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BFD Alert: 2013 Cole Memo is Safe (For Now)

Attorney General Jeff Sessions seems to have made it his personal M.O. to potentially go after and take down state legal marijuana programs and businesses, medical and recreational alike (he’s made no bones about it that he’s not a fan of marijuana or its users). As of yesterday though, the state-legal marijuana industry can exercise a (slight) sigh of relief on the heels of Sessions finally providing some guidance from the Department of Justice–essentially, according to Sessions, this administration will follow the 2013 Cole Memo in its enforcement of marijuana-related crimes in states that have marijuana legalization and/or medicalization and corresponding regulatory systems.

During the House Judiciary Committee oversight hearing yesterday, Sessions stated on the record that,

Our policy is the same, really, fundamentally as the Holder-Lynch policy, which is that the federal law remains in effect and a state can legalize marijuana for its law enforcement purposes but it still remains illegal with regard to federal purposes.

Hopefully then, cannabis businesses in states with “robust regulation” that adhere to the eight enforcement priorities of the 2013 Cole Memo will be the lowest enforcement priorities for the DOJ. However, neither that Memo nor Sessions’ apparent acceptance of it do anything to change the federal Controlled Substances Act–marijuana remains illegal under federal law. Still, Sessions agreed with Representative Steve Cohen (derived from a line of questioning from the Congressman) that marijuana is not as dangerous as heroin (despite the Schedule I classification they share under the federal Controlled Substances Act). Despite all of Sessions’ anti-marijuana rhetoric (and his poking and prodding of states that have highly regulated recreational marijuana licensing systems), it seems he’s finally coming around to facts and science. Do not though expect this Attorney General to make any effort to reschedule marijuana anytime soon as he toes the Republican Party line on continuing the failed war on drugs.

Another big boon from yesterday’s hearing is that, despite the fact that Sessions requested that Congress essentially undo the state medical marijuana protections set forth in various Congressional budget riders (which have actually shown major teeth in the Ninth Circuit), Sessions ultimately kowtowed to the fact that the DOJ must respect those laws as long as they’re in place. What a shock that the DOJ must abide by current federal laws.

So, for now, the 2013 Cole Memo remains the DOJ’s current enforcement policy when it comes to state legal marijuana, and we can expect states to continue their democratic experiments with marijuana regulatory systems at a regular clip. Do not forget though that the 2013 Cole Memo is meaningless when it comes to the actual state of the law insofar as marijuana remains federally illegal. We’re glad to see that the DOJ will (hopefully) follow the 2013 Cole Memo, but we’re even happier that Sessions plans to respect the federal budget riders (as he should have done from the get go) and that he recognizes that marijuana is not as unsafe as heroin (which is an obvious no brainer at this point for anyone who respects science and empirical data).

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Cannabis Won on Tuesday’s Election Day 2017


The recent election bodes well for cannabis.

By now you have probably seen a dozen articles about the blue tidal wave that hit Virginia, New Jersey, and almost everywhere else that held elections on Tuesday, November 7. The consensus seems to be that Democrats, who are usually apathetic about off-year elections, showed up in large numbers to express their displeasure with the Trump administration. But this election was also heavily tinged with green and it bodes well for the prospects of an eventual end to federal cannabis prohibition. It also had some immediate benefits for recreational cannabis in the short term.

We have often written about prominent Democratic presidential hopefuls (i.e. democratic members of Congress) speaking rationally on cannabis (here, here, here, here, and here). These comments dovetail nicely with recent polling showing public support for cannabis legalization is at an all-time high, with 64% of the public in support (71% among Democrats, 62% among independents, and breaching 50% among Republicans for the first time). On November 7, the age-old political rule that the president’s party gets clobbered in mid-terms seems to have held true yet again. We expect that federal prohibition’s time is short, and if Democrats take the Senate and/or the house in 2018, we expect Attorney General Jeff Sessions’ options will be limited when it comes to federal interference with state-level recreational regimes.

But no doubt before the results of this last election impact federal cannabis, they will more likely impact cannabis on the state level. For instance, the election of Phil Murphy (D) as the next Governor of New Jersey all but guarantees the Garden State will legalize cannabis soon. Shortly after the election, we reached out to our Garden State legal colleague, Paul Strauchler, an attorney at Post, Polak Goodsell and Strauchler and one of the leaders of the firm’s Hospitality, Alcoholic Beverages, and Cannabis Group, to get an on the ground view on what the transition from cannabis-hating Chris Christie to Phil Murphy will mean for New Jersey. Paul is optimistic about the results: “Since Phil Murphy’s very entry into New Jersey public life, he has been an advocate for the legalization of cannabis: for its medicinal value and potential; for its commercial and economic opportunities; and for its remediation of a full spectrum of social justice issues. We look forward to working with Governor-Elect Murphy and the Lt. Governor-Elect and their team as New Jersey prepares for a new era.” In other words, just about everything cannabis just took a sharp upward turn for New Jersey.

Governor-Elect Murphy campaigned on legalization and he has vowed to legalize cannabis in his first 100 days. If he succeeds with this New Jersey will be the first state to legalize cannabis through legislation, rather than via a public ballot initiative.

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Mystery Cannabis Litigation Theatre 2017: Future Enforcement of Pot Patents

Cannabis patent litigation
Noted cannabis patent expert

In previous posts, we’ve discussed how cannabis is patentable, and what these patents might mean for a cannabis business. Today, we peer into the not-so-distant future to imagine what a lawsuit to enforce a cannabis patent might look like. My research has discovered no such lawsuits filed to date.

Keep in mind that all patent infringement cases must be heard in one of the 94 federal courts, with very few exceptions. No non-federal trial or appellate judge has jurisdiction to decide any issue relating to patent infringement.  There are at least four major parts of a potential cannabis patent litigation in which the federal illegality of cannabis raises concerns: pleadings, discovery, proof/evidence, and remedies.

Pleadings: In the initial phase of a lawsuit, each party must detail its allegations in pleadings. A pot patent plaintiff will allege she owns a patent for a cannabis plant and that the defendant has infringed the patent by growing, selling, offering to sell, or importing the patented plant in the United States. Because a patent is merely a right to keep someone else from practicing the patent, the plaintiff needn’t plead anything about her own business, although there are good strategic reasons for her to do so. The defendant must then either admit or deny each and every allegation made by the plaintiff; there is no “no comment” option. In most cases, this means the defendant must plead, in substance: “I grow marijuana.” Pleadings are almost always publicly available, including to federal law enforcement. Though under past practice the Department of Justice has not prioritized cannabis enforcement in states where cannabis has been legalized, each set of pleadings will remain as a public record admission of criminal activity and therefore available to any DOJ attorney who wants to pursue such cases.

Discovery: In this phase of litigation, each party collects evidence to support its claims or defenses. One form of discovery allows a party to force the other party to admit or deny any fact related to the lawsuit, under oath. Here is an actual request I saw recently: “Admit that the products sold at [defendant’s cannabis shop] containing marijuana and/or cannabinoids are illegal under federal law.” It may be possible to plead the Fifth Amendment privilege against self-incrimination to avoid answering such requests. But if a defendant can “take five” to avoid admitting many of the facts a plaintiff must prove to show infringement of a patent case, how will cannabis patent plaintiffs enforce their patents as a practical matter?

Proof/evidence: In almost every plant patent trial, the plaintiff must hire an expert to provide an opinion that the patent applies to the plant accused of infringement. In a cannabis patent case, this means the plaintiff (or plaintiff’s counsel) must have the expert botanist or horticulturist analyze the accused cannabis product. That means the lawyer, or the client, or the expert, must possess or transport the cannabis product, which constitutes a federal crime.

What will happen if counsel or a witness tries to bring cannabis to the courtroom to use as evidence? Under some circumstances like drug prosecutions, illegal narcotics are introduced into evidence in federal court under highly restrictive conditions. But it is far from clear whether federal judges will routinely allow parties to a civil suit to bring Schedule 1 narcotics into a courtroom, at least without Congressional approval.

Remedies: The most common remedies in a patent suit are damages, e.g., lost profits or a reasonable royalty, and/or an injunction prohibiting further infringement of the patent. But will a federal judge be willing to order the losing defendant to pay over the profits from its illegal activity to the successful cannabis patent plaintiff? Will the judge enter an injunction relating to the sale of an illegal product?


If cannabis patents are so hard to enforce, we may wonder why the Patent Office grants them. The reason is that the PTO, an agency in the Commerce Department, is empowered to grant patents and cannabis is patentable. The Department of Justice, another department, is empowered to enforce criminal laws passed by Congress, including the CSA. The courts, in another branch of government altogether, hear patent cases, as well as criminal prosecutions. Isn’t federalism fun?

Cannabis patent litigation

 

 

 

 

 

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Federal DOJ Admits it Can No Longer Prosecute the Kettle Falls Five for State-Legal Medical Cannabis

Washington and Federal Cannabis lawsLast week, the Federal Department of Justice (DOJ) filed a motion with the Ninth Circuit Court of Appeals to stay or remand appellate proceedings in its case against Rhonda Firestack-Harvey, Rolland Gregg and Michelle Gregg, the remaining members of the Kettle Falls Five, because it does not have funds to continue the prosecution. The Kettle Falls Five is the name given to a group of medical marijuana growers in Kettle Falls, a town in North East Washington. The group consisted of Rhonda Firestack-Harvey and Larry Harvey, their son Rolland Gregg and his wife Michelle, and Jason Zucker.

The Kettle Falls Five were charged by the federal government after a 2012 raid on their farm in Northeast Washington. The group was collectively growing medical cannabis plants in an amount permitted by state law. The federal government vigorously prosecuted the Kettle Falls Five over the last five years. The feds originally sought 10-year mandatory prison terms. The feds dropped charges against Larry Harvey who was battling stage four pancreatic cancer. Mr. Harvey passed away in August 2015.

Jason Zucker pleaded guilty and testified against the other defendants prior to trial. He was sentenced to 16 months of prison time based on his cooperation.  The remaining defendants faced charges of growing, possessing, and distributing cannabis, in addition to charges relating to firearms found on the same property as the cannabis grow. Rhonda, Rolland, and Michelle were acquitted of all charges except growing cannabis. Michelle and Rhonda received a sentence of one year and a day and Rolland received a sentence of 33 months.

The Kettle Falls Five appealed to the Ninth Circuit. The DOJ was expected to continue its vigorous prosecution, which makes its recent motion to stay or remand the case quite a surprise. In its motion, the DOJ provided the following explanation:

This motion is based upon Congress denying funding to the Department of Justice for the prosecution of medical marijuana patients in states where medical marijuana is lawful. The purpose of this motion is to acknowledge that the United States was not authorized to spend money on the prosecution of the defendants after December of 2014 because the defendants strictly complied with the Washington State medical marijuana laws.

This refers to the Rohrabacher-Blumenauer Amendment which limits prosecution of state-compliant medical marijuana actors.  As part of a federal budget deal in December 2014, Congress cut off funds for the federal prosecution of medical marijuana growers and users in states where medical cannabis is legal, so long as those actors are following state law. Since 2014 the Amendment has repeatedly been renewed.

The DOJ’s motion also cites United States v. McIntosh,  in which the Ninth Circuited decided the Rohrabacher-Blumenauer Amendment prohibited the DOJ from “spending funds for the prosecution of individuals who engaged in conduct permitted by the state medical marijuana laws and fully complied with the laws.” The DOJ’s motion states that the “prohibition regarding DOJ expenditure of funds applies even though the prosecution was properly initiated prior to [Rohrabacher-Blumenauer’s] enactment.”

The DOJ asks the court either to either back off on the appeal or to send the case back to the trial court. This is promising as it appears the DOJ may have finally seen the writing on the wall and is going to drop its case against the Five. However, it may also mean the DOJ is attempting to hold off on prosecuting the defendants to see if Congress reaffirms the Rohrbacher-Blumenauer Amendment, which is not guaranteed, especially given the current political status of our federal government. It should go without saying that Jeff Sessions has openly lobbied Congress against the Amendment.

In any event, this is an opportunity for defense counsel to ask the judge to toss out the case, which we fervently hope will be its eventual outcome. On a broader scale, this motion shows that the Rohrabacher-Blumenauer Amendment is a powerful tool to limit federal prosecution of medical cannabis growers.

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Cannabis Business Entity Selection: Effects of Tax Reform

Cannabis taxesOn September 27, 2017, the Trump Administration introduced its framework for tax reform, known officially as the “Unified Framework for Fixing our Broken Tax Code.” Not surprisingly, the proposal leaves the details to Congress. Though the current proposal is short on detail, cannabis businesses should be aware of the impact the overall rate may have on their choice of legal entity.

Up front caveat: there is no chance Congress will pass a tax bill that exactly matches the current proposal. The proposal doesn’t have enough detail, for one. But more important is that the Congressional meat grinder of wheeling and dealing and lobbying generally ends up yielding a product that differs greatly from initial proposals they receive from the White House. Regardless, it’s useful to get an idea of what direction the administration and Congress are likely to push taxes.

Tax Proposal Highlights. The centerpiece of the current tax proposal is to dramatically reduce tax rates, as per the below.

Business Form

2017 Tax Rate

Proposed Tax Rate

Sole Proprietor 10%-39.6% 25%
Partnership/LLC 10%-39.6% 25%
S Corporation 10%-39.6% 25%
C Corporation 15%-39.0% 20%

The current proposal will change how entities treat the costs of equipment and other capital assets under the tax code. Under current law, businesses cannot deduct the full cost of capital equipment — the cost is deducted over a period of years through scheduled depreciation. The new proposal would, at least for a limited time, treat capital expenses the same as operating expenses, allowing companies to deduct the full cost of capital equipment in a given year. This could be a significant benefit to cannabis growers and producers, who can categorize most of their capital equipment as costs of goods sold. Retailers, on the other hand, are unlikely to benefit because deductions for their capital equipment expenses are generally barred by IRC §280E.

In determining the legal structure for your cannabis business, you have two fundamental choices. Do you form a corporation, which is subject to federal income tax itself, or do you form a “pass-through-entity” (typically a limited liability company) where the entity pays no tax, but profits or losses are allocated to the company owners, and those owners must pay individual taxes?

C Corporations. C Corporations are liable for federal income tax at the entity level. Shareholders are not individually liable for those taxes, but they are liable for taxes paid on dividends they receive. This is the dreaded “double taxation” people refer to when criticizing the corporate tax system. But if the corporate tax rate for C Corporations is reduced to 20% across the board, C Corporations may become very attractive to cannabis businesses.

C Corporations can offer additional benefits. If the IRS audits a C corporation, additional taxes assessed are a liability of the corporation, not a personal liability of the shareholders. Compare to a partnership, where even if a partner were completely innocent of any blame in a situation where prior year profits were understated, that partner would be individually liable for any assessment of unpaid taxes. The IRS treats shareholders active in a C corporation as employees and thus not subject to the 15.3% self-employment tax. C Corporations also typically offer greater flexibility regarding employee benefits and incentive compensation.

Limited Liability Companies. Limited liability companies have become the most common entity choice for those starting a business, cannabis or otherwise. They protect their members from personal liability like a corporation, and they also provide considerable management flexibility, lacking the mandatory formal structures of corporations.

For income tax purposes, the LLC is a chameleon and may take on many forms. An LLC with a single individual member is treated as a disregarded entity — individual members report business operations directly on their personal tax returns. Under the current tax proposal, a sole proprietor’s (or single member of an LLC’s) income from his or her business activity would be taxed at 25%, however, it also indicates that a “wealthy individual” may not avoid “the top personal tax rate.” But the proposal does not have any details on how exactly that exception would be included in a final tax bill.

An LLC with more than two members is treated as a partnership and tax is imposed at the partner level, with the partners’ share of income or losses reported on their personal income tax returns. Again, under the proposal, each partner’s tax rate is capped at 25%.  Presumably, a partner that is a C Corporation will be taxed on 25% of its pass-through income.

Finally, an LLC may “check-the-box” and elect to be treated as C or S corporation. S Corporations are pass-through-entities and S Corporation shareholders are taxed at the shareholder level similar to partners in a partnership. The income of an LLC that elects to be treated as a C corporation would presumably be taxed at the 20% corporate tax rate.

One benefit of a pass-through-entity is that a partner is not subject to double taxation as cash distributions to a partner may be received tax-free. In addition, an LLC/partnership generally may be dissolved with a lower risk of triggering recognition of income on the liquidation. For example, let’s say that a C corporation buys a piece of real estate for $400,000, and two years later the real estate has appreciated in value to $600,000. The shareholders’ original investment in corporate stock is $300,000. If the corporation dissolves and the shareholders receive the real estate, they have to pay tax on the fair market value of the property ($600,000) less their original stock investment ($300,000). So, the shareholder must pay tax on a gain of $300,000. But in an LLC/partnership, the liquidation of the partnership would not be a taxable event, so the partners would not immediately pay tax on that value. 

There are a few drawbacks to partnerships in the cannabis space. As discussed earlier, partners have individual liability for tax that the partnership owes, so all partners must be diligent to ensure they are making sufficient tax payments. Additionally, because of some quirks in the partnership tax code, IRC 280E has the effect of making a partner that is selling its interest pay more tax on the sale of that partnership interest than a similarly situated shareholder in a C corporation would pay. Finally, members/partners must pay employment taxes at the 7.65% rate, whereas the C Corporation pays a shareholder employee’s share of such taxes. 

If you are making an entity selection decision soon, keep an eye on Congress. The tax code can be hard to understand, and the media doesn’t always concentrate on details that can have a dramatic effect on things like business entity selection. Any major tax reform will create a lot of confusion and will change some common assumptions, so stay vigilant.

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Much Ado About RICO and Cannabis, Part 2

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Defendants describe the lawsuit as an “attempt to put some shiny federal lipstick on an otherwise quite beleaguered pig of a state-law nuisance claim.”

We’ve previously discussed a RICO case that is slowly worming its way through federal court in Portland, Oregon. Styled as McCart v. Beddow et al., the case was filed by an attorney who is fed up with two neighboring cannabis grow operations next to her rural home. But rather than focusing solely on the allegedly troublesome cannabis producers, the McCart plaintiffs have filed suit against anyone even tangentially related to the producers’ business, including many dispensaries (“Dispensary Defendants”) that only purchased their product. We counted over 70 named defendants!

In our previous discussion, we suggested that the plaintiffs’ case against the Dispensary Defendants is fairly weak and our opinion hasn’t changed. Since we last checked in, the plaintiffs have filed a substantially expanded amended complaint, and numerous defendants have filed motions to dismiss. Although the Court won’t consider the motions to dismiss until January, it is worth checking in on the parties’ current positions. We are going to continue to focus on the Dispensary Defendants because there could be serious repercussions in the industry if the Dispensary Defendants are found liable even though they apparently didn’t have anything to do with the grow operation.

The Law

RICO law is complex, but as a general matter the RICO statutes allow a plaintiff to recover treble damages in a civil claim if the plaintiff can prove the following:

  • The existence of an “enterprise” affecting interstate or foreign commerce;
  • The specific defendant was employed by or associated with the enterprise;
  • The specific defendant conducted or participated in the conduct of the enterprise’s affairs;
  • The specific defendant’s participation was through a pattern of racketeering activity; and
  • Plaintiff’s business or property was injured by reason of defendant’s conducting or participating in the conduct of the enterprise’s affairs.

Of course, the devil is in the details, as the Dispensary Defendants point out in their motion to dismiss.

The Amended Complaint

The plaintiffs filed their amended complaint on September 1, which added 95 paragraphs onto their hefty original complaint. The amended complaint adds many new defendants, including employees at the farms and it alleges that nearly all of the defendants were exporting product out of Oregon.

In broad terms, the plaintiffs’ claims against the Dispensary Defendants have not changed in that they still allege the following:

  1. The cannabis grow operation (“Marijuana Operation”) is an enterprise affecting interstate commerce, as defined in the RICO statutes;
  2. All of the defendants were associated with and conducted the Marijuana Operation’s affairs through racketeering activity;
  3. Plaintiffs suffered a variety of kinds of harm as a result of the Marijuana Operation:
    1. Physical Injury to Real Property: littering, driveway damage, tire tracks, damage to some trail cameras, and unreasonable use of easements.
    2. Diminution of Property Value: noise pollution, light pollution, vibration, odors, exhaust fumes.
    3. Personal Injuries: harassment and damage to plaintiffs’ use and quiet enjoyment of their property.

The Motions to Dismiss

Eighteen Dispensary Defendants joined together in a single motion asking the Court to throw out plaintiff’s entire case against them. Their motion is well worth the read, not least for its colorful language, such as the lipstick-on-a-pig quote below the pig picture above. The arguments in this motion fit into two general categories:

The Dispensary Defendants are not part of a racketeering enterprise.

To establish an “enterprise” exists for RICO purposes, plaintiffs must show there was an ongoing organization with a common purpose. Both of these elements get to the same idea: a criminal enterprise is a group of people all working together to enrich themselves. Courts have found “ongoing organizations” among disparate businesses when there are legitimate interconnections between the entities, such as similar ownership and overlap in personnel. Similarly, courts have found a common purpose where the alleged members are working to promote a single economic interest, and not where they are simply pursuing individual economic interests. There don’t appear to be any of these kinds of links in this case. The Dispensary Defendants appear to be owned, operated, and staffed by distinct individuals working towards their own individual business purposes. This ties back to our initial read of this case: mere supplier-purchaser relationships like these do not rise to the level of RICO enterprises.

In any event, plaintiffs need to establish that the Dispensary Defendants were associated with and conducted or participated in the enterprise. Yet plaintiffs have not alleged that the Dispensary Defendants had any say over the operation of the farms. Their case against the Dispensary Defendants will likely die here.

Plaintiffs’ alleged harms cannot be recovered as a matter of law.

Even assuming plaintiffs can get over the hurdle of establishing that the Dispensary Defendants directed the farms, plaintiffs still must establish that their specific harms are actionable. The Dispensary Defendants also seem to be on the right side of the law here, arguing that the alleged harms and the speculative claim that the value of plaintiffs’ home has decreased cannot form the basis of a RICO claim against any of the defendants and cannot form the basis of a state-law claim nuisance claim against the Dispensary Defendants, in particular.

The plaintiffs face a number of legal obstacles that seem insurmountable. First and foremost, Oregon has long since decided that it is in the best interests of the state to protect farming uses and it has decided to treat cannabis the same as any other farm crop. Accordingly, Oregon’s Right to Farm Act likely bars plaintiffs’ nuisance and trespass claims for damages based on odors, noise pollution, light pollution, vibrations, and smoke fumes. The Dispensary Defendants rely on ORS 30.936(1), which provides farmers in farming areas with immunity from suit for any trespass or nuisance claims, defined elsewhere as claims “based on noise, vibration, odors, smoke, dust, mist from irrigation, use of pesticides and use of crop production substances.” Since RICO case law suggests that harms to property interests should be determined by state law, plaintiffs’ diminution of value claims are likely dead on arrival.

In any event, plaintiffs’ specific diminution of value claims are likely too speculative. The Dispensary Defendants argue that a RICO plaintiff must plead and prove that plaintiff has suffered a “concrete financial loss” but that plaintiffs’ complaint only contains pure guesswork that the odors, etc. diminished the value of plaintiffs’ property. Even if the plaintiffs could plead a specific dollar amount of diminished value, Oregon law bars claims for diminution of property value if the nuisance can be stopped. In other words, if the harm would disappear if the grow operations shut down, plaintiffs cannot recover damages for loss of value. Instead, plaintiffs should be asking the court to shut down the grow operations, which would have little to no effect on the Dispensary Defendants.

Plaintiffs will also likely fail on their claims for loss of quiet enjoyment and harassment because personal injuries like these are not compensable under RICO.

We will have to wait until next year to find out if the Court agrees with the Dispensary Defendants but we predict vindication for the dispensaries. In fact, we predict the claims against all of the defendants will get tossed, except possibly some small state-law claims. It seems that if you are a good neighbor and you don’t set up your operations next door to property owned by a lawyer, then you’ll likely never be drawn into a mess like this.

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Target Sold CBD Online: Was it Legal?

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BuzzFeed recently reported on Target’s short-lived effort at selling cannabis-based products online. By the end of the day on which the story ran, the major retailer had already removed the product from its website. The Phoenix New Times quoted Target spokesperson Kate Decker as saying, “We started carrying Charlotte’s Web hemp extract items last week on Target.com. After further review, we have decided to remove it from our assortment.” However, the Phoenix New Times reported earlier in September that Target was selling CBD products online. Decker could not confirm exactly when Target started selling CBD. The only certainty is that it ended the same day as BuzzFeed’s article.

The thing is that many online retailers (WalMart, Groupon, and Amazon) sell or have sold CBD online. This is in part likely because of the complex legal status of CBD. The Drug Enforcement Agency’s (“DEA”) stance is that CBD, and other cannabinoids derived from cannabis, are Schedule I substance under the Controlled Substances Act (“CSA”), regardless of their source. Last year the DEA created a rule defining “marihuana extract” as an extract “containing one or more cannabinoids derived from any plant of the genus Cannabis,” as marijuana, a Schedule I controlled substance. Use of “any” means it applies to any derivative of the cannabis plant including, CBD and other cannabinoids found in cannabis. This far-reaching definition, on its face, purports to make parts of the cannabis plant that were seemingly legal illegal.

Setting aside the Rule, there are three scenarios in which cannabis extracts are arguably legal under federal law. The first being when extracts are derived from the “mature stalk” of the cannabis plant because the CSA’s definition of marijuana “does not include the mature stalks of such plant, fiber produced from such stalks, oil or cake made from the seeds of such plant, any other compound, manufacture, salt, derivative, mixture, or preparation of such mature stalks (except the resin extracted therefrom), fiber, oil, or cake, or the sterilized seed of such plant which is incapable of germination.” 21 USC § 802(16). The DEA has clarified that the Rule does not include portions of the plant specifically exempt from the CSA’s definition of marijuana but also maintains that products that contain any meaningful amount of CBD can be derived from the mature stalks.

The second scenario is when extracts are derived from an industrial hemp plant lawfully grown in compliance with section 7606 of the 2014 US Farm Bill (“the Farm Bill”). The Farm Bill allows states to enact pilot programs for hemp research making hemp legal in the state’s borders. Hemp cultivated in compliance with a State’s program is expressly legal under the Farm Bill. Extracts from compliant hemp are legal in the State in which they were derived though the sale of these products in other states is not explicitly allowed.

The final scenario is when products are derived from imported hemp. In the early 2000s, two cases out of the Ninth Circuit, Hemp Indus. Ass’n v. DEA, 357 F.3d 1012 (9th Cir. Cal. 2004) and Hemp Indus. Ass’n v. DEA, 333 F.3d 1082 (9th Cir. 2003) determined that the DEA cannot regulate hemp products simply because they contain trace amounts of THC. This is because some portions of the cannabis plant are explicitly outside the scope of the CSA and the DEA was not permitted to expand its scope to encompass all parts the plant. At the time of the ruling, it was illegal to grow hemp so it only applied to hemp imported from outside the USA. However, its holding could also apply to hemp grown pursuant to the Farm Bill. In other words, marijuana extracts from non-psychoactive (industrial) hemp with only trace amounts (or less) of naturally occurring THC are permitted under the Ninth Circuit’s ruling.

The Hemp Industries Association has sued the DEA over the “marijuana extract” rule and that case is still pending and until it is decided, uncertainty remains as to the legality of CBD products. The DEA may very well lose because the Rule appears to conflict with the Farm Bill and the Hemp Industry cases from the early 2000s.  Nonetheless, despite potential legal flaws, the Rule is currently in place and anyone who distributes “marijuana extracts” is a potential target of the DEA. This is likely why online retailers like Target have flirted with selling CBD products online but often end up pulling products.

 

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Cannabis Edibles and the FDA: An Update

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The FDA is the 800 pound gorilla of cannabis edibles.

The Food & Drug Administration (FDA) has only the jurisdiction Congress gave it in the Food, Drug and Cosmetic Act (FDCA). Under this act, the FDA has broad regulatory powers over legal drugs, with more limited powers over food.

Under the FDCA, the FDA categorizes a substance as either a food or a drug depending on how it is labeled or advertised. If labeling suggests the substance is “intended for use in the diagnosis, cure, mitigation, treatment, or prevention of disease, or is an “article[]” (other than food) intended to affect the structure or any function of the body of man or other animals,” the FDA will regulate it as a drug (except as noted below).

Cannabis edibles should stay out of the drug category if possible because drugs are subject to a comprehensive regulatory scheme that controls every part of the process, including formulation, testing for safety and efficacy, pre-clearance, manufacturing, labeling, sales, and recalls. For drug firms, the FDA is the 800-pound gorilla in the room.

The FDA categorizes food as anything people ingest that is not a drug. The FDA’s role in food is essentially hands-off. Though the FDA has promulgated hundreds of pages of food regulations, it mostly relies on food makers to self-enforce these regulations. However, when the FDA learns of regulatory violations it can and will take action.

The food/drug distinction is not always clear. In the Dietary Supplement Health & Education Act (DSHEA), Congress permitted some labeling claims for food (including dietary supplements) formerly limited to drugs. Under DSHEA, the FDA has issued regulations allowing certain specific health claims to be made on foods, e.g., “Three grams of soluble fiber from oatmeal daily in a diet low in saturated fat and cholesterol may reduce the risk of heart disease.” Food makers can also ask the FDA to permit other health claims if supported by scientific evidence. Other claims may be made, e.g., the role of an ingredient intended to affect a structure or function of the human body, under certain limited circumstances.

What does all of this mean for makers of cannabis edibles? If your cannabis label or your advertising does not make claims that bring your product within the FDA’s drug definition, the FDA will not treat your edible as a drug under the FDCA Act. This does not make it federally legal of course; it just means you won’t have to spend time having to deal with the FDA.

What if your edibles are marked with health claims or structure/function claims under DSHEA for cannabis or cannabis components, e.g., THC or CBDs? The FDA has in the past sent warning letters to firms making claims like these:

  • Studies have found CBD to possess the following medical properties: … Antipsychotic – combats psychosis disorders…combats neurodegenerative disorders … Anti-tumoral – combats tumor and cancer cells …combats…depression disorders
  • CBD helps with cancer, multiple sclerosis …diabetes, arthritis, dystonia, Crohn’s disease
  • Treats rheumatoid arthritis

The FDA has said that: “It is important to note that these products are not approved by FDA for the diagnosis, cure, mitigation, treatment, or prevention of any disease. Consumers should beware purchasing and using any such products.” If you make any health claims regulated by FDA for cannabis edibles, you risk federal administrative enforcement action.

For more on what the FDA has done with marijuana, check out the following:

There may though be change on the horizon. FDA Commissioner Scott Gottlieb recently said that “It’s high time [pun intended?] to start looking at rules around the [cannabis] plant, which some states have legalized for medicinal or recreational use.” Gottlieb also predicted that “We’ll have some answers to this question very soon because I think we do bear some responsibility to start to address these questions.”

 

Stay tuned.

 

 

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The Incredible, Shrinking, Anti-Cannabis Administration

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Leaving on a jet plane

Tom Price, Secretary of Health and Human Services (HHS), resigned his post last week amid public health and personal travel debacles. Mr. Price’s resignation drew very little coverage from cannabis reporters, however, which was sort of strange because the HHS Secretary wields more influence over cannabis law and policy than any other public official besides Attorney General Jeff Sessions, and whomever the new DEA Administrator turns out to be. If marijuana is ever to be re- or descheduled administratively, it will have to go through HHS.

The federal Controlled Substances Act (CSA), at 21 USC §811, provides that the Attorney General may remove drugs from the CSA: (1) on “his” own motion; (2) at the request of the HHS Secretary; or (3) on the petition of any interested party. Number 1 will never happen and number 3 has often failed, but if a reasonable HHS Secretary were appointed, number 2 could get people talking. CSA §811 further provides that prior to the Attorney General moving drugs around, he must consult with HHS for scientific and medical findings. HHS recommendations to the Attorney General are binding, including any “do not control” recommendation.

HHS is also senior on its organizational chart to the Food and Drug Administration (FDA), a well-known agency with the power to conduct independent research on marijuana and to approve cannabis-based pharmaceuticals. The FDA is the agency that works with HHS whenever “any interested party” makes a petition to remove a drug from the CSA, as referenced above. In fact, the FDA made one such recommendation to HHS and DEA last year on marijuana. Unfortunately, it chose the status quo.

Tom Price was an old-school, War on Drugs hardliner, whose judgment as to cannabis was nearly as bad as his judgment on government travel. Cannabis advocates should be glad to see him go. Given the composition of President Trump’s cabinet, however, it seems unlikely we will have a fair-minded HHS Secretary anytime soon. Most of the candidates being floated as replacements have poor or unascertainable records on marijuana policy.

Ultimately, it seems more likely that marijuana will be re- or descheduled through Congressional action than administrative channels. And as it stands today, two of the three most critical cabinet posts on cannabis—the HHS Secretary and the DEA Chief—are oddly vacant. For cannabis professionals and consumers alike, it seems better to have these posts remain vacant, than occupied by the Chuck Rosenbergs and Tom Prices of the world.

Let’s enjoy it while it lasts.

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The Top Five Cannabis Business Tax Myths

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I regularly speak with clients regarding the tax issues that impact their buying, selling or operating a cannabis business. There are certain things I hear again and again regarding their taxes and their tax planning that are simply not true. The below are the five most common.

1. Calculating the Odds of Getting Audited Constitutes Tax Planning. It does not. This is a dangerous myth as it causes businesses to focus on the wrong question. This handicapping is called “audit lottery” and it will always lead you astray. The IRS only audits a small portion of small business and individual returns, but as Mark Twain once said, there are “lies, damn lies and statistics.”  Stating the obvious, a cannabis business is just not comparable to any other legal business and its odds of being audited by both the federal government and the state where it operates are much higher than for other types of businesses.

Other factors auger against playing the audit lottery. To increase efficiency, the IRS selects issues or industries it believes are rife with noncompliance or abuse. Based on a history of noncompliance by cannabis businesses, the IRS is active in auditing cannabis businesses. A recent law change has made it easier for the IRS to audit partnerships and LLC’s and beginning in 2018, the partnership/LLC is responsible for remitting tax due on any IRS adjustment on audit.

The energy spent guessing the odds of an audit are better spent understanding how to comply with federal tax law and how to document transactions in the most efficient manner.

2. Drafting Legal Documents Are Sufficient To Support My Tax Return.  We have written on the importance of corporate governance and compliance here, here and here.  The same concepts apply to taxes.  You should have legal documentation to support the fundamental financial events of your business. Is this transaction a loan from an owner or a contribution to equity? What are the management rights and responsibilities of a new partner? The answer to these and other questions should be supported by your legal documentation.

But having contracts in place is merely the starting point when it comes to your taxes. An important tax law maxim is that the “tax follows economics.” This means the proper tax treatment reflects what happens in your business, not what contracts are drafted and placed in a file.

In evaluating the tax consequences of a transaction, the IRS will always start with the documents, but it will then analyze how the business really operates (i.e., its economics) and compare that to the documents. Unsigned documents are ignored. Documentation that does not support the economics of the business are ignored. Contracts and legal documents not reflected in your books and records are ignored. Your contracts and corporate documentation must reflect how your business operates. Then, and only then, are they useful in determining the correct tax treatment.

3. Compliance with State Law is not Relevant for Federal Income Tax Purposes. Our cannabis clients often wrongly believe state law operates independently from federal law. In administering federal tax law, the IRS often restructures or ignores transactions with no business purpose or that were structured solely for tax avoidance purposes. Most often, the starting point in that evaluation is state law and a transaction that comports with state law has a greater chance of being viewed favorably by the IRS. Conversely, a transaction or structure that does not comport with state law, will most likely be rejected by the IRS on its face.

4. Having a Tax Professional Prepare My Return Limits My Responsibility.  Wrong. You the taxpayer have the ultimate responsibility for the information presented on your return. By signing your tax return, you are declaring, under penalty of perjury, that to the best of your knowledge, the information presented is, true, correct and complete. This includes information presented on schedules and statements. It is therefore crucial you have a clear understanding of the facts presented on the return and the reasons behind any tax treatment of a transaction.

5. Tax Law Applies to My Cannabis Business Differently Than Other Businesses. This is true to the extent that cannabis businesses are forced to reckon with IRC §280E. But generally, the principles of federal income tax law apply to a cannabis business the same as they do for a non-cannabis business. The tax law allows for a degree of flexibility in evaluating how a legal entity and its owners are subject to tax. A business may choose to operate as a limited liability corporation, and as such, be treated for tax purposes as a disregarded entity (i.e., the sole member is subject to tax) a partnership (i.e. each partner is subject to tax) or as a “C” corporation (i.e. the corporation is subject to tax). The tax law governing these options are no different for a cannabis business.

The cornerstone of the cannabis industry is strict state regulation, reporting, and compliance. Understanding and avoiding the tax myths discussed above will assist you in evaluating how to properly and effectively comply with both state cannabis law and federal income tax law.