California’s illegal market for cannabis dwarfs the size of the legal one. Different sources claim the ratio is anywhere from 3 to 1 all the way to 6 to 1, although the real number is nearly impossible to pin down. The existence of the illegal market hampers the ability of legally compliant cannabis businesses to be successful, as they are often unable to compete with the cheaper prices in the black market. There are also many knockoffs that show up, ripping off the marketing, branding, and goodwill of legal operators, with little to no recourse. Further, unregulated markets lead to dangerous and harmful products that ultimately may cause harm to consumers, such as unhealthy pesticides, illicit ingredients, and hazardous chemicals.
The reason why the legal market continues to stagnate are numerous, but ultimately there is one thing that matters more than everything else: profits. You have to follow the money. Until the financial incentives make sense for cannabis businesses to be legally compliant, the legal market will remain dwarfed by its counterpart, and the black market will continue to thrive.
Currently, in California, there are (at least!) four major financial hurdles that make the legal market financially unviable for businesses. Each of these hurdles negatively impact a business’s bottom line and thus incentivize cannabis businesses to continue to skirt the law.
The first and most obvious hurdle is taxes. The legal market requires the payment of cultivation tax, retail excise tax, sales and use tax, and local tax. Each of these is an added cost that ultimately reaches the consumer. As one example, the immense tax burden could entail that the actual cost of getting an 1/8th of flower to the buyer’s hands skyrockets from about $14 dollars to over $25 dollars — an more-than 75% increase. This means either charging the consumer a higher price, or taking a smaller profit. Either way, it’s less desirable for everyone involved.
When the federal tax season comes around, companies are in for another big hit. Internal Revenue Code Section 280E prohibits “drug traffickers”, which includes state-legal cannabis companies, from deducting ordinary business expenses from their profits. This means that a company has to pay significantly more taxes than a regular business. Every year there are companies that are crippled by the size of their tax bill, because they just don’t have the money to pay it. A savvy attorney or accountant can help a company find strategies to minimize their tax liability, but it is still a huge deterrent for those deciding whether to come out of the shadows or not.
In addition, the cost of licensing is an exorbitant charge. First, under California’s dual licensing scheme, a cannabis company must incur costs to obtain both a local and state license. To get a license issued by the state, you must submit dozens of items to the Bureau of Cannabis Control, plus a filing fee, and include proof that you have already applied for and obtained a local license. The documentation can be complicated and time consuming, require numerous disclosures and detailed business and security plans, and simple mistakes can be costly. Many cannabis businesses also choose to hire an attorney to assist with the forms, which of course can cost a lot up front but can save thousands and help avoid headaches on the back end. For a company that has been operating in the traditional market, having to spend all of this time and money to get a license and operate legally is a big reason not to come out of the shadows.
Once the license is granted, and the operation begins, there aren’t any more hidden costs, right? Wrong! Ongoing due diligence is a must. The license allows you to operate in the exact manner you described in the application. If you want to make any small changes, you might have to file an amended application and wait for approval. If you fall out of compliance, you could lose the license and all the money you paid to get it. This is an ongoing expense that can be costly for a business.
Now, with all of this being said, companies often feel compelled to weigh the financial benefits of staying in the illegal market against the potential risks. Here is where enforcement comes into focus. If the enforcement rate was 100%, meaning everyone operating illegally got busted, then the aforementioned additional costs suddenly look more attractive, because they are the only way to do business. If enforcement is zero, the vast majority of companies would say “no, thank you” to the costly barriers to entry in the legal market, and continue operating illegally. The government is of course aware of this, as well as the size of the illegal market. However, they have limited resources to regulate and enforce the rules, but eventually will need to do more on the enforcement side to give the legal market a fighting chance.
Regulators are already talking about enforcement getting stepped up in 2020. Task forces are being created. They will not have the resources to get the rate anywhere close to 100%, but they can make enough of a dent to scare people. Companies are going to continue to get raided. Assets will be seized. Criminal penalties will be levied. All of this will happen on a larger scale this year. Regulators are aware that increased enforcement is a MUST if the legal market is to succeed. They are poised to raid more businesses this year than ever before.
I cannot emphasize enough how important it is to know your rights before, during and after enforcement actions are taken against your company. Speaking to a lawyer before anything happens can save you plenty of headache. We can help you devise a plan for enforcement if it occurs, as well as minimize your risks by helping you stay compliant with state law.
Disclaimer: This article has been prepared and published for informational and educational purposes only and is not offered or intended, nor should it be construed, to be legal advice.