The marijuana industry is a prime example of a “current, emerging and future” risk area, given the number of perplexing difficulties CPAs face when trying to assess the special considerations pertaining to marijuana business clients and to the CPA firms that service such clients. At the heart of the difficulties is the split between federal law, under which marijuana is basically illegal, and the laws in states where voters or legislators have approved measures to allow the use of marijuana for medical and/or recreational purposes.
Twenty-three states have legalized marijuana for medical use, and four of those states, as well as the District of Columbia, have also legalized it for recreational usei . When states began passing laws to legalize marijuana, starting in 1996 with California allowing medical use, a “state-legal, federally-illegal” situation was created. Marijuana is listed on Schedule 1 of the federal Controlled Substances Act (CSA) of 1970 and as such has “no currently accepted medical use,” according to the CSA, leading to legal problems in states wishing to legalize medical marijuana.
The U.S. Supreme Court reinforced the precedent of federal law over state law in 2001 (United States v. Oakland Cannabis Buyers’ Coop) and 2005 (Gonzales v. Raich) by ruling that the federal government has the right to regulate and criminalize marijuana even when state law allows for its use.ii Since then, the federal government has given states the opportunity to enforce their own marijuana laws, but when state enforcement has been inadequate on occasion (by federal standards), federal agencies have moved to enforce the laws themselves. For example, preventing the distribution of marijuana to minors is an enforcement priority of the U.S. Department of Justice (DOJ). If there is evidence that an entity is in violation of state law by operating too close to a school, playground, child care center, or library, the DOJ may take actions to close the entity. Those actions might result in news reports.
Legal Recreational Use
The legalization of recreational (or “adult use”) marijuana began in Colorado and Washington when those states passed laws in 2012. Recreational sales to the public began on Jan. 1, 2014, in Colorado, and similar sales began in Washington on July 8, 2014. Alaska was the next state to do so, with its Measure 2, effective Feb. 24, 2015, and Oregon was the latest when Ballot Measure 91 took effect on July 1, 2015.
Initiative 71, passed in Washington, D.C., became effective Feb. 26, 2015, allowing adults to possess up to two ounces of marijuana, to grow up to six plants, and to gift up to one ounce to other adults. Sales in D.C. remain banned, however, as the initiative process in D.C. does not allow spending mandates, which commercialization would require.
By March 2014 in Colorado there were 190 recreational marijuana businesses projected to gross $1 billion in 2014 sales.iii The marijuana industry is growing, from $1.55 billion in 2013 to $2.7 billion in 2014, according to one research firm, with projections of future growth depending in part on how many other states legalize marijuana. If 16 more states were to legalize use, the market could grow to $11 billion annually by 2019. If all 50 states were to legalize it at some point in time, the market could grow to $36 billion or more, the equivalent of the organic food industry. iv
Meanwhile, some basic questions for CPAs remain unanswered in many respects: Where does a thriving marijuana business find ethical, qualified and professional tax and accounting advice? Are the CPAs, attorneys, and other advisers who counsel such a business at risk of jeopardizing their practices or professional standing by working with them?
Banking Problems
Many marijuana businesses have to operate as cash-only, as banks are understandably reluctant to accept money from businesses engaged in activities considered illegal under federal laws. The result is that marijuana businesses are susceptible to theft and robberies, requiring expensive security measures. Banks are also required to file a Marijuana Priority Suspicious Activity Report (SAR) if they believe a business is acting illegally, or a “Marijuana Limited” SAR if they believe the business is following state guidelines for legal sales. v
Other complications for banks pertain to violations related to money-laundering laws, especially banks with multinational operations exposed to drug cartels. The DOJ prosecutes banks it believes are violating such laws, and sentences can include lengthy prison terms. The potential for investment fraud is also present in the marijuana industry. In May 2014, the Securities and Exchange Commission issued an Investor Alert to warn investors about securities in the marijuana industry, and the SEC temporarily suspended the trading of securities in five companies operating in the industry.
On April 30, 2015, U.S. Reps. Ed Perlmutter, D-Colorado, and Denny Heck, D-Washington, along with a bipartisan group of 16 other Republicans and Democrats, re-introduced H.R. 2076, the Marijuana Business Access to Banking Act of 2015. The purpose of the bill is “to create protections for depository institutions that provide financial services to marijuana-related businesses” and to resolve the banking crisis that marijuana-related businesses are facing. vi
Policy Issues
The District of Columbia presents an interesting case study on the range of opinions on marijuana policy. By passing Initiative 71 in the November 2014 election, D.C. voters decriminalized possession of small amounts for personal use. However, the federal spending bill passed by Congress in December 2014 blocked the District from using any federal or local funds to implement Initiative 71, partly due to congressional objections to the use of marijuana for recreational purposes. However, Initiative 71 took effect after a 30-day congressional review period elapsed.
The same December 2014 federal spending bill also prevents the DOJ from using funds to enforce federal law with medical marijuana programs acting in accordance with state laws; i.e., state laws must be adequately enforced. The federal CSA, however, still holds that there is no currently accepted medical use for marijuana (as a Schedule I drug). Some advocates believe that marijuana should be removed from Schedule I, which would acknowledge currently accepted medical use, but opponents in Congress disagree.
The language in the Washington and Colorado proposals highlights some of the political issues.
Washington’s Initiative 502 called for “a new approach.” The intent of the law, as stated in its text:
(1) Allows law enforcement resources to be focused on violent and property crimes;
(2) Generates new state and local tax revenue for education, health care, research, and substance abuse prevention; and
(3) Takes marijuana out of the hands of illegal drug organizations and brings it under a tightly regulated, state-licensed system similar to that for controlling hard alcohol.
The measure authorizes the state liquor control board to regulate and tax marijuana for persons 21 years of age and older, and to add a new threshold for driving under the influence of marijuana.vii
Colorado’s Amendment 64 cites similar interests, such as “the efficient use of law enforcement resources, enhancing revenue for public purposes, and individual freedom.” The amendment also calls for marijuana to be taxed and regulated in a manner similar to alcohol, and it states that “legitimate, taxpaying business people, and not criminal actors, will conduct sales of marijuana,” subject to “additional regulations to ensure that consumer are informed and protected.” Distribution to minors remains illegal, as is driving under the influence of marijuana.
Other policy concerns pertain to a disproportionate enforcement of marijuana laws among the poor and people of color, giving rise to questions about whether the laws are being used by local governments in a fair and appropriate manner. At a time when incarceration rates are considered by many to be too high, governments may look for ways to reduce the number of arrests, and that may lead to legalizing and regulating activities that had been illegal and unregulated. The regulatory landscape at least appears to be moving toward more lenient penalties.viii
Risk Management Considerations
Opportunities for CPAs in the marijuana industry are just one side of the equation. The other side includes risk management issues as well as social and moral issues that have become national in scope and remain moving targets because of disagreement among Americans on how best to deal with them.
For CPAs, though, the specific issues tend to boil down to whether CPAs should accept marijuana business clients. Some CPAs have had many marijuana business clients over the years and have been able to manage the related risks within their risk appetites. Entities engaged in growing, supplying, distributing and selling marijuana will seek professional assistance related to tax preparation, accounting, attestation, internal control evaluations and/or other financial services. Before accepting such an engagement, though, CPAs should carefully consider whether the prospective client would be a good fit for their firm.
Is This a Client the Firm Would Like to Have?
A variety of factors need to be considered in answering this question, ranging from the client’s reputation and integrity to its commitment to appropriate accounting practices and to internal controls. Analyze the risks posed by the client by “thinking backwards through time,” a process that helps to promote a better analysis and review of relationships with new and continuing clients. These analyses and reviews are used to project the adverse situations that could develop in the future while representing the client. You then decide what, if any, decisions or choices can be made now to mitigate the potential damages to your firm in the event of such adverse developments.
For example, spend time to evaluate and think about any potential damage to your firm’s reputation by being associated with a marijuana business client. What if the client becomes the target of a federal investigation or prosecution, and the association between the client and the firm becomes public? Would your potential or existing clients view this association in a negative light?
Federal investigation can come from several different agencies, including the federal Drug Enforcement Administration, the DOJ, and the Internal Revenue Service. If this occurs, your firm may be subpoenaed for documents and/or depositions for testimonies.
Accountant-Client Privilege
Given that the accountant-client privilege is limited and does not cover information obtained in providing tax compliance services, think ahead about what your firm would do if a client discloses something to you that could damage the client if revealed to a regulatory body. What can you do, or should you do, to mitigate the potential exposures to your firm if that were to occur? For example, you may want to clearly define in your engagement letter the limitations of the accountant-client privilege, as well as to specify the conditions under which you will need to fully disclose information to regulatory and/or legal bodies.
It may also be beneficial to include billing policies in your engagement letters and to clarify that clients would be responsible for your fees and reasonable copy charges when responding to subpoenas or depositions.
The business implications of rendering services to marijuana business clients are significant aspects to your client-screening assessment. There are high-risk clients and high-risk engagements. Some CPAs rank their clients according to how cooperative, knowledgeable, reasonable, difficult, or time-consuming they are. Engagements can be ranked as well by the complexity of the work. Don’t forget, though, to also include the “reputational” implications to your firm. Generally, difficult clients with complex work pose the highest risk to the CPA firm from a technical perspective, but clients that could pose significant harm to your firm’s reputation are also of great risk from a business perspective.
Other considerations are addressed in “An Issue Brief on State Marijuana Laws and the CPA Profession,” published on May 16, 2013, and updated on Jan. 5, 2015, by the AICPA with input from the Washington and Colorado state societies of CPAs. ix
Client Screening
A CPA firm presented with opportunities to take on marijuana business clients should consider the following client screening measures:
- Situational proficiency: What are your firm’s skills and experience relative to professional standards, the complexity of your clients’ businesses, and the types of services you are asked to provide? Proficiency addresses the fit between the CPA firm and the situation, not just the technical aspects.
- Discuss your firm’s potential legal ramifications with the firm’s attorney.
- Discuss any illegal activities with those charged with governance of the client, and contemporaneously memorialize those discussions.
In summary, your firm’s client screening and retention policies should clarify and address your firm’s risk tolerance for providing services to marijuana business clients. Clearly, a “mismatch” in client/firm fit can spell trouble and possibly expose your firm to reputational damage, disputes and even possible lawsuits.
Federal Income Tax Treatment for Marijuana Business Clients
Tax practitioners advising clients in this area must possess a good understanding of the relevant tax law. Although a business may be illegal under federal law, it is still obligated to pay federal income tax on taxable income. Marijuana (as a Schedule I controlled substance) is considered illegal under federal law, and its growth, distribution or possession is a federal crime.
According to IRC § 280E, no deduction or credit is permitted for amounts paid or incurred in carrying on any trade or business if such trade or business involves trafficking in controlled substances. For purposes of IRC § 280E, the sale and/or distribution of marijuana are considered “trafficking”. However, a marijuana business may reduce gross receipts by the cost of goods sold (COGS) in order to determine gross income. The reason for this disparity is simple: deductions are considered legislative grace, while determining gross income is not. Determining COGS is not simple and is beyond the scope of this article. However, a good place to start would be recently issued guidance from the IRS Office of Chief Counsel.
IRS Chief Counsel Advice Memorandum 201504011x provides guidance regarding the capitalization of inventory costs and deduction of cost of goods sold for taxpayers considered to be trafficking in Schedule I and II controlled substances (see CCA 201504011). The memorandum also provides the method for determining the COGS for marijuana dispensaries.
Accounting Treatment for Marijuana Businesses Clients
Even though certain marijuana-related business activities are currently legal under certain state laws, marijuana is still considered an illegal substance under federal law. Consequently, the accounting treatment for entities engaged in such activities requires special consideration. Illegal acts are addressed by AU-C 250 (SAS No. 122), AR 80 and AR 90 (SSARS No. 19), and AR-C 90 (SSARS No. 21).
Professional standards do not preclude issuing a “clean” report on financial statements of an illegal venture as long as there is no scope limitation and the financial statements have the appropriate disclosures. Transparency in financial reporting is the best approach from GAAS, SSARS, financial reporting framework (e.g., U.S. GAAP) and risk management perspectives.
The following are suggestions for a CPA firm faced with this client issue:
- Discuss the potential legal ramifications to the firm with the firm’s attorney.
- Discuss the illegal activities with those charged with governance of the client, and contemporaneously memorialize those discussions in writing.
- Be certain that the financial statements appropriately disclose any related party interest, the nature of the relationship, the marijuana business, that the state considers this activity to be legal, that the U.S. federal government considers the activity to be illegal, and note that the federal government’s current policy is not to target marijuana distributors unless they violate
both federal and state laws. - The financial statements should also include a contingency footnote describing the illegal activity and the potential consequences to the client.
- Obtain a representation letter from the client describing the activities and the client’s estimates (if any) of the potential consequences of this association/business. It is management’s obligation to estimate the potential consequences, and the CPA’s responsibility to assess the reasonableness of those representations. The representation letter should document the basis for the financial statement reporting of this matter.
- Add an emphasis-of-matter (EOM) paragraph to the auditor/accountant’s report to draw attention to the situation.
- If the client does not have an estimate of the potential consequences, that fact should be noted in the EOM paragraph.
- Disengage if the client refuses to provide either the representations requested or the financial statement presentation proposed by the CPA.
Note that the financial reporting treatment is not impacted by the level of service (audit, review, compilation). The financial reporting presentation would be the same regardless of the level of service, as the financial statement presentation is a financial reporting framework issue. SSARSs permit compiled financial statements that omit substantially all disclosures. However, to highlight the situation, CAMICO strongly encourages practitioners compiling financial statements that omit substantially all disclosures to add an EOM paragraph to their compilation reports, add the disclosures described above, and label the disclosure “Selected Information—Substantially All Disclosures Required by
The above suggested disclosures would add clarity and reduce the potential risk to the CPA firm were a third party to later allege the CPA conspired with the client in producing misleading financial statements that harmed the third party by not disclosing this activity.
For additional information on addressing risk management considerations, please refer to the preceding section in this article on “Risk Management Considerations.”
As always, CAMICO policyholders can contact the Loss Prevention department with any questions, either by calling 1.800.652.1772, or emailing lp@camico.com.
____________________________________________
1. National Conference of State Legislatures, http://www.ncsl.org/research/health/state-medical-marijuana-laws.aspx
2. An Issue Brief on State Marijuana Laws and the CPA Profession, http://www.aicpa.org/advocacy/state/downloadabledocuments/marijuanacpasissuebrief-updatedjan2015.pdf
(The Department of the Treasury issued guidance for banks on Feb. 14, 2014, and reiterated the “eight priority factors” cited earlier by the DOJ:
- Preventing distribution to minors.
- Preventing revenue from marijuana sales from funding criminal enterprises.
- Preventing legal marijuana from being transported over state lines to where it’s not legal.
- Ensuring that state-sanctioned marijuana businesses aren’t fronts for illegal activity.
- Keeping guns and violence out of the legal marijuana supply chain.
- Preventing drugged driving.
- Avoiding growing marijuana on public lands.
- Keeping marijuana off of federal property.
(The DOJ released a memorandum on Aug. 29, 2013, known as the Cole Memo (after Deputy Attorney General James Cole) on “Guidance Regarding Marijuana Enforcement,” which states in part that the DOJ expects states to create “strong and effective regulatory and enforcement systems … with a tightly regulated market …” The guidance also states, “If state enforcement efforts are not sufficiently robust … the federal government may seek to challenge the regulatory structure itself in addition to continuing to bring individual enforcement actions, including criminal prosecutions …”)
3. Internal Revenue Service Advisory Council (IRSAC) 2014 Public Report, http://www.irs.gov/PUP/taxpros/2014-IRSAC-Full-Report.pdf
4. The State of Legal Marijuana Markets, 3rd Edition, ArcView Market Research, http://www.arcviewmarketresearch.com/
5. An Issue Brief on State Marijuana Laws and the CPA Profession (see preceding)
6. “Colorado lawmaker fights to ease marijuana banking,” Denver Business Journal, http://upstart.bizjournals.com/news/wire/2015/04/30/colorado-lawmaker-fights-to-ease-marijuana-banking.html
7. Initiative Measure No. 502, http://sos.wa.gov/_assets/elections/initiatives/i502.pdf
8. The State of Legal Marijuana Markets (see preceding)
9. An Issue Brief on State Marijuana Laws and the CPA Profession (see preceding)
10. Office of Chief Counsel, Internal Revenue Service, Memorandum Number 201504011 (http://www.irs.gov/pub/irs-wd/201504011.pdf)