Banking considerations and the law of unintended consequences

Lack of options force most companies to be cash-only

With the current push for the legalization of recreational cannabis across several states, the cannabis industry is being forced to face difficult choices with respect to banking options.

Of course, marijuana remains illegal under federal law and is classified as a Schedule I drug under the Controlled Substances Act. This makes it a federal crime to grow, distribute, dispense or possess marijuana, and it is also illegal to operate a business with the purpose of manufacturing, distributing or using marijuana.

As a result, banks remain hesitant to deal with cannabis businesses because they are unwilling to bear the risk of being charged with money laundering or racketeering, since marijuana is still federally illegal.

Moreover, many financial institutions have cited the Patriot Act as potentially subjecting them to liability for doing business with marijuana dealers.

Because of the conflict between state and federal laws, the Department of Justice issued the Cole Memo in August 2013, outlining provisions guiding federal prosecutors on where to focus their cannabis-related enforcement efforts, including the regulation of funds in the cannabis industry. Examples include preventing marijuana revenue from funding criminal enterprises, gangs or cartels, and preventing the use of state-legal marijuana sales as a cover for illegal activity. Notwithstanding the Cole Memo, there remained a lack of clarity as to whether the many ancillary businesses that have typical relationships with cannabis enterprises — such as banks — were exposed to any criminal liability.

In early 2018, the current administration revoked the Cole Memo, leaving even more uncertainty in the marketplace.

In some states, though, there are small steps being taken to provide a banking infrastructure for the marijuana industry. California lawmakers debated, but ultimately rejected, a bill to create cannabis limited state charter banks and credit unions. Partner Colorado, a credit union in Denver, provides checking accounts specifically for the marijuana industry through its Safe Harbor Private Banking Division, according to a January 2018 New York Times Magazine article. It is a meticulous program where potential clients are thoroughly vetted and deposits and withdrawals are matched to legal marijuana transactions in the state. If there is a hint of suspicious activity, the banker launches a full investigation of the client’s books, and if funds cannot be accounted for, there is a high probability that Safe Harbor will close the client’s account. At the time of the New York Times article, federal regulators had not expressed issues with the program.

However, in states where the legalized cannabis markets are less mature than Colorado and California, banking options remain unnervingly absent. The reluctance of banks to work with marijuana businesses has forced many to conduct their business transactions in cash. This undoubtedly exposes these businesses to the risk of white-collar crime and is an unfortunate, unintended consequence of the federal government’s failure to clarify the boundaries of criminal liability. For example, difficulties in handling and tracking cash provides opportunities for money-laundering activities and for employees to defraud the business. Untraceable cash can facilitate bribery to obtain permits.

Furthermore, many cannabis operators must pay taxes in cash. Not only is this dangerous­­, as evidenced by the California treasury’s suggestion to hire armored couriers for the collection of businesses’ taxes, but it has also resulted in tax evasion, according to a story in The Economist. This could lead to heightened scrutiny by the IRS. For example, in a recent 10th Circuit Court decision, the court permitted the IRS to launch an investigation into a cannabis dispensary’s business records to determine whether the dispensary was disqualified from taking federal tax credits and deductions (Green Sol. Retail, Inc. v. United States). An increase in the number of investigations by the IRS could potentially increase the cost of tax compliance for cannabis businesses.

With the risk of white-collar crime heightened due to the lack of banking options, cannabis businesses are well served to consider robust compliance programs to provide necessary checks on those tempted toward malfeasance. Such considerations include both physical security and robust accounting procedures. Businesses should consider using drop safes, cameras on registers and other standard “cash-handling” best practices to minimize opportunities for theft by insiders or outsiders.

With respect to accounting procedures, businesses should consider assigning two employees to count cash and rotating those assigned on a periodic basis to provide opportunities to detect anomalies. Inventory should be tied to cash receipts on a frequent basis to track discrepancies. Finally, cash businesses are magnets for tax audits and reviews, so it necessary to over-document transactions with register receipts reconciled to cash receipts on a daily basis. Should an audit occur, the tax reporting will then be well documented.

The risks of the cash business model can be managed with proper care; accountants or attorneys with experience in accounting controls, white-collar defense and internal investigations can provide assistance in designing appropriate controls and systems.

 

David Burch is a partner at Barclay Damon LLP. He litigates in state, federal and administrative courts and has handled numerous administrative tax hearings and appeals as well as state and federal civil and criminal cases. He routinely advises businesses on project development matters and is a member of the firm’s cannabis team.

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