The White House Office of National Drug Control Policy (ONDCP) recently released “An Initial Assessment of Cannabis Production, Distribution, and Consumption in Oregon 2018 – An Insight Report.” The report “does not purport to be a policy evaluation or policy performance review; rather [the] assessment provides a verifiable analysis of assorted information and data.” A review of the data and its presentation raises more questions than it answers. The assessment presents data in a way that conflates Oregon’s adult-use, medical and black markets. As a result, it is challenging to determine what, if any, policy response might be appropriate.

The U.S. Attorney for the District of Oregon provided a statement in response to the assessment. The statement describes the production, distribution and consumption in Oregon as “out of control” and suggests, “state officials should respond quickly and in a comprehensive manner to address the many concerns raised.” The U.S. Attorney requests, “continues to be for transparency, responsible regulation, adequate funding, and a willingness to work together.” He further adds, “[i]t’s time for the state to wake up, slow down, and address these issues in a responsible and thoughtful manner.”

Fair enough. So let’s take a look the assessment and see how meaningful the current data really is. The assessment’s key findings include:

  • The Oregon Burn Center spent $9.6 million for initial acute care treating impatient burn victims from July 2015 through January 2018 that related to cannabis extract production.
  • During the same period, law enforcement investigated 64 cannabis processors, 21 of which resulted in fire or explosion.
  • A mature cannabis plant consumes 22.7 liters (6 gallons) per day.
  • A single kilogram (2.2 pounds) of finished flower requires 5.2 megawatt hours of electricity — this is equivalent to running a 1,000 watt grow light 24 hours a day for 225 straight days!
  • Cryptocurrencies such as bitcoin and ether are used for cannabis transactions.
  • A glut of cannabis stockpiles stemming from overproduction caused a 50 percent annual price drop since 2016.
  • As of 2018, only 31 percent of available cannabis inventory was distributed, leaving 69 percent unconsumed within the adult-use program.
  • Illicit cannabis cultivation on public lands persists unabated, despite the state-sanctioned adult-use market.
  • Illicit out-of-state distribution persists after the emergence of the state-sanctioned adult-use market.
  • Oregon’s annual production capacity far exceeds its estimated annual consumption demands — there is one grow site for every 19 users (probably includes both medical and recreational grows, but not adult-use home grows).

There is an obvious elephant in the room.  The production and sale of cannabis remain illegal under the Controlled Substances Act, and the Attorney General has made his views on the state legalization of marijuana quite clear. So there might well be an inherent bias as a result (similar to EPA’s recent conclusion that larger cars will reduce fatalities and fuel consumption because people will drive less because fuel will be more expensive and they can carry more groceries in their cars). That said there is the obvious problem of cannabis demand throughout the U.S., including in states without medical or adult-use programs. Prior to its medical and adult-use programs, people were illegally producing and exporting cannabis from Oregon. Few would question the conclusion that Oregon has, and will continue to have, an export problem when there is money to be made from illegally producing and selling cannabis.

Still, at least two of the data points stand out as possibly incorrect or at least misleading given the report’s statement that they constitute “verifiable analysis of assorted information and data.” The first is the statement that a single mature plant consumes, on average, 6 gallons of water per day. The second is that it takes approximately 5.2 megawatts of electricity to produce a single kilogram of (indoor) finished flower.

Digging deeper into the assessment, it notes, “definitive information varies about the water needs of cannabis cultivation with estimates ranging widely from 1 to 15 gallons daily.” The six gallons per day figure comes from a California study. That study relied on “high-resolution aerial imagery to estimate the number of marijuana plants being cultivated in four watersheds in northwestern California” and “estimated the water demand of marijuana irrigation.” However, the water estimates “were based on calculations from the 2010 Humboldt County Outdoor Medical Cannabis Ordinance draft.” I was unable to locate a specific water estimate in that ordinance. It simply states, “the cultivation of marijuana in areas not served by public water systems may result in large, unregulated withdrawals of water from creeks, streams, and rivers.” It remains unclear where the 6 gallons per day figure actually comes from, how accurate it actually is, and whether it equally applies to indoor and outdoor operations, which are in compliance with state law.

The claim that it takes approximately 5.2 megawatts of electricity to produce a single kilogram of finished flower comes from a 2017 paper titled “High Time to Assess the Environmental Impacts of Cannabis Cultivation.” The paper does not analyze electricity use, but rather states “it has been estimated that the power density of marijuana cultivation facilities is equal to that of data centers and that illicit grow operations account for 1% of the U.S.’s average energy use.” The paper cites a 2012 paper titled “The carbon footprint of indoor Cannabis production.” A subsequent paper titled “Trends and Observations of Energy Use in the Cannabis Industry,” citing the 2012 study, notes the author “calculates that it takes approximately 13,000 kWh per year to operate a standard production module that is 4’x4’x8’. This is based on a production cycle of 78 days, for 4.7 cycles per year, and simple assumptions about the equipment capacities and use.” There is an obvious leap between a small 4’x4’ grow space and larger indoor production facilities that employ LED lighting. Indeed, the author of the subsequent paper suggests that, “falling product prices will drive the need for more competitive operating costs, which will largely be presented in the form of energy efficiency.” There are arguably energy savings from larger indoor grows, outdoor production and the use of indoor greenhouses that rely on light deprivation techniques.

My view is that the U.S. lost the federal war on all drugs long ago, not just cannabis. Nevertheless, the law is the law and, regardless of Oregon legalization, we cannot permit growers to operate on federal lands. OLCC licensed businesses must support efforts to eliminate market participants that do not follow the rules, and they must take better care to ensure that their product does not enter the black market. Lastly, OLCC enforcement also needs to be stepped up — following adequate funding from the State Legislature — if for no other reason than to prevent further wrath of the federal government.

Most of our readers probably concur that the U.S. Attorney’s call to Oregon to “wake up” is misplaced. Our federal anti-drug resources would be far better directed at the community-destroying opioid crisis, but that seems unlikely to happen under the current Attorney General unless and until Congress gets its act together to pass the STATES Act. Evidence already exists that medical marijuana (1) reduces the daily doses filled for opioids, (2) reduces opioid overdose deaths, and (3) facilitates the substitution of marijuana for opioids. Removing cannabis from the Controlled Substances Act in states where the people and the local government have decided that there are larger public health issues to worry about would allow our federal government to not only respect public sentiment regarding cannabis but also liberate funds do help those affected by life-destroying pharmaceuticals.

What if a company patented any liquid form of high-potency cannabis? And, what would happen if that company used the patent to shut down the operations of anyone making these liquid forms? Those are the questions raised by a lawsuit filed in Colorado federal court on July 30, 2018, and the answers could have existential consequences for many cannabis businesses.

In July, United Cannabis Corporation (“UCANN”) sued Pure Hemp Collective, alleging infringement of U.S. Patent No. 9,730,911, “the ’911 patent.” The UCANN case has major implications for U.S. cannabis businesses, and it is critical for the industry to understand exactly what UCANN is claiming, and the strength of its claims. This will require understanding a bit about U.S. patent law, and, importantly, the limitations inherent in the U.S. patent system.

A patent provides its owner with statutory protection over patented “inventions,” including “any new and useful process, machine, manufacture, or composition of matter….” 35 U.S.C. § 101. The scope of protection is defined by the “claims” in the patent, which are succinct descriptions of what is covered by the patent, similar to the “metes and bounds” description on a real property deed. Each claim operates like a “mini patent” in the context of the patent as a whole. Patent infringement occurs when someone, without permission, practices the “invention” described in any of the claims of a patent.

UCANN claims that Pure Hemp is infringing the claims of the ‘911 patent, which is directed to compositions of matter, and it alleges specifically as follows:

UCANN purchased Pure Hemp’s Vina Bell 5000mg product and ran chemical composition tests on it to determine whether the cannabinoid formulations within the product are covered by the ’911 Patent.  The analysis revealed that the product contains a cannabinoid formulation that directly infringes one or more claims of the ’911 Patent, including exemplary claim 10: “A liquid cannabinoid formulation, wherein at least 95% of the total cannabinoids is cannabidiol (CBD).”  Specifically, the Vina Bell 5000mg product contains a cannabinoid formulation wherein at least 95% of the total cannabinoids is CBD.  Pure Hemp sells other cannabis products with similar cannabinoid compositions that infringe other claims of the ’911 patent.

Complaint, ¶ 22.  UCANN references Claim 10 of the ‘911 patent, which reads in its entirety as follows:

A liquid cannabinoid formulation, wherein at least 95% of the total cannabinoids is cannabidiol (CBD).

On its face, Claim 10 would appear to cover any liquid formulation containing CBD so long as at least 95% of the cannabinoids in that formulation consist of CBD. This is a very broad claim, apparently encompassing a significant number of CBD products currently on the market. Of the thirty-six claims in the ‘911 patent, claims 1, 5, 16, 20 and 25 are similarly broad, and would appear to cover, in turn, high-potency formulations containing: THCa; THC; THCa and CBDa; THC and CBD; and CBD, CBN, and THC. Assuming the ‘911 patent is valid, any cannabis company selling such formulations could risk a similar lawsuit.

It is not possible, however, to infringe an invalid patent. Under 35 U.S.C. § 101, an invention must be “new” to be valid and to qualify for patent protection.  This “novelty” requirement is analyzed by the U.S. Patent & Trademark Office (PTO) during the application process for the patent. Although, the PTO is not the final word in our U.S. patent system. The federal courts are empowered to review the validity of patents made the subject of federal lawsuits.

In reviewing the validity of a patent, the federal courts will be guided by the principle that “that which infringes, if later, anticipates, if earlier.” This means that the reviewing court will look at the patent claim(s), determine their scope, and then look at both the accused infringer, and also the “prior art” that predates the patent. If the invention is described in the prior art, it is not “new,” and therefore fails the novelty requirement under § 101. It will be ruled invalid, and cannot be enforced.

Here, UCANN has asserted that Pure Hemp infringes because “[Pure Hemp’s] product contains a cannabinoid formulation wherein at least 95% of the total cannabinoids is CBD.” Taking UCANN’s assertion at face value, any prior art that establishes the existence of “a [liquid] cannabinoid formulation wherein at least 95% of the total cannabinoids is CBD” will invalidate Claim 10 of the ‘911 patent.

Qualifying prior art will include any patent or printed publication, or corroborated evidence of the existence of such a formulation, prior to the “critical date” of the ‘911 patent. The earliest effective filing date of the ’911 patent is October 21, 2014. The critical date under the U.S. patent system will be one year prior, i.e., October 21, 2013.

So to be clear, Claim 10 of the ‘911 patent will be invalidated by a showing essentially that on any date prior to October 21, 2013, there existed a liquid cannabinoid formulation wherein at least 95% of the total cannabinoids was CBD.*

For one with familiarity with the history of the cannabis, and cannabinoid biopharmaceutical industries, this would appear to be easy to show. GW Pharma’s Epidiolex, for example, is a 99% pure liquid formulation of CBD and has been in development for well over ten years. In addition, high-potency liquid CBD formulations have been sold in the U.S. for a very long time. This leads to the question: how did the PTO miss this in allowing the ‘911 patent to issue with these very broad claims? One answer: there is a lack of published prior art of the sort upon which a patent examiner typically relies. The federal illegality of cannabis in the U.S. has contributed to this shortage of published art.  One group that is trying to remedy this shortage by establishing a library of cannabis prior art is the Open Cannabis Project. Their stated goal is “keeping cannabis in the public domain.”

Maintaining an open and accessible marketplace for cannabis products depends on tracking this kind of patent activity. Lane Powell closely monitors this activity for its clients, and stands ready to assist.

___________

* To my colleagues in the patent field: you will recognize that I have simplified some of the patent issues including the process by which prior art is evaluated.

Justin Hobson made a guest appearance on episode #6 of CFN Insider’s “Profit From Cannabis” podcast. The episode, entitled “The US Cannabis Marker: New Promise, Persistent Constraints,” covers:

  • The FDA’s approval of GW Pharma’s Epidiolex,
  • Impact of rescheduling cannabis and DEA’s rescheduling possibilities (isolate vs. cannabis plant),
  • Resulting investment plays (cannabinoid drug developers, hemp extracts), and
  • A legalization roundtable that discussed how state cannabis programs are faring under the Trump Administration.

Hobson commented on the growing risks investors’ face since the rescission of the Cole Memo, the increased scrutiny that applicants have observed from the Oregon Liquor Control Commission, and the industry’s problem with product diversion. Have a listen!

A significant tax bill may await RICO plaintiffs involving cannabis lawsuits because in most cases the plaintiffs will be taxable not only on amounts recovered but also on the amounts spent on lawyers and court costs.

We recently discussed the latest in a series of Oregon RICO cases that generally involve property disputes. Plaintiffs and plaintiff attorneys find RICO cases attractive given the status of cannabis under the Controlled Substances Act and the availability of treble damages plus attorney’s fees. The most recent complaint alleges property damage from “noxious” odors and illegal activities that resulted in reduced property values.

There is at least an argument that the dollar value attributable to these items is zero or some nominal amount. One of the earlier RICO cases settled out of court. There are no public details of the agreed upon settlement. However, a number of the defendants successfully fought the cases against them and obtained dismissals. The remaining defendants probably found it cheaper to settle than face a drawn out legal battle. It is probably fair to say that a significant amount of the settlement went to pay attorney’s fees. This conclusion is, in part, based on the fact that the same attorney has represented multiple plaintiffs in cannabis RICO claims. While these claims might provide plaintiff attorneys a meal ticket, the plaintiffs themselves might be left holding the bag when they determine their federal income tax liability.

Specifically, section 61 of the Internal Revenue Code of 1986, as amended (“Code”) defines “gross income” for federal income tax purposes as income from “whatever source derived.” This means that the general starting point for determining taxable income is that any amount received is taxable to the recipient. Furthermore, under the “assignment of income” doctrine, a taxpayer is often taxed on the gross amount recovered, even if the taxpayer does not directly receive custody or take possession of the income amount. Thus, in the typical contingent fee arrangement, a plaintiff might agree to pay an attorney 40 percent of any damage award. Any settlement is generally paid to the plaintiff attorney’s client trust account where 60 cents of every dollar goes to the plaintiff and the remaining 40 goes to the plaintiff’s attorney. For tax purposes, this is generally treated as the plaintiff receiving the entire dollar and spending 40 cents for legal fees notwithstanding the contingency fee arrangement.[1]

Several code provisions provide for excluding certain types of damage awards from taxable income. For example, section 104 of the Code excludes from taxable income amounts received that are on account of personal physical injury or physical sickness. Those income exclusion provisions are not likely to apply in these RICO cases.

Deductions from gross income are a “matter of legislative grace.”[2] Trade or business expenses are generally deductible under section 162 of the Code — subject to denial under section 280E for any trafficking business. Alternatively, section 212 of the Code allows a deduction for all ordinary and necessary expenses paid or incurred for the production of income and for the conservation of property held for the production of income. Regulations under section 212 note that expenses paid or incurred for conservation of property used by taxpayer as a residence are not deductible under section 212, but are deductible if the property is used for the production of income (e.g., rental property).

Prior to 2018, section 212 expenses were considered miscellaneous itemized deductions that were subject to a minimum floor, typically two percent of adjusted gross income. If the expenses did not exceed the floor, then they were not deductible to the taxpayer. However, code section 67(g), added by the so-called Tax Cuts and Jobs Act of 2017, temporarily eliminates the availability of such miscellaneous itemized deductions even over a taxpayer’s 2 percent floor. Section 165 casualty losses were also materially limited by the same “tax reform” — now allowing itemized deductions for such losses only to the extent they exceed 10 percent of a taxpayer’s adjusted gross income.

Section 62 of the Code provides several so-called above-the-line deductions. Above-the-line deductions are not miscellaneous itemized deductions and subject to the temporary elimination noted above. They remain deductible for federal income tax purposes. Section 62(a)(2) provides a deduction for attorney fees and court costs involving most discrimination lawsuits, and claims under chapter 37 of title 31 of the United States Code. However, RICO claims typically fall under section 1962 of title 18 of the United States Code. Therefore, the deduction available under section 62 for legal fees in certain cases would not be available in connection with cases involving RICO damages.

In sum, if the RICO claims relate to property used for personal purposes (e.g., as a residence), then no deduction should be available under sections 162, 165 or 212 for any legal fees incurred. Indeed, whenever RICO plaintiffs are not engaged in the active conduct of a trade or business they probably cannot deduct their legal fees or even offset the gross amount recovered in such suits by legal fees retained by their lawyers.

Hypothetically, a plaintiff could settle a RICO case for a nominal amount of say $10,000 plus attorney’s fees of $50,000. The taxpayer-plaintiff probably needs to recognize the entire $60,000 as taxable gross income under section 61 and in many cases will not be entitled to claim a deduction for the $50,000 paid (or deemed paid) to the attorney. Assuming a 40 percent combined federal and state tax rate on the $60,000 of income, the tax due is $24,000, which significantly exceeds the plaintiff’s net proceeds of $10,000. The irony of this situation is that it is the exact problem many cannabis businesses face under section 280E — the taxpayer’s net income is less than the tax liability.

The takeaway? Potential RICO plaintiffs should consult with a tax advisor before pursuing RICO claims. Failing to do so could leave them with a tax debt exceeding a damage award or settlement amount.

[1] Commissioner v. Banks and Commissioner v. Banaitis, 543 U.S. 426 (2005).

[2] Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

Like coworkers to donuts, the cannabis industry has attracted a host of adjacent industries that interface with the business of marijuana in one way or another. Some, like security, cash management, and analytical services, support the industry in ways that are integral to its success. Others . . . do not. Enter the Oregon attorney who has been busy of late filing civil RICO complaints against what at this point constitutes a significant minority of Oregon cannabis businesses.

The joys of civil RICO claims came onto the Oregon industry radar in 2017, when over 70 people and entities were sued by an attorney who owned property adjacent to several of the defendants’ businesses. The lawsuit alleged that the activities of marijuana businesses on adjacent properties had diminished the value of the plaintiff’s land. This was not in and of itself novel — cannabis businesses face nuisance-type complaints from neighbors with some regularity. Last year’s innovation was the addition of federal civil RICO claims to a garden-variety neighbor dispute, following the measured success of this tactic in a 10th Circuit case out of Colorado. The first case settled earlier this year.

While the terms of the settlement are confidential, it seems to have been favorable enough that RICO-infused property disputes have become a cottage industry. To that end, two other civil RICO complaints have been filed, with the latest coming in this past Friday. Filed on behalf of a property owner in Sandy, Oregon, the complaint alleges diminution to the value of the plaintiff’s property due to odors, alleged harassment, and the undesirability of living next to an “illegal drug manufacturing site that might easily explode and set the whole neighborhood on fire.”

The merits of the claims aside, the complaint appears to follow an emerging pattern in anti-cannabis litigation: getting nuisance-based neighbor disputes into federal courts using the federal prohibition of cannabis and “Reefer Madness”-type scaremongering. And while some of the more florid language in the complaint is amusing, civil RICO actions are quite serious, with the potential for triple damages and attorneys’ fees if a plaintiff prevails. We’ll be posting updates as we work through the details of the complaint. In the meantime, be nice to your neighbors, and take lawsuits like this seriously. If you or someone you know is affected by this kind of lawsuit, we can help. Contact our experienced litigation team today to discuss your options.

On July 3, the New York Department of Financial Services (“DFS”) issued its “Guidance on Provision of Financial Services to Medical Marijuana & Industrial Hemp-Related Businesses in New York State (PDF).” In the memorandum, DFS Superintendent Maria T. Vullo examines the current banking issues facing the state-legal marijuana businesses and states (in our view correctly) that:

Forcing medical marijuana and industrial hemp businesses to operate solely with cash creates a public safety issue, as cash intensive businesses and their suppliers, employees and customers become targets for criminals. Large amounts of cash distributed outside the regulated banking system is unacceptable and creates risks to the companies, and their employees and business partners. Further, large scale cash operations impede tracking funds for tax and anti-money laundering purposes. None of this is necessary. Positions taken by the federal government are only exacerbating these problems, rather than remedying them. New York must act.

Notwithstanding DFS’ guidance (including its reference and reliance on the rescinded Cole Memo), banks are likely to be reluctant to respond to the Superintendent’s encouragement for “New York State chartered banks and credit unions to consider establishing banking relations with [New York state sanctioned] marijuana-related business.” Most banks continue to have concerns that the federal regulators, including the FDIC, will not sanction this activity. This is evident in states that have enacted recreational-marijuana programs, where concerns about federal regulators and burdensome compliance requirements limit options to a handful of banks charging onerous rates for basic services. In any event, this memo represents a significant marijuana banking “shot across the bow” to federal banking regulators by the principal bank regulator of the state that serves as the center of the country’s banking business.

As our regular readers are aware, Senators Warren and Gardner introduced a bi-partisan bill in the Senate for the federal government: (1) to generally defer to state laws legalizing marijuana and (2) to effectively allow all banks to provide services to legal cannabis businesses in the same way that they treat other legal businesses (STATES Act, S. 3032). S. 3032 has been read twice and was referred to the Senate’s Judiciary Committee when it was introduced on June 7. An identical bill was introduced in the House (H.R. 6043), also on June 7, and was referred to the House’s Judiciary and Energy and Commerce Committees on the same day. No action has been taken on either bill since they were introduced.

Earlier this month, Congress continued to avoid providing bank access to state-legal cannabis businesses by voting against measures in appropriations bills that would have prohibited bank regulators from using federal funds to punish banks that provide bank services to state-legal cannabis businesses. This failure by Congress to allow cannabis business access to the banking system continues to cause serious business and safety problems for state-legal cannabis businesses.

With the midterm elections now coming into clear view, and with dramatic divisions in both houses of Congress, it appears unlikely — at the present time — that Congress will take any steps to solve this cannabis banking problem. It also remains unclear if, without Congressional action, the federal banking regulators will take any useful steps in the area, especially in light of the rescission of the Cole memo by Attorney General Sessions.

We will continue to follow and report on this, but unless an imaginative and scalable solution is found, the risks (including to public safety) and difficulties in dealing in an all-cash business is likely to be a significant hurdle for state-licensed  cannabis businesses.

Due to some interesting developments in health science, the future of the industrial hemp industry may be in the hands of the DEA once again.

For the first time ever, the FDA approved a drug derived from marijuana. The active ingredient in Epidolex, which in clinical trials reduced the frequency of seizures in people with certain forms of epilepsy, is cannabis-derived cannabidiol. Cannabidiol, commonly known as CBD, is used to (questionably?) treat a host of conditions, including anxiety, insomnia, chronic pain, and various neurological disorders such as seizures. Now, following a successful clinical trial, anecdotal claims of CBD’s efficacy, at least as they relate to epilepsy, have been given some scientific substance. While Epidolex is not the first approved drug based on compounds found in cannabis, the others (Marinol, Syndros, and Cesamet) contain synthetic versions of cannabinoids or cannabinoid analogues, whereas Epidolex is made from Cannabis Sativa L. itself.

The FDA’s blessing puts the DEA in an interesting position. CBD — along with every other compound extracted from the naughty parts of Cannabis Sativa L. — sits on Schedule I of the Controlled Substances Act, due in part to the DEA’s determination and Schedule I requirement that it has “no currently accepted medical use in treatment.” In response to the FDA’s determination that CBD does, in fact, have medical uses, the DEA is expected to reschedule CBD within the next 90 days.

That rustling sound you hear is industrial hemp growers shifting uneasily in their seats. Over the past few months, we’ve written about the growing legitimacy of the industrial hemp industry. Current internal DEA guidance differentiates cannabinoids sourced from marijuana and cannabinoids from industrial hemp, and there is active and increasing congressional support for the industrial hemp industry.  Interest in industrial hemp is driven in large part by the fact that some industrial hemp-derived CBD is not currently (at least not clearly) restricted by the CSA, and thus can be sold freely in the United States except in those few states with explicit prohibitions. If the DEA reschedules only cannabis-derived CBD, hopefully they will acknowledge that the reason for such limited release is that industrial hemp-derived CBD is already exempted by the 2014 Farm Bill. Otherwise, the DEA will disrupt a market and continue to obfuscate the law to promote political objectives.  (See this great Leafly article for more info on the topic.) We will be monitoring the DEA’s actions closely, and will post updates here when further information is available.

On June 13, the U.S. Tax Court issued Tax Court Memo 2018-83, Alterman and Gibson v. Comm’r. Based on the way this case is being reported in the trade press, one might think that this decision portends doom and gloom for taxpayers in the cannabis industry. Such fears are not justified for anyone who maintains good records and does even basic tax planning.

The Alterman Tax Court held:

  • Taxpayers selling both cannabis and paraphernalia were not carrying on a separate non-trafficking business and, therefore, could not allocate expenses between trafficking and non-trafficking businesses;
  • Taxpayers failed to substantiate amounts allocable to cost of goods sold (COGS); and
  • Taxpayers were subject to 20 percent accuracy-related penalties.

The doom and gloom of the holdings fade once you appreciate the relevant facts:

  • Taxpayers’ non-trafficking business was limited to selling products that contained no cannabis (e.g., pipes, papers and other consumption-related items) and represented less than 5 percent of total revenue;
  • Taxpayers’ kept very poor books and records;
  • Taxpayers’ filed tax returns, which included facially “questionable” amounts for beginning and ending inventory, and which could not be traced to the balance sheet or general ledger;
  • Taxpayers’ accountant prepared a profit and loss statement, but failed to produce supporting work-papers; and
  • “The 2011 general ledger bizarrely recorded that ‘Total Inventory’ was $12,279, which was the same dollar amount recorded in the ‘Total Inventory’ entry in the 2010 ledger.”

The last point is an actual quote from the Tax Court’s findings of facts. Bad facts often result in bad law, especially when jurisprudence is summarized in the trade press where headlines attract readers and clicks. However, bad facts provide opportunities to distinguish yourself with good (or at least better) facts. So here are the key takeaways from the Aterman case that are worthy of attention:

  • Taxpayers should maintain true, accurate and complete books and records; this taxpayer lost because of bad records not because the court overreached or applied Internal Revenue Code Section 280E in a particularly egregious manner;
  • Alterman is a memorandum opinion that does not create new law or alter existing law;
  • Taxpayers should identify and follow an inventory costing method that maximizes COGS;
  • Taxpayers using a CHAMPS strategy to allocate non-COGS items between trafficking and non-trafficking businesses arguably requires some level of substance and recordkeeping — we generally recommend that clients conduct non-trafficking businesses in a separate legal entity and report on a separate income tax return;
  • Taxpayers should engage competent accountants, bookkeepers and tax return preparers that understand applicable accounting methods and tax planning strategies; and
  • Failing to keep accurate books and records may result in significant tax exposure and penalties.

With a little bit of luck, legislation pending in Congress will soon be enacted and henceforth relieve the state-legal industry of the unfair burden imposed by IRC Section 280E. But we can promise that no legislation will help taxpayers with shoddy record keeping.

Right on schedule, the Agricultural Improvement Act of 2018 (i.e., the Senate’s version of the Farm Bill) was announced on Friday, and brings with it some good news for the U.S. hemp industry. As we predicted last month, hemp supporters in the Senate worked successfully to include the Hemp Farming Act (the “Act”) in this version of the Farm Bill.

The Act, sponsored by Senators McConnell (R-KY), Paul (R-KY), Merkley (D-OR) and Wyden (D-OR), gives states and Indian tribes the opportunity to have “primary regulatory authority” over the production of hemp with that state or on tribal land by submitting a control plan to the Secretary of Agriculture for approval. The plan is required to include, at a minimum:

  • Legal descriptions of land on which hemp is produced in the state or territory;
  • Procedures for testing to ensure compliance with federal restrictions on the THC content of industrial hemp;
  • Procedures for disposal of non-conforming hemp; and
  • Procedures for enforcement of the Act’s requirements.

Department of Agriculture oversight is significant in that the Farm Bill of 2014, on which current state programs are based, did not name a responsible federal agency. This framework will also shape changes to current state applications for licenses to produce industrial hemp and to state rules to the extent that they do not currently address the above requirements.

Another welcome effect of the Act is the specific exclusions of industrial hemp from the Controlled Substances Act (CSA). The CSA’s applicability to industrial hemp is currently murky at best, and while states and various federal agencies have indicated that it is excluded, clarity in this area will be of huge benefit to the industry. In addition, as we wrote about last week regarding the STATES Act, exclusion from the CSA also confers benefits with respect to banking and tax.

The Act further provides for easier funding for industrial hemp research, makes crop insurance available to the industry, and states that the Act, in and of itself, may not be construed to authorize the federal government to interfere with the interstate commerce of industrial hemp.

Nothing is certain in Washington, D.C. these days, but consensus seems to be that the Senate’s Farm Bill has bipartisan support and a much greater chance of success than the House version, which failed to pass in May. If it becomes law, the U.S. hemp industry will be on much stronger footing.