The Great Eight California Marijuana Industry Pitfalls

California marijuana laws
California cannabis laws. Change is coming.

Implementation of the MMRSA and the impending vote on the AUMA, are causing big changes to California’s cannabis industry and creating all sorts of new regulatory and business pitfalls for cannabis businesses. And just as we have seen in other states with new and changing cannabis laws, we are seeing a panoply of red flags and nightmare scenarios.

I set forth below the top eight California cannabis industry pitfalls, in an effort to prevent you from becoming a victim of any of them.

  1. Investing in or buying and selling a nonprofit. It drives me crazy when I hear both industry participants and even attorneys talking about investing in a nonprofit or, worse, buying or selling nonprofit entities in California. Though California laws forbid selling cannabis (including medical marijuana), it was actually the California State Attorney General who, in a 2008 memo, interpreted those laws to mean that qualified patients could form “collectives” (e.g., nonprofit mutual benefit corporations) or statutory nonprofit cooperatives to “collectively or cooperatively” cultivate and/or distribute medical marijuana to each other. For-profit entities are not allowed under Proposition 215, SB 420, or the California Health and Safety Code (though they will likely be allowed under the MMRSA through AB 1575). When dealing with nonprofits, there is no concept of equity, period. Nonprofits do not have owners, partners, or shareholders. They can though have directors, officers, and salaried employees. This means that it simply is not possible to invest in or buy or sell a nonprofit entity. But because of shoddy legal advice or straight up shady dealings, we have seen (and we are continuing to see) all sorts of “deals” involving the buying and selling of California nonprofits.
  2. Ignoring the importance of local approvals. Any cannabis consultant who tells you that local control doesn’t matter or suggests you just open your cannabis business regardless of local law is giving horrible advice. Unfortunately many do. In 2013, in the case City of Riverside v. Inland Empire Patients Health and Wellness Center, the California State Supreme Court unanimously decided that local governments are free to ban MMJ distribution. Nothing in current California MMJ laws or regulations prevents local governments from banning MMJ entities from operating within their borders. This means that California cities and counties are free to regulate MMJ operations in addition to (but not in conflict with) state laws and regulations. Ignoring local laws and regulations can (and does) lead to civil lawsuits, fines, penalties, and even criminal charges. Moreover, since the MMRSA requires local approval as a condition for receiving a license to operate, if you defy or ignore local laws you’re probably not going to net that invaluable approval. For more on current local laws, check out Tiffany Wu’s terrific series, The California Cannabis Countdown.
  3. Cannabis delivery may not be legal in your area. The legality of cannabis deliveries depends entirely on local laws because California state MMJ laws and regulations do not explicitly prohibit it. However, certain cities and counties definitely do not allow cannabis delivery services. For example, pursuant to Proposition D, the City of Los Angeles completely banned delivery, and the city attorney has successfully litigated this issue. Los Angeles even gets a pass under the MMRSA (which will also stand under the AUMA) by being allowed to keep its current local cannabis delivery laws.
  4. You probably cannot get a state-registered trademark in California. It’s commonly known that the U.S. Patent and Trademark Office generally will not issue a trademark for any marijuana goods or services (though it will for marijuana related goods and services like t-shirts, hats, etc.). Consequently, many marijuana businesses file for trademark protection with their state governments. However, since the State of California follows federal standards for goods classifications and registration, the California Secretary of State has routinely denied state trademark protection for MMJ operators. Unfortunately, it appears that common law trademark protections are all that can be had right now in the Golden State.
  5. Management companies for banking, investment, and taxation purposes can be very risky. Because California MMJ nonprofits are so hamstrung by current state and federal laws, they often use management companies as vehicles for investment, to secure a bank account, and to cut corners with federal income taxes. Using management companies for these sort of things is very risky. The main problem with these sort of structures is that they can easily be viewed as constituting money laundering and/or tax evasion under federal law. These sorts of structures can open your cannabis business not only to criminal liability, but also to civil liability from the companies with which you do business. To avoid potential liability, management companies should be used only for legitimate business purposes and any dealings with the nonprofit should be structured as arms-length transactions with appropriate, market-rate fees.  It also bears mentioning that California nonprofit regulators aggressively pursue non-profit cannabis entities that distribute profits on the sly. Though a management company structure is legally feasible, it must be done correctly to avoid dire legal consequences.
  6. Not all medical marijuana extraction is legal in California. Not all forms of MMJ extraction are lawful in California. For exampleCalifornia Health and Safety Code section 11379.6, makes manufacturing a controlled substance by chemical extraction punishable by imprisonment of up to seven years and a fine of up to $50,000. Though the general public usually associates this law with illegal “meth labs,” its language also applies to manufacturers of marijuana products using certain types of extraction methods. Marijuana is a controlled substance under both federal and California law, and section 11379.6 applies to methods of creating marijuana products using volatile chemicals which pose a danger to the public, such as butane. Just last year, Governor Jerry Brown signed a new law increasing punishments for producing hash oil within 300 feet of a residential building. It may be legal in California to possess and distribute medical marijuana extracts produced under any method, but it is still illegal to manufacture cannabis extracts using butane and other volatile solvents.
  7. California cannabis businesses need to be aware of products liability issues. Just because a marijuana business is violating federal law does not make it immune to being sued for selling a product that injures someone. Products liability plaintiffs and lawyers don’t care about lack of government regulation and products liability cases are making their way into the cannabis industry and Proposition 65 definitely applies to cannabis. California’s Proposition 65, or the Safe Drinking Water and Toxic Enforcement Act of 1986, requires the state to publish a list of approximately 800 chemicals known to cause cancer, birth defects or other types of reproductive harm. Proposition 65 also requires businesses provide their customers with notice of these chemicals when present in the products they purchase, in their homes or workplaces, or that are released into the environment. As of June 19, 2009, marijuana smoke was added to the Prop 65 list of chemicals known to cause cancer. The Carcinogen Identification Committee (CIC) of the Office of Environmental Health Hazard Assessment (OEHHA) “determined that marijuana smoke was clearly shown, through scientifically valid testing according to generally accepted principles, to cause cancer.” Check out the complete Proposition 65 list here. You’ve been warned.
  8. California imposes a sales tax on MMJ transactions. Even though California’s current MMJ laws and regulations prohibit cannabis sales, California’s Board of Equalization takes a different stance when it comes to imposing a sales tax on marijuana transactions:

In California, all sales of tangible personal property are taxable unless the law provides a specific exemption. The law defines tangible personal property as an item that can be seen, weighed, measured, felt, or touched. Medical cannabis and cannabis-related products are generally considered tangible personal property and without a specific exemption, sales of such property are subject to tax. Although medical cannabis is considered a medicine, sales of medicines are generally subject to tax unless dispensed on prescription filled by a licensed pharmacist or furnished by a health care facility. Dispensaries are not licensed pharmacies or health care facilities. Therefore, sales of medical cannabis do not generally qualify as an exempt sale of a medicine.

The BOE is of the view that because MMJ is not dispensed via prescription, there’s no sales tax exemption on patient transactions and therefore, all California MMJ operators must register for a seller’s permit with the BOE or face the consequences at tax time. And, of course, the IRS does not recognize marijuana nonprofits as tax exempt entities, and it applies I.R.C. section 280E accordingly.