with retail adult sales 2x 3x 5x? There are 3.5 million adults in Colorado, what percent will use marijuana? 10%? 20%? 40%? If 20% of adults use marijuana, it s a $1.3B industry not counting the tourism trade 32

17 Gross Profit For The Mm Industry 33 IRS s View Of An Illegal v. A Legal Business Legal Business Sales Cost of goods sold Gross profit Overhead Net income before taxes Income taxes Net income Illegal Business Sales Cost of goods sold Gross profit Net income before taxes Income taxes Net income 34

18 Tax On Gross Profit MMC Liquor store Sales 1,000,000 1,000,000 Cost of goods sold 333, ,000 Gross profit 667, ,000 Retail overhead 250, ,000 Income taxes on GP at 40% 266,800 92,000 Net Income after taxes 150,200 13,000 Effective tax rate 63.98% 35 Understanding The Trial Balance Of A Typical Medical Marijuana Center Sale tax returns and reported revenue Depreciation issues, capitalized garden improvements Cost segregation studies Adjusting inventory for weight on hand at year end Inventory is defined as dried, weighed and bagged (Medical Marijuana Enforcement Division, Colorado Department of Revenue) Can be at OPC or Center Valued at estimated cost to grow Can Include 263A allocated costs (undecided at this time) 36

19 Understanding The Trial Balance Of A Typical Medical Marijuana Center (Cont d) Separating labor based on job descriptions Analysis W-2s and 1099s Other costs, state and local licensing fees The IRS uses reasonableness tests in audits-build up sales from COGS 37 Elections On Initial Tax Returns Farmer or manufacturer? Not mutually exclusive, example: a bread factory Business code and other presentation issues: all other miscellaneous health practitioners This will change for legal retail in CO and WA Electing 263A-can t be elected by taxpayer if not required Per the IRS can only be used for manufacturing costs and Retail costs cannot be allocated Forms 8275 and 8275R have been helpful on audits 38

20 IRS Issues And Audits Minimizing non deductible expense under IRC section 280E Square footage allocations vs. the stop watch method-both rejected by the IRS Overhead after 263A allocation not deductible Is overhead deductible for Colorado tax purposes? Yes, beginning January 1, Balance Sheet Issues A typical MMC with and OPC trial balance Assets are typically cash, inventory and fixed assets and security deposits Security deposits can be large as landlords compensate for risk 40

21 Balance Sheet Issues (Cont d) Section 179, qualified retail for 15 year life and bonus depreciation should be considered May want to elect out of bonus and elect straight line depreciation to preserve deductions for new partners who can use the write-offs in the future, especially for retail assets And 280E may be amended for State legal business 41 Balance Sheet Issues (Cont d) Liabilities are sales and payroll taxes payable and accounts payable Loans are generally from family members or private sources, no bank loans Loans need to be documented and have recourse if being used for basis Regulators want to know where capital came from 42

22 Balance Sheet Issues (Cont d) Equity sources need to be documented Client should confirm names addresses, social security numbers and percentage of ownership of partners or shareholders each year Get documentation for initial capital contributions and changes in ownership 43 Income Statement Issues Sales, tie to Sales tax returns Sales tax returns should also report wholesale sales Sales tax returns have been very helpful with IRS audits looking for unreported income 44

23 Income Statement Issues Expenses, IRS can and has accepted verbal testimony at audits for medicine purchased for cash with no receipts based analytical review (build down from sale) Not and issues where growing is required or allowed in regulated marijuana markets Payroll, no place for 1099s in current regulatory system 45 Income Statement Issues Important to categorizing all costs of growing (garden) in COGS Warehouse rent, and utilities are major costs of growing Labor- job descriptions on all W-2s and 1099s Supplies, clones, beds nutrients and soil Depreciation on garden build outs and equipment (lights) should be posted to COGS even on Sch. Cs Don t want to have classification an issue on audits 46

24 Income Statement Issues Overhead related to garden should be minimal and generally not deductible under 280E Marijuana Infused Products Manufactures Hashes, oils, edibles, candies and baked goods Should allocate part of COGS to ending inventory under 263A Retail overhead-big issue, is it deductible? 280E came out 13 years before California had MMJ Applying 280E to a legal retail business affects other areas of tax code like basis 47 IRS s View Of An Illegal v. A Legal Business Legal Business Sales Cost of goods sold Gross profit Overhead Net income before taxes Income taxes Net income Illegal Business Sales Cost of goods sold Gross profit Net income before taxes Income taxes Net income 48

25 Three Ways To Calculate 280e Non Deductible Expenses Ignore it and don t disclose the business is MMJ related Call the IRS and ask what to do-no overhead applies Allocate retail overhead to legal and illegal activity Include Form 8275, skip not deducting overhead Use Form 8275R if deducting all overhead expenses 49 Tax On Gross Profit MMC Liquor store Sales 1,000,000 1,000,000 Cost of goods sold 333, ,000 Gross profit 667, ,000 Retail overhead 250, ,000 Income taxes on GP at 40% 266,800 92,000 Net Income after taxes 150,200 13,000 Effective tax rate 63.98% 50

26 Are Partnership And Schedule C s Better Than S-Corps? W-2s for an S-Corp could be taxed twice when 280E is applied Basis issues for third party loans Flexibility for division of profits and losses Guaranteed payments can produce same results as W-2s double taxation This is an example of how 280E conflicts with other areas of the tax code like reasonable compensation 51 Selling Expenses o Advertising and cannabis consultants could be considered selling costs and therefore non- deductible under 28OE and are not able to be allocated under 263A o Cannabis employees should tract their time carefully. 52

27 Credits Colorado EZ credits Manufacturers section 199 deductions info to K-1s R&D credits 280E applies to credits 53 Valuation Issues Cash flow analysis Vetting forecasts Tax effecting the cash flow Possible liability for IRS audits, how is 280E handled? Risk factors unique to the marijuana industry 54

28 Valuation Issues PV=CASH FLOW (ECONOMIC BENEFITS)/RISK (DISCOUNT RATE)-g This is true for the value of any asset Also true of a marijuana business 55 Valuation Issues Cash flow analysis is the same as any business Net income after taxes Plus Depreciation Less Capital expenditures Plus/minus Working capital requirements Equals Enterprise cash flow Less Debt service Plus Loan proceeds Equals Cash flow to equity 56

29 Valuation Issues: Things That Can Effect The Cash Flow Of A Marijuana Business Plants in the ground and growing capacity Crop failures If you grow it you can sell it Vetting cash flow forecasts: ask management about anticipated harvests and garden expansion plans Marijuana generally has a 90 day growing cycle from seed or clone to harvest Three to four harvests a year 57 Valuation Issues Tax effecting the cash flow Generally apply marginal tax rates to gross profit Unrecorded tax liabilities: how has client dealt with IRC section 280E Inquire about IRS audit results, IRS notices and ongoing IRS audits C Corp vs. flow through entities 58

30 Valuation Issues Risk factors: marijuana businesses are committing felonies daily Department of Justice guidance memo of August 29, 2013: does this reduce risk? Discount rates should be similar to a high tech start up business: 30-45% Key employees: is the main gardener an owner? Do owners have business experience? Leases: iron clad with options to renew? Is their bank financing on the property? Cash payments: are 1099s issued? Internal controls over cash and inventory? 59 The End 60