1200 Fifth Avenue, Suite 600 Seattle, WA 98101 206.267.7100 www.kcba.org/CLE

I-502 Impact: New Marijuana Legislation October 29, 2013

The electronic versions of all the documents are available on the KCBA website:

https://www.kcba.org/cle/EventDetails.aspx?Event=102913

Chapter 3 1:00 – 1:30pm Litigation and Corporate Transactional Work in the Marijuana Industry Hilary Bricken, Canna Law Group, a practice group of Harris Moure, PLLC

Electronic format only:

1. I-502 Impact : New Marjiuana Legislation

2. US Deputy AG Memo – Guidance Regarding Marijuana Enforcement

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KCBA I-502 Impact: New Marijuana Legislation—October 29, 2013

Hilary Bricken

Corporate formation, Industry pitfalls, Taxation, Banking, Intellectual property, and Cannabis civil litigation

1. Corporate formation:

a. Under I-502, entrepreneurs can incorporate as either for-profit

or non-profit entities;

b. Does your client have aspirations of being publicly traded? Think again because of the three-month residency requirement.

2. Industry pitfalls:

a. Handshake deals are a thing of the past—get it in writing!

b. Landlord/tenant commercial leases—permitted use should clearly list I-502 use if you want to avoid litigation in the future;

c. Make sure you are able to negotiate escape clauses for local, State, or Federal intervention (30-day landlord letter from the Federal government is latest means of mass enforcement in Western District of Washington);

d. Establish a working and transparent relationship with your municipality;

e. Pay attention to changes in local law (i.e., zoning and land use); and

f. Federal uncertainty regarding enforcement (does the most

recent Cole memo mean anything for industry participants and supporting services?).

3. Taxation:

a. 280e is still alive and well (all illegal businesses are still taxable and they’re entitled to one deduction only: Costs of Goods Sold (COGs));

b. Tax planning (CPAs) and tax attorneys are important in assessing COGS and walking clients through 280e audits;

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c. Leading cases on 280e: Still C.H.A.M.P and Olive;

d. What to do if your client receives an audit letter from the

Internal Revenue Service;

e. Grover Norquist (Americans for Tax Reform) calls for reckoning of 280e and States with licensed cannabis regimes; and

f. Despite passage of new and coming State marijuana laws, 280e must still be factored into the business plans of these operations (retailers are likely most impacted).

4. Banking:

a. Federal anti-money laundering laws prohibit banks from doing business with the cannabis industry;

b. This means a lack of access to banking and an inability to obtain financing (possibilities of litigation are usually low because banks have deep pockets and a firm legal position because of current Federal law);

c. Are management companies the way to obtain a bank account? Why the answer is likely no;

d. Denny Heck introduced technical banking bill fix in Congress (with a 2% chance of passing);

e. GOOD NEWS: Bank of America has agreed to take Washington State’s marijuana tax dollars; and

f. What does Bank of America’s decision mean for the cannabis industry and access to banking? A State license makes all the difference (in addition to the recent Cole memo).

5. Intellectual property and the cannabis industry:

a. Federal protection not possible unless marijuana is Federally

re-scheduled;

b. In the alternative, state trademarks are possible in the States in which your clients are doing business;

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c. Auxiliary businesses may still enjoy Federal trademark protection;

d. Even if your client gets the State or Federal trademark, what should they do to protect their branding?; and

e. High Times v. Northern Cross (Federal Court trademark infringement lawsuit filed in the Western District of Washington in October 2013).

6. Cannabis civil litigation—stakeholders versus municipalities:

I-502:

a. Cities/counties cannot enact any local law that preempts State law under I-502;

b. Current moratoria on I-502: the how and the why;

c. Zoning, land use, and nuisance—the vehicles for pretext;

d. What the August 29, 2013 Cole memo means for municipal litigation;

e. I-502 litigation to come (cities/counties arguing Federal preemption); and

f. Effective causes of action to try to defeat moratoria.

Legal Cannabis Dispensary Taxation: A Textbook Case of Punishing Law-Abiding Businesses Through the Tax Code

September 12, 2013 Abstract: Section 280E of the Internal Revenue Code (IRC) creates a gross receipts tax situation for legal cannabis dispensary small businesses. This is due to an accident of history and a perversion of Congressional intent. ATR supports fixing this mistake. H.R. 2240, the “Small Business Tax Equity Act of 2013” does so. ATR urges all Congressmen to support this common-sense legislation. What’s the issue? Under tax law, legal cannabis dispensaries are unable to claim the ordinary and necessary business expense deductions that any other legal business can claim. Why does the tax code discriminate against the cannabis dispensary industry like this? As a longstanding matter of tax law, all income derived from whatever source is taxable. Criminal prosecutors have long used this rule to assess taxes and penalties on organized criminals. In the 1981 tax court case Edmonson v. Commissioner (T.C. Memo 1981-623), a criminal facing a tax assessment for ill-gotten gains asserted his right under tax law to deduct “ordinary and necessary” expenses against this income. The court ruled that if a tax liability is asserted by the government, the taxpayer does get to deduct his business expenses, even in the context of a criminal proceeding. The person in question went on to deduct telephone, automobile, and other business expenses. Congress retaliated. In 1982, part of the TEFRA tax increase (P.L. 92-248) created a new Section 280E of the code. It reads:

“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”

The clear intent of Congress at the time was to prevent street dealers from avoiding a heavy tax liability by claiming expenses as if they were running legitimate businesses. What does this have to do with cannabis dispensaries? Under the Controlled Substances Act, cannabis (a.k.a. marijuana) is a Schedule I substance. Thus, income from the sale of cannabis is taxable as income, but ordinary and necessary business expenses are not deductible against that income for the determination of taxable profit.

Page 2 of 4 What about states that have legalized cannabis dispensaries? Since 1996, 20 states and the District of Columbia have legalized medical use of cannabis, with many of those states establishing state licensed dispensaries. Last November, voters in Colorado and Washington State made the cultivation and sale of cannabis to all individuals 21 years of age or older legal through state licensed stores.

When the cultivation and sale of cannabis has been regulated, legitimate businesses have been created in response. Colorado, for example, has approximately 5000 employees working in this legal industry. But the fact that a cannabis dispensary is legal under state law does not change the Schedule 1 status of the product.

What tax penalties do legal cannabis dispensaries face in these states? Like any other business, cannabis dispensaries must pay taxes on all business revenues. Unlike other businesses, however, this industry cannot deduct ordinary and necessary business expenses to arrive at a true taxable business profit. In essence, they pay a gross receipts tax instead of an income tax.

What type of ordinary and necessary expenses are denied to this industry under Sec. 280E of the code? Expenses include but are not limited to:

Wages and salaries

Commissions and payments to contractors

Health and other insurance premiums

Pension plans

Equipment for the business such as computers and furniture

Rent and home office expenses

Marketing and advertising costs

Travel and lodging expenses

Automobile expenses

Business meals and entertainment

Interest paid on business loans

State and local taxes and fees

Legal and other professional expenses

Repair and maintenance

Telephone, internet, and other utility costs To use a very simple example, let’s say two nearly identical businesses each have $500,000 in business revenue. Each business is allowed to deduct the cost of goods sold ($250,000), but only the first business can also deduct ordinary and necessary business expenses. The first business can deduct $150,000 of ordinary and necessary business expenses, but the second business cannot because it’s restricted by Sec. 280E. Assume a 35% tax rate for each business:

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Normal business Sec. 280E Business

Revenue $500,000 $500,000 Cost of goods sold $250,000 $250,000 Ordinary and necessary $150,000 $0 Real World Profit $100,000 $100.000 Taxable Profit $100,000 $250,000 Tax (35%) $35,000 $87,500 Avg. Eff. Tax Rate 35% 87.5% The second business faces a tax bill $52,500 greater and an average effective tax rate much higher than the first. The only reason is that this business cannot deduct the same expenses as any other business. This creates a huge disincentive for the second business to hire more workers, increase wages, provide additional benefits, or invest in things like infrastructure improvements. Can’t the IRS just waive Sec. 280E? Unfortunately, no. In a letter to Congressman Pete Stark on December 16, 2010, the IRS told the Congressman the following: “Because neither section 280E nor the Controlled Substances Act makes exception for medically necessary marijuana, we lack the authority to publish the guidance that you request. The result you seek would require the Congress to amend either the Internal Revenue Code or the Controlled Substances Act.” Is there a bill to fix this tax law quirk? H.R. 2240, the “Small Business Tax Equity Act of 2013,” has been introduced by Cong. Earl Blumenauer (D-Ore.). His bill amends Sec. 280E of the IRC to add the following language: “unless such trade or business consists of marijuana sales conducted in compliance with State law.” In other words, if a state legalizes cannabis, the businesses which act in accordance with state law will be treated like any other businesses. Why is H.R. 2240 good tax policy? It’s a basic principle of tax policy that the tax code should not pick winners and losers. There aren’t many clearer examples of this principle being violated than this Sec. 280E issue. Under no reasonable scenario should a perfectly-legal business, organized under state law, be denied the same ordinary and necessary business expenses as any other business. Another basic tax principle is that gross receipts taxes are unfair. They only measure one side of the profit equation—revenues—and take no account of the expenses which were incurred to garner those revenues. Two very different businesses profit-wise could have identical business receipts in the door. No tax policy expert—left, right, or center—believes that gross receipts taxes are good public policy. Section 280E imposes a de facto gross receipts tax on this industry. Finally, the intent of Congress is important in tax law. In 1982, Congress wanted to send a message to kingpin drug dealers by enacting Section 280E. More than three decades later, a newly legal business sector finds itself punished in a way Congress never intended. This inequity in tax law must be corrected in order for Congress to clarify its true intent in the matter.

Page 4 of 4 What about conservative opposition to illegal narcotics? That’s not at issue here. By definition, these businesses are operating in states where their product is no longer illegal. Changing Section 280E in this way thus has nothing to do with any narcotics that remain illegal under federal and state law. Congress never intended for legal businesses to face unfair and punitive treatment at the hands of the tax code. Moreover, there is a countervailing conservative value of limiting the size and scope of government. Section 280E raises tens of millions in taxes from a fledgling industry which is immediately being spent in Washington. What’s the revenue score? The Joint Committee on Taxation has not evaluated this proposal. However, relative to the broader U.S. economy, the cannabis dispensary industry is very small and exists in a minority of states for the moment. It is very likely that a score would produce negligible revenue effects. If anything, H.R. 2240 is a very modest tax cut for small businesses.

KOMO News

Wash. state shops for a bank to handle marijuana moneyBy JORDAN SCHRADER, The Olympian Published: Sep 22, 2013 at 1:00 PM PDT (2013-09-22T20:00:19Z)

OLYMPIA, Wash. (AP) - Wanted: A bank for state government. Must offer attentive customer service.Must be able to handle several deposits a day, with drop-offs of up to 40 bags at a time. Must allow anaccount to be overdrafted during the day by more than $1.2 billion.

Oh, and must accept proceeds from the sale of marijuana.

As Washington shops for a bank, that last demand might not be as hard to meet as it sounds.

The state's current banker has already agreed to it, according to the state treasurer, who says despitefederal restrictions Washington shouldn't face reprisals for banking and spending the revenue that iscoming soon from pot taxes and fees.

"I'm not too worried about it," Treasurer Jim McIntire said. "It's actually one of the advantages of havingBank of America as your contractor. It's unlikely, I think, that the federal government would raid them. .And they're big enough to look out for themselves on this."

Bank of America's seven-year contract to hold the state's main account runs through June 30, and thestate asked for bids this month in a request that specifically calls out deposits of marijuana revenue as amust-have.

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In the meantime, the state expects to start depositing revenue from Initiative 502, which legalized therecreational use of marijuana. The Liquor Control Board will receive its first fees in November fromapplicants asking the board for licenses to grow and sell the drug, and the Department of Revenue startscollecting taxes as soon as March after the first licenses are awarded.

Much of the revenue could arrive in the form of cash, since banks are reluctant to do business with potdealers without changes in federal policy that treats banking of marijuana proceeds as money laundering.

Handling all those bills presents a hurdle for the state Department of Revenue. But some had suggested abigger problem would be trying to store and spend the money.

The uncertainty was reflected in Wednesday's quarterly report from Washington revenue forecasters, whosaid they wouldn't count I-502 revenue in their projections until the Liquor Board finishes writing rulesand "an agreement is reached with the federal government with respect to the legality of depositingcannabis-sourced tax receipts into state accounts."

As recently as July, Liquor Board member Chris Marr said not a penny could be deposited without risk oftainting other state money - unless federal authorities took action. Marr has dialed back his alarms, butsaid last week he would still like clarity from the federal government.

Bank of America is confident, the treasurer's office says. After all, Washington taxpayers may be breakingall sorts of laws, and that doesn't deter the bank from taking their tax money when state governmentdeposits it.

Its bankers have "checked this out with their compliance department and they don't see it as any differentthan say, medical marijuana or any other activity," Assistant Treasurer Wolfgang Opitz said. "There couldbe other illegal activities going on in this state that happen to be in the tax base."

Medical-marijuana sellers are not regulated or licensed by the state and they operate in what some see asa legal gray area. But they are supposed to pay sales tax and business tax, which goes into the state's bankaccount.

The new I-502 businesses are different. They will be licensed by the state, so revenue collectors can'tplead ignorance of the companies' business practices. Liquor Board Director Rick Garza said he askedother state officials if the licensing would affect the state's ability to deposit the revenue. Not necessarily,he was told. Washington is not the first state to license marijuana businesses, and the federal governmenthas never cracked down on states' bank accounts, Garza said.

Garza said he's confident that the state will be able to bank and spend its revenue. The next problem toresolve is marijuana businesses' inability to bank. Marr worries about the inefficiency of collecting cashand hopes for a federal resolution.

"We're really not equipped to accept cash," he said. The Liquor Board might rely on the revenuedepartment's collection network.

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Marr is hopeful that a solution will come now that the U.S. Department of Justice has decided to allowrecreational marijuana sales in Washington and Colorado to go forward. Banks say their regulators are intalks with DOJ.

Even if all those questions are answered, it will be hard for forecasters to say how much revenue the stateshould expect.

If tax rates don't change, I-502 might bring in between $1.4 billion and $3.2 billion over a decade,consultants told the Liquor Board - a wide range.

The revenue depends largely on how much of the existing illegal and quasi-legal market the new potstores can capture. The board figures they will start out with 13 percent of the market and expand to 25percent in a year.

When will budgeters be confident enough to bank on the money?

"When we can bank on it," House budget chairman Ross Hunter, D-Medina, told reporters. "Whichmeans, when we can actually count it."

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From the Puget Sound Business Journal:http://www.bizjournals.com/seattle/blog/2013/03/us-trademark-protection-for-your-pot.html

Mar 15, 2013, 10:00am PDT

Want to trademark your pot productwith the feds? Don't hold your breath

Greg LammStaff Writer- Puget Sound Business JournalEmail | Twitter

Marijuana and marijuana-infused products like Space Queen and Ganje Roast Wake N BakeCoffee are already for sale at some of Seattle’s medical marijuana shops. So withWashington state launching a legal pot industry, it stands to reason that marijuanaproducers and sellers would want to protect their brands from infringement.

But if a pot-selling startup is looking for federal trademark protection like a Starbucks orMcDonald’s, forget it, says Anne Glazer, a trademark attorney with the law firm Stoel RivesLLP.

For a short period three years ago, it seemed like the U.S. Patent and Trademark Officehad opened its doors to companies seeking trademark protection for marijuana brands. InApril 2010, the federal agency announced it had created a new trademark category formedical marijuana. That set off a stampede to the patent office from pot dealers across theU.S. But three months later, the Patent and Trademark Office said never mind, pot brandscouldn’t get federal trademark protection after all. It called the whole matter a mistakebecause its was (and remains) a federal crime to sell pot.

Still, Glazer said there are some things companies can do to protect their brands.

“I wouldn’t bother applying with the U.S. Patent and Trademark Office, but we think it wouldbe worth putting a registration in with the Washington Secretary of State’s office, which alsoregisters trademarks at the state level.” Glazer told me recently.

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For a $55 fee, the Washington Secretary of State will register a trademark. For broadestprotection, the state agency says it’s best to register with the U.S. Trademark and PatentOffice. But the state agency says it can offer protection from trademark infringement for atrademark used exclusively within the state.

Glazer said companies also should select a distinct trademark. But avoid a trademark alreadyfiled by someone else. Another no-no: Don’t use descriptive names closely associated withthe product, including slang names such as weed or pot. “Apple” was fine for the iPhonemaker. But it would cause legal trouble from competitors if a Wenatchee apple grower triedto brand its company “Apple,” Glazer said.

Businesses can do simple searches to see if a brand already falls under trademarkprotection. A simple internet search is a good place to start. The Patent and TrademarkOffice’s website also offers an option to search the federal agency’s database of registeredtrademarks or pending applications.

For a more exhaustive search, companies can hire an attorney to do a commercial searchthat can cost a few thousand dollars.

Glazer said attorneys at her firm are not getting many questions from companies thinkingabout brand protection. But they are getting a fair amount of inquiries from companiesseeking legal advice about the state’s licensing of marijuana growers, distributors andsellers. Meanwhile, Avvo Inc., a Seattle-based company that offers legal advice on the web,recently launched a new legal guide addressing questions related to marijuana, includinghow to set up a legal business. Avvo said it saw a big up-tick in inquiries about pot,especially since November, when voters in Washington and Colorado approved ballotmeasures legalizing marijuana.

Glazer said businesses interested in setting up shop in Washington have been focused onlicensing issues. She said inquiries about trademarks will come, unless, of course, the federalgovernment decides to enforce the federal prohibition and shut down pot sellers inWashington and Colorado.

“If there’s one thing businesses and investors don’t like, it is any kind of uncertainty,” Glazersaid. “It will be interesting to see how many people jump in anyway because the potentialfor revenue is so great.”

Greg Lamm covers banking & finance and law for the Puget Sound BusinessJournal.

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