By: Steve Masur and Amanda Chiarello
What’s Kosher, What’s Crowded, and What Will Get Crushed?
As public opinion continues to shift in favor of legalizing marijuana and state legislatures respond accordingly, many people, including investment firms and financial analysts, believe that legalized cannabis and cannabis-related products will become the next big market. We’ve been advising an increasing number of entrepreneurs with cannabis-related products—from a high-end chocolatier to an investment fund to a mobile app that directs the user to dispensaries based on the strains carried. This article addresses some questions that often arise when entrepreneurs consider getting into a cannabis-related product business, or “cannabusiness.”
A Patchwork of Laws
One of the biggest issues entrepreneurs encounter when venturing into the cannabis industry is the inconsistency at the federal and state levels, and among the states, regarding the legal status of marijuana.
Although numerous states have legalized marijuana, the drug remains illegal at the federal level. The Controlled Substances Act (CSA) (21 U.S.C. § 801 et seq.) classifies marijuana as a Schedule I controlled substance, which the CSA defines as a drug or substance with a high potential for abuse and without currently accepted medical use and accepted safety controls.
As of the date of this post, twenty-six states and the District of Columbia have reformed their marijuana laws in some form, whether to legalize for medicinal or recreational use or to decriminalize. Legalization refers to repealing the prohibition on cultivating, possessing, and using cannabis, sometimes only for a specific purpose (e.g., medicinal use), whereas decriminalization just lessons enforcement measures and associated penalties, often depending on the amount of marijuana. Often, both legalization and decriminalization measures are limited by restrictions relating to public usage, age, driving under the influence, licensure, and other public safety issues. Even in states where marijuana is legal, cannabusinesses still face significant issues when attempting to operate legitimate commercial enterprises.
Taxation and Finance
Since marijuana is illegal at the federal level, cannabusinesses often run into difficulties when filing their federal income tax returns. While Section 61 of the Internal Revenue Code does not differentiate between income derived from legal and illegal sources, cannabusinesses remain obligated to pay tax on its taxable income, though Section 280E bars medical and recreational marijuana businesses, which may be operating legally in their home states, from certain benefits afforded to other “legal” businesses under federal tax law, such as taking tax deductions. This means cannabusinesses are taxed on their gross income without any deductions for business expenses, which according to a 2015 New York Times article, leads to these businesses paying as much as 70% of its profits in federal income taxes, which many entrepreneurs cannot sustain. The IRS has put out a memorandum on this topic. Cannabusinesses are also responsible for state income taxes, sales taxes, and, in many cases, excise taxes as well.
In addition to the high tax burden, cannabusinesses also face banking obstacles. Even though the Department of the Treasury issued a guidance on how banking institutions might serve marijuana related businesses, many banks remain reluctant to take on clients in the marijuana industry for fear of legal repercussions, such as government seizure by the Federal Deposit Insurance Corporation (FDIC) or charter forfeiture. This forces some cannabusinesses to operate on an all-cash basis, making it harder to track revenue and pay taxes.
While trademark rights arise from use in commerce and do not depend on registration, filing for and obtaining a federal trademark registration from the United States Patent and Trademark Office (USPTO) affords the owner a powerful tool in its brand protection arsenal. While the USPTO will not necessarily reject an application simply because the words “marijuana” or “cannabis” or a graphic of a cannabis leaf is part of the applied-for mark, the USPTO will reject a mark if the class description in its application contains goods or services that are illegal at the federal level. The Trademark Manual of Examining Procedure requires that, to be valid for registration, “the use of the mark has to be lawful,” and if it is not, “the use of the mark fails to create any rights that can be recognized by a federal registration.” Section 907 specifically calls out goods or services involved in the sale or transportation of a controlled substance or drug paraphernalia in violation of the Controlled Substances Act as the basis for refusing registration, regardless of state law. The USPTO has granted trademarks for goods and services that do not pertain to the sale or transportation of the Schedule I drug, for example, LEAFLY, for a website that provides visitors with cannabis recommendations, dispensary locations, and cannabis events, and WEEDMAPS, for a website that finds local dispensaries and delivery services. This is not to say that cannabusinesses are not afforded any trademark rights in states where their businesses are legal, as state trademark statutes and common law unfair competition law continue to apply.
Federal copyright law has proved more lenient, and the Copyright Act of 1976 (17 U.S.C. § 101 et seq.) provides very few prohibitions on the subject matter or nature of a work eligible for copyright protection. In an article written for the American Bar Association’s magazine Landslide, one former USPTO examining attorney pointed to cannabis grow guides and cookbooks as an example of how federal copyright law can protect cannabis-related products and further stated, “For cannabis brands, federal copyright protection is available to protect the text and artwork on logos, labels, product tags, product packaging, instructional materials, and the ornamental product design, as long as the foregoing contain sufficiently original and creative content to be copyrightable.” Case in point are High Times and Snoop Dogg’s cannabis lifestyle media platform, Merry Jane.
Making and Enforcing Contracts
Contracts made for an illegal purpose, or where the purported consideration or object of the contract itself is illegal, are void and unenforceable. This can present cannabusinesses with significant problems in carrying on a successful business considering the federal prohibition and interstate inconsistencies, especially with out-of-state suppliers, merchants, retailers, and consumers and on nationwide e-commerce platforms. However, various trial courts in states where marijuana is legalized have upheld the enforceability of certain cannabusiness contracts since contract law is largely a matter of state law and, therefore, their legality or illegality would depend on the underlying state law, and not on federal law.
For example, in Green Earth Wellness Center, LLC v. Atain Specialty Insurance Co., 63 F. Supp. 3d 821 (D. Colo. 2016), a federal district court judge in Colorado ruled that an insurance company could not void its commercial liability policy and deny coverage to a medical marijuana business following wildfire damage to its plants and theft of its plants. The judge rejected the insurance provider’s argument that the federal prohibition on marijuana required the policy be void on public policy grounds since medical marijuana is legal under Colorado law and the company willingly, knowingly, and intelligently entered into the contract to insure the medical marijuana dispensary.
The Future of the Market
In a 2016 report titled The Green Gold Rush, M&A advisory and financing firm Ackrell Capital, which launched a venture fund to target the cannabis industry, forecasted that the legal cannabis market for recreational and medicinal use will rise to approximately $9.5 billion by 2019, $50 billion by 2023, and $100 billion by 2029, though these projections assume marijuana prohibition ends by 2020. As we approach the 100-year anniversary of alcohol prohibition in the United States, we may be on the cusp of a watershed moment in public policy, yet exactly when, or how, remains difficult to predict for entrepreneurs and investors.
For such time as marijuana remains illegal at the federal level and in about half of the states, a cannabusiness could be shut down at any time, and as a result, everything from finding investors to creating good business practices for manufacturing products to working out legal lines of distribution will remain difficult. Still, as we have seen time and time again, the biggest and greatest entrepreneurial opportunities are rarely to be found where everyone else is looking, or without risk—and that is what funds like Ackrell Capital are betting on. Entrepreneurs must decide for themselves whether the risks are worth the possible huge rewards.
*We would like to thank our intern Amanda Chiarello for her contribution to this article.