On March 30, the New York State Assembly and State Senate both overwhelmingly passed the Marijuana Regulation & Taxation Act, decriminalizing the use of adult-use marijuana and establishing an office for the regulation of cannabis. The Act permits adults 21 and over to purchase marijuana and grow the plant in their home. By decriminalizing marijuana, the Act is being heralded as criminal justice reform. According to the bill’s sponsor, Senator Liz Kruger, “New York’s program will not just talk the talk on racial justice, it will walk the walk.” Other key provisions of the law include:

• 13 percent excise tax on retail sales: 9 percent to the state, 4 percent to the municipality
• 40 percent of cannabis tax revenues to be spent on education, 40 percent for community reinvestment grants for communities harmed by marijuana prohibition, and 20 percent to drug treatment and public education programs
• Marijuana arrests and convictions legalized under the law to be expunged, and law enforcement prevented from using the odor of marijuana as a pretext for a search
• The opportunity for New Yorkers currently working in the illegal market to obtain one of ten different licenses to work in the new cannabis economy

That new cannabis economy is projected to create $350 million in taxes each year as well as 30,000 to 60,000 jobs statewide.

“The New York approach is interesting and very smart, I think, in terms of taking an assertive criminal justice position as part of the deal,” noted Christopher T. Marrie, HBK Principal and National Co-director, HBK Cannabis Solutions. “That is an element missing in the federal position on legalizing cannabis. It’s going to be difficult to do it without tying it to criminal justice reform.”

Marrie pointed out that, “New York was a very tight market, allowing the sale of extracts only, not flower. It will be interesting to see how the transition unfolds.”

That is expected to take about 18 months, Marrie said. “In the meantime, the State has likely created a huge black market. It’s legalized but not regulated. That’s what happened in Michigan where it was legalized in 2008 but not regulated until 2017. It wound up being regulated differently in every municipality.

“New York City will be a huge market,” Marrie proposed. “Some retailers in the big cities, like Chicago and Philadelphia, are doing more than $25 million in annual sales.”

Marrie also said that he expects the tax rates in New York will increase as marijuana is commoditized. “I expect to see the tax rate rise to 20 or 21 percent,” he said.

The new law comes in response to what has become a huge issue in the state. According to reports, in the 1990s and early 2000s, more than 800,000 New Yorkers were arrested or ticketed for marijuana, more than anywhere else in the world.

The cannabis industry currently looks a lot like a combination of the1940s advent of gambling in Las Vegas and the repeal of prohibition in the 1933. The status of the industry at this point in its evolution has added significant challenges and complexity to valuing cannabis businesses.

Arguably the biggest challenge in the cannabis sector from a valuation standpoint is assessing risk versus return, a practice that due to the unique nature of the cannabis industry, requires a thorough understanding of the industry and its inherent risks.

The following issues should be considered in any cannabis business appraisal engagement; they make industry experience critical to a meaningful and supportable valuation:

• Internal Revenue Code Section 280e
• Banking and cash management challenges
• A relatively new industry
• Jurisdictionally driven
• Location
• Lease
• Regulatory environment
• Lack of reliable market data
• Lack of reliable financial forecasts
• Risk/return challenges in developing cost of capital and market multiples

Internal Revenue Code Section 280e
U.S. Tax Code Section 280E states that, “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” ¹

Cannabis is currently classified as a Schedule I controlled substance. Only cost of sales can be deducted for income tax purposes. The inability to deduct general and administrative expenses leaves cannabis businesses compromised in value compared to other businesses that are allowed to deduct those expenses.

Banking and cash management
As of June 30, 2020, of the nation’s 12,000 financial institutions, only 553 banks and 162 credit unions were servicing cannabis businesses. Because cannabis is a Schedule I substance, any transfer or deposit of money yielded from the sale of cannabis may be deemed “money laundering” in violation of the Bank Secrecy Act (BSA). The Treasury Department has provided guidance on providing financial services to marijuana-related businesses and due diligence practices to follow to avoid prosecution, but many financial institutions have decided it is not worth the cost of compliance. Operating with large amounts of cash creates numerous problems, including greater operating costs and risk of theft.

Traditional sources of capital are rare. Banks are unwilling or unable to lend due to the continuing federal constraints stemming from the Controlled Substances Act, leaving cannabis firms to investments by venture capital and private equity firms. When cannabis businesses find financing, they are often forced to pay significantly greater interest rates than non-cannabis businesses.

A relatively new industry
Dynamic changes continue to take place. Public company cannabis stocks are extremely volatile, as evidenced by the following:

Date	Stock Price
January 31	13.13
February 14	11.10
February 28	9.69
March 13	7.21
March 31	5.82
April 15	7.22
April 30	7.17
May 15	6.38
May 29	7.61
June 15	8.98
June 30	9.71

For a smaller non-public company, fluctuating values are a significant factor in making a sound valuation.

Jurisdictionally driven
The mere location of a cannabis business poses multiple challenges. What are a certain jurisdiction’s requirements and limitations? Are there residency requirements? What are the restrictions on transferability? Can a license holder also hold other licenses or be involved in ancillary enterprises? What are the reporting provisions and how well is the enterprise positioned to comply?

Location. How many competitors are in the area and what is the outlook for new competitors? Can the facility be expanded or redesigned if needed to accommodate license requirements (e.g. medical and adult use sales in the same facility)?

Lease. How solid is the lease arrangement and relations with the landlord, if not operating in owned space? What are the restrictions on hours of business, signage, parking and the like? Who are the surrounding tenants and have they “bought in” to having a cannabis operation as a neighbor? What is the term of the lease and what are the renewal options?

Regulatory environment
Local, state, and federal laws and pending legislation require cannabis and their advisors to maintain a close watch on all this regulatory. What is the current and prospective outlook for regulatory change in the subject jurisdiction?

Lack of reliable market data
As opposed to fair market value, industry transactions made at investment or “synergistic” value where the buyer will pay more to get into a specific market, to acquire a competitor, or for another non-financial reason. The premium paid is difficult to quantify because the business may be worth different amounts to different buyers.

Lack of reliable financial forecasts
The anticipation of future legalization for adult use purposes and the unknown effect on prices adds several degrees of difficulty to forecasting. Knowledgeable industry appraisers understand how to develop realistic forecasts based on analyses of similar markets.

Risk/return challenges in developing cost of capital and market multiples
The greater the risk, the lower the value of a business. To illustrate: The value of a business deemed stable with a cash flow of $100,000 and a 15 percent appraiser-assessed rate of return is $667,000. A second appraiser considering the business riskier than the first and assessing a 17% rate of return results in a value of $588,235. Due to the lack of reliable forecasts, among other factors, cannabis businesses are assessed a much higher rates of return than established businesses in other industries.

Due to these challenges alone, it is crucial for owners and management of cannabis businesses to work with financial professionals with deep industry experience.

HBK Cannabis Solutions is a dedicated team of cannabis industry subject matter experts within HBK CPAs & Consultants, an Accounting Today Top 100 CPA firm. We were among the first accounting firms to specialize in the cannabis industry and have worked beside entrepreneurs in all industry segments—cultivators, processors, retailers—from single facility to multi-location and integrated operations. We counsel owners, management and investors in multiples states and countries, helping them with key financial activities: from planning start-ups to connecting operators with investment bankers to facilitating M&A; from pre-offering projections, state applications and licensing to management planning and operations.

1 – 26 U.S. Code § 280E – Expenditures in connection with the illegal sale of drugs

As of September 30, 2020, cannabis has been legalized for medical applications in 33 states and for adult use in 11 states and the District of Columbia. United States cannabis sales are estimated to reach $11-$13 billion this year and expected to exceed $28 billion by 2023 according to the Marijuana Business Factbook¹. Federal legalization would expand the recreational cannabis market exponentially, with potential annual revenues estimated at $50-$60 billion, compared to the $72.2 billion domestic wine market, the $46 billion pizza market, and the $37 billion beer market².

The fundamentals used to value a cannabis-related business are no different than those in other appraisal assignments, including the valuation date; standard of value; premise of value; and methods and approaches of valuation. But there are distinct differences in how those fundamentals are applied in valuating cannabis businesses.

Asset-Based Approach
Many enterprises in the cannabis sector are so new they have limited, if any, operating history. Similar to any other start-up or development-stage business, a close study of costs associated with the specific business model can provide a foundational reference point compared to other valuation approaches and methods. The Adjusted Net Assets Method is based upon the value of a company’s assets, net of its liabilities. Adjustments to the balance sheet are made to mark the assets and liabilities to market value, as well as to reflect the value of any off-balance sheet items.

Market Approach
The Comparable Transactions Method is based on prices paid in sales of private companies in the same or similar industries, as reported by investment bankers or business brokers. Multiples of revenue, EBITDA, EBIT, earnings, cash flow, etc., can be computed and applied to the subject company to determine the value of that business.

The Guideline Public Company Method uses market multiples of comparable publicly traded companies. The value multiples are ratios derived by dividing the guideline company’s market capitalization or enterprise value (“EV“) by various measures, including revenue, net income, EBIT, and/or EBITDA. The public company multiples are typically adjusted to compensate for differences between them and the subject company based on performance metrics and the operational and risk profile.

Empirical market data in the cannabis space is anecdotal at best. Even with the limited data that can be found, it is subject to limitations due to jurisdictional differences. In addition, given the rapid changes occurring within the sector, market-based transactions become obsolete very quickly as compared to other more stable industries.

Income Approach
Valuations using the income approach are based on the theory that an investment in a business is worth the present value of the future benefits it will produce for its investors. The future benefits are discounted back to present value at a rate of return reflecting the investment risks—that is, the degree of uncertainty associated with realizing those returns on investment.

The Capitalized Cash Flow Method is considered when a company generates a reasonably stable return that can be assumed to grow at a constant rate into the future, or alternatively, when historical performance has been somewhat volatile and this volatility is anticipated in the future as well. Currently, this is not applicable to the cannabis industry.

The Discounted Cash Flow Method is used when future operations are expected to be volatile or different than the past. This method involves the use of discrete period projections until operations are assumed to stabilize (in the terminal year). The present value of these amounts is added to the terminal value. The terminal value represents future cash flow in the terminal year reduced to a single amount assumed to grow at a sustainable rate into perpetuity.

Well-reasoned, detailed financial projections are key to the valuation of an enterprise operating within the cannabis sector. The application of a Discounted Cash flow Method using an appropriate risk-adjusted discount rate often becomes the cornerstone of the valuation process.

When getting a valuation in the cannabis industry, it is crucial owners and management find professionals with experience in the industry. HBK Cannabis Solutions is a dedicated team of cannabis industry subject matter experts within HBK CPAs & Consultants, an Accounting Today Top 100 CPA firm. We were among the first accounting firms to specialize in the cannabis industry and have worked beside entrepreneurs in all industry segments—cultivators, processors, retailers—from single facility to multi-location and integrated operations. We counsel owners, management and investors in multiples states and countries, helping them with key financial activities: from planning start-ups to connecting operators with investment bankers to facilitating M&A; from pre-offering projections, state applications and licensing to management planning and operations.

1 – Marijuana Business Daily Factbook 2019 (February 2020 update)
2- https://www.bevindustry.com/2020-beer-market-report

Cannabis businesses have been excluded from any national legislated business support program, including the major stimulus package approved March – despite an industry appeal to authorities to put aside restrictions on federal aid and allow industry workers and businesses to apply for federal assistance. However, cannabis cultivators, processors, and retailers should have access to the same relief as other businesses in the states where they are based. Industry-wide Issues Conducting business in the COVID-19 environment and emerging from the crisis alive and well requires cannabis businesses of all types to be aware of and attend to key financial management issues:

• Cash management. As COVID-19 disrupts business as usual, companies will need to pay particular attention to cash management. Access to capital will be even more difficult for industry firms in the coming months, perhaps even years. The impact on collections is unclear, so it is imperative to assess your cash position, including as to what it means to the makeup of your workforce.If you have a banking relationship, you should meet with your banker to discuss your immediate and long-term capital needs. Many institutions are not lending cannabis businesses working capital; if your working capital is coming from cash flow you will need to make sure you can support your projections without your bank as a safety net. If you have a line of credit, it might be time to take draws to ensure you have sufficient working capital to get you through at least the next three to four months.
• M&A. With the environment growing more challenging, we are likely to see an increase in the number of mergers and acquisitions. On one hand, the crisis might serve to reduce some of the unrealistic pricing for businesses in our markets; it could make acquisitions more attractive. On the other hand, a slower economy could force additional bankruptcies.
• Accounting. In any time of income peaks and valleys, the timeliness of accounting information is important. If you have to wait to understand where you are until you close your books a month or more down the road, it could be too late to react to your financial needs. Cash will be tight coming out of the crisis, and most of the support programs will be first-come-first-served, so take the opportunity now to tighten your accounting practices so you can present credible financial statements when you need to apply for any available loans or other support. The better prepared you are, the easier it will be to get necessary and immediate assistance.
• Sanitation. In light of the current virus crisis, you must ensure that you have procedures in place that protect your crop as well as adhere to the directives of the CDC. If a worker tests positive for the virus, an entire season’s crop could be lost. As well, check your inventory of supplies. It could be increasingly difficult to acquire the clothing, masks and gloves you need to harvest your product safely.
• Taxes. The federal tax filing extension and payment deferral periods are available to industrial businesses and their owners and operators. The deadline for both relative to 2019 income has been moved to July 15, 2020.
• FMLA. As our businesses withhold and submit payroll taxes, the provisions of the Family and Medical Leave Act continue to apply.

  State-by-State Rules and Programs The HBK Cannabis Industry Group has compiled information from industry states on operations and programs specific to the COVID-19 crisis.

• Oregon. Marijuana businesses and liquor stores can remain open for business as long as they comply with Executive Order 20-12. Effective immediately, marijuana and liquor businesses must designate an employee or officer to establish, implement, and enforce social distancing policies consistent with guidance from the Oregon Health Authority. Retailers are not mandated but currently allowed to deliver on-site within certain parameters, essentially curbside pick-up. A temporary rule increases the amount of flower OMMP cardholders and caregivers can purchase to 24 ounces per day but no more than 32 ounces per month.
• Illinois. Both medical and adult-use are considered essential under Illinois’ COVID-related executive order. Industry businesses must adhere to social distancing and other requirements applicable to all businesses. The state has granted a variance for curbside pick-up to medical patients under certain conditions but not to adult-use purchasers.
• Missouri. The state is currently in the process of establishing its medical marijuana program. Expectations are for dispensaries to open this summer and the state has announced there will be no delays to the program as a result of COVID-19.
• Ohio. The governor’s stay-at-home order designates medical marijuana dispensaries healthcare and public health operations. As a result, they are permitted to stay open and patients are permitted to leave their homes to seek medical treatment at the dispensaries. The number of caregivers a patient can have at any time has been expanded to three. In addition, telephone orders for cannabis products are temporarily permitted. Cultivators, processors and labs are considered essential businesses. Social distancing and increased sanitation requirements apply to all businesses.
• Michigan. The governor’s stay-at-home order allows marijuana businesses to stay open as essential businesses. The state allows home delivery in compliance with certain guidelines. The state is encouraging provisioning centers and adult-use retailers to use home delivery when applicable. They have also expedited an approval process for delivery with 24 to 48 hours and will allow delivery to medical patients whose address is now different from that on their medical card. Michigan will temporarily allow curbside pick-up in compliance with certain parameters.
• Pennsylvania. The governor has temporarily suspended regulations that require all dispensing to occur inside a dispensary. Pennsylvania will temporarily allow curbside pick-up at dispensaries. It also permits approved caregivers to deliver medical marijuana to an unlimited number of patients.
• New Jersey. Medical dispensaries are considered an essential business and allowed to remain open. Curbside delivery is allowed.
• New York. Medical dispensaries are considered an essential business and can remain open. New York will also allow for the expansion of delivery services without government approval, as well as sales through doors and windows at a dispensary as long as they comply with all other laws.
• Maryland. Medical dispensaries are considered an essential business and allowed to remain open. Under Maryland’s temporarily modified rules, dispensaries may deliver products to patients in their cars, outside of the licensed premises. Maryland officials have also suspended current sales practices that involve communal gathering and the use of shared “sniff jars” to encourage social distancing and reduce infections.
• Massachusetts. The state has deemed medical cannabis essential. Adult-use retailers have been deemed non-essential and were forced to close March 24th at noon.
• Florida. Medical dispensaries remain open as of March 24th. The state health department is now allowing existing Florida medical marijuana patients to re-certify their recommendations without having to physically see a doctor. It can be done via telemedicine.

In an October 2019 U.S. Tax Court ruling, the IRS denied federal tax deductions proposed by the petitioner in the case, Northern California Small Business Assistants Inc. (NCSBA) v. Commissioner of Internal Revenue, 153 T.C. No. 4 (October 23, 2019).

NCSBA, a California corporation that operates a medical-marijuana dispensary legally under California law, argued the following points:

(1) Internal Revenue Code (“IRC”) Section 280E (“280E”) violates the Eighth Amendment to the US Constitution;
(2) Only ordinary and necessary business expense deductions (under IRC Section 162) are disallowed and does not apply to other sections of the IRC; and
(3) NCSBA was operating legally under state law and therefore is not subject to 280E.

The Eighth Amendment states that, “excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.” If it was determined that 280E violates the Eighth Amendment, the following would be viewed as facts: the Eighth Amendment applies to corporations; 280E functions as a penalty; and the penalty is excessive.

The Court ruled that 280E is not a penalty because the denial of a tax deduction is not a punishment or penalty. Further, the Court stated 280E was meant to limit or deter certain actions of a taxpayer (selling controlled substances).

NCSBA argued that 280E only disallowed ordinary and necessary business expenses (under Section 162). The Court determined Congress “could not have been clearer” when it stated, “No deduction or credit should be allowed.”

Finally, the petitioner argued that 280E applies only to businesses that engage in illegal or disreputable sales of controlled substances. They contend that the word “trafficking” in 280E implies some illicit purpose in the business’ operations. The Judge pointed to case law such as Canna Care Inc v. Commissioner, which set the precedent that the sale of medical cannabis pursuant to California law constitutes trafficking within the context of 280E.

In its conclusion, the Court stated that it is limited in its powers based on the law, and that the proper avenue to redress petitioner’s grievances is through Congress because changing tax laws is a legislative process that must originate with Congress. The fight to allow tax deductions for dispensaries operating legally under state law is a legislative fight not a judicial one.

To contact a member of HBK’s Cannabis Industry Group about this or related tax issues, please call 330-758-8613.

EDITOR’S NOTE: This article was written by HBK Senior Associate Dominic Pinina and reviewed by HBKVG Director Stacey Udell.

While the legalization of adult use of marijuana is currently off the table in New Jersey, New Jersey and other states will have to contemplate taxation in anticipation of future legalization. Determining a “right” sales tax that balances revenue receipts as it serves to eliminate a black market is not an easy task.  The following article sheds light on various marijuana taxation methodologies. (For purposes of this article, local taxes are not being considered.) There are two primary ways states tax the sale of adult use marijuana products: as a percentage of the selling price, similar to sales tax, or by weight. Taxing based on sales is easier to calculate. However, prices will likely decline once the market matures (see FIGURE 1), so tax revenue will decrease as well. As well, vertically integrated businesses could manipulate markups to reduce the tax burden. The Colorado Department of Revenue’s Marijuana Enforcement Division reported pounds of flower and bud sold in 2018 as of the date of the writing of this article. They had not reported revenue.  The Average Market Rate per pound of has been reported and, as shown in FIGURE  1, decreased significantly in 2018, then started to rebound in 2019.  
Weight-based taxes are more complicated in that it requires determining the amount of the tax and when the tax is assessed.  For example, a weight-based tax could be assessed at the cultivator, processing or retail level.  At the retail level, taxes would need to be set at different rates for different types of products: flower, concentrates, edibles. When taxing edibles, how would the non-cannabis ingredients be accounted for?  When taxing tinctures, would the potency and quantity be considered? There are significantly more factors to consider when ‘weighing’ the options of a weight-based tax. History indicates that prices tend to be higher immediately following legalization; lower tax rates can encourage the legal purchase of cannabis.  When prices decline, tax rates could be increased, keeping out-of-pocket costs to consumers the same or almost the same.  If taxes are too high, whether weight-based or assessed as a percent of sales, many customers will continue to purchase through the black market.  States must also consider that when the United States de-schedules or legalizes marijuana, it is highly likely a federal excise tax will be placed on sales of the product.  This will replace the burden of Internal Revenue Code Section 280E currently burdening business taxpayers. What is the effect in dollars of taxing based on a percent of sales versus weight? To illustrate, we analyzed Colorado’s reported sales and the wholesale weight of flowers/buds sold from January 1, 2014, to December 31, 2018.  As Colorado has not yet reported weight data for 2018 yet, we used the 2017 monthly data adjusted for the year-over-year sales increase. These computations are for illustrative purposes only and are subject to the following assumptions:

• includes only the weight of sales of flowers/buds;
• assumes no markup no profit made by the cultivator, distributor, or retailer; and
• ignores local taxes.

FIGURE 2 reflects a computation of tax revenue (medical and adult use) for the first four years of legal adult use in a state with a population of 8.908 million (specifically New Jersey).  
Based on this analysis, total sales tax collected for the five years was $52.8 million greater using a weight-based tax structure of $42 per ounce compared to the 12% percent of sales tax.  Obviously, the 25% tax rate would generate more revenue – but it would likely be a less effective means of eliminating the black market.   Examples of Sales Tax on Marijuana  
As FIGURE 3 shows, the process of taxing marijuana can range from simple to complex and the amounts of tax collected can vary significantly.   Nine states (and Washington DC) do not impose their general sales tax on medical marijuana while four states (Alaska, Delaware, Minnesota, and New Hampshire) do not levy sales taxes. FIGURE 4 illustrates a sample transaction ($250 per ounce based on no markup of product and all taxes being passed through to the consumer) in both medical and adult use markets and the different amounts that would be charged to the ultimate consumer and the taxes collected.  On the medical side, the purchase of an ounce of marijuana results in a purchase price ranging from $250 to $342.50, depending on the state.  For adult use, the price paid would range from $282.50 to $360.75.  
Under the weight-based tax structure ($42 per oz), the consumer’s cost for medical marijuana would be $266.63 (the fourth lowest, with two states levying no taxes).  For adult use, the $42 per ounce tax would result in being at the halfway point compared to other states.  It is very important to realize that the price will not be the same in all states and that this example is presented for comparison purposes only. Sources: Colorado Marijuana Enforcement Division’s Market Size and State Demand for Marijuana in 2017 – Market Update (Aug. 2018) https://www.colorado.gov/pacific/sites/default/files/MED%20Demand%20and%20Market%20%20Study%20%20082018.pdf Colorado Marijuana Enforcement Division: 2016 Annual Report https://www.colorado.gov/pacific/sites/default/files/2016%20MED%20Annual%20Report_Final.pdf Colorado Marijuana Enforcement Division’s Market Demand and Size Study, July 2014 https://www.colorado.gov/pacific/sites/default/files/Market%20Size%20and%20Demand%20Study%2C%20July%209%2C%202014%5B1%5D_3.pdf https://www.colorado.gov/pacific/revenue/colorado-marijuana-tax-data https://www.colorado.gov/pacific/revenue/colorado-marijuana-sales-reports https://www.colorado.gov/Tax/marijuana-taxes-file Economic Impact of Tourism in New Jersey, 2017 – January 2018) https://www.visitnj.org/sites/default/files/2017-nj-economic-impact.pdf