Proposition 215 Conversions: California Legislature Anticipated this Problem

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AUTHOR:  aBIZinaBOX Inc. CPAs – Jordan S. Zoot, CPA
PUBLISHER:  CANNABIS LAW REPORT

A few days ago, we published a short note that described how a Cannabis Cooperative Association (“CCA”) could be utilized to circumvent the confiscatory nature of Internal Revenue Code (“IRC”) §280E[i]. Several our readers, including some purported experts, advised us that our suggestion would not work for them because the business organization with which they were involved pre-dated the enabling legislation for CCAs.

Read the law! The California Legislature anticipated this problem. The Legislature was aware many collectives and cooperatives were organized based on Proposition 215 long before a glimmer of hope for legalization even existed in fantasies regarding the future. Beginning even before Proposition 215 was passed, collectives and cooperatives were organized under various provisions of California law for the cultivation and underground distribution of marijuana. Many such groups formed a Nonprofit Mutual Benefit Corporation. Most did little else in the way of the creation of formalizing an organizational structure. There were, of course, some significant exceptions in which a group of individuals established formalized organizations.

Regardless of the extent to which an existing cannabis collective or cooperative has an established legal structure and formal documentation, the California Legislature created an avenue for such organizations to become CCAs. The enabling legislation for CCAs is found in Chapter 22, Title 10, of the Business and Professions Code (“B&P”). Articles 1-10 of Chapter 22 provide the substantive legislation for CCAs. The Legislature included Article 11 to specifically address the issue of existing cannabis collectives and cooperatives that would benefit from a conversion into a CCA[ii].

 

Article 11 provides in relevant part:

“26231. A corporation that is organized or existing pursuant to any law . . . may be brought under the provisions of this chapter by amending its articles of incorporation, in the manner that is prescribed by the general corporation laws, to conform to this chapter. If a corporation amends its articles of incorporation to conform to this chapter, it shall be deemed to be organized and existing pursuant to, and entitled to the benefit of, and subject to this chapter for all purposes and as fully as though it had been originally organized pursuant to this chapter.

“26231.1. Articles of incorporation shall be deemed to conform to this chapter within the meaning of Section 26231 if it clearly appears from the articles of incorporation that the corporation desires to be subject to, and to be organized, exist, and function pursuant to this chapter. [Emphasis added.]

“26231.2. If the amended articles conform, as provided in Section 26231.1, provisions in the articles of incorporation that appeared in the original articles or some previous amended articles, are ineffective if, and to the extent that, they are inapplicable to, or inconsistent with, this chapter.”

It takes far more, of course than an amendment to Articles of Incorporation to convert a collective or cooperative into a duly organized and operating CCA. A CCA that engages in commercial cannabis activity pursuant to the Medical and Adult-Use Cannabis Regulation and Safety Act (“MAUCRSA”) is a special form of corporation expressly created to engage in commercial cannabis activity in California’s cannabis industry through the equivalent of an agricultural cooperative. A CCA is a sophisticated form of an incorporated entity. A CCA is subject to California’s general corporate laws as well as the special provisions of B&P §§26220-26231.2. The combination of these two bodies of law creates operational business advantages for CCAs. The special provisions of law set forth in B&P §§26220-26231.2 trump the general corporate law in the event of a conflict.

A CCA is also subject to special rules for California and federal income tax purposes. A CCA files a return for federal income tax purposes as a cooperative pursuant to Subchapter T[iii]. A CCA files similarly for California income tax purposes. These special filing rules provide income tax advantages for CCAs.

All existing collectives and cooperatives should not be converted into CCAs. Proposition 64 preserved all the rights granted to Californians under Proposition 215. There will be a place in California for unlicensed, unregulated medical collectives for the foreseeable future. The cottage industry of unlicensed, closed-loop collectives is entitled to continue to operate as not-for-profit collectives. Such organizations cannot engage in commercial cannabis activity.

There will also be a place in California for licensed medical collectives and cooperatives for the foreseeable future. Those Proposition 215 collectives and cooperatives that intend to engage in commercial cannabis activity must be licensed. The foundation for a Proposition 215 medical collective is not consistent with commercial cannabis activity. Any such an organization should consider conversion into a CCA. There is no prohibition against a CCA operating as a not-for-profit organization that is engaged in commercial cannabis activity for the benefit of both its cultivator members as well as its consumer members. Any such a collective or cooperative, however it is presently organized, will have a financial advantage over any conventional business structure if the organization properly converts into a CCA.

The special treatment of CCAs for income tax purposes makes these special corporations financially more efficient than conventional business structures for the conduct of cannabis business in California. A CCA also has operational advantages over conventional business structures in connection with the conduct of commercial cannabis activity. The conduct of commercial cannabis activity through a CCA requires experienced legal counsel. Of even greater importance, accounting and tax-reporting advice from a CPA firm are essential to the successful conduct of commercial cannabis activity through a CCA.

A CCA that does nothing more than act as a cooperative marketing representative provides a valuable service for its member growers. In this regard, an organization that acts as a broker must be licensed as a distributor. Marketing representation and sales representation are not the same things, although they are frequently conflated. Licensing is required for representation in connection with sales. The use of a CCA solely for marketing merely scratches the surface of the benefits such an organization can provide with respect to commercial cannabis activity. As we pointed out in the article referenced above, even for a modest cannabis business operation the tax savings that can be secured using a CCA can exceed $1.0M per year.

A CCA that engages in cannabis business activities beyond acting as a cooperative marketing representative, for example operating a wholly-owned cannabis distributor, requires a capable business organization. Such a business operation necessarily requires sophisticated operational and financial record-keeping systems and procedures in order to comply with the regulatory requirements of the California Dept. of Tax and Fee Administration [“CDTFA”] Bureau of Cannabis Control [“BCC”] and other cannabis regulatory agencies as well as the multiple tax filing requirements for California cannabis businesses.

A CCA that operates a wholly-owned cannabis distributor should establish an accrual method of accounting for federal income tax purposes. A number of additional record-keeping benefits, as well as significant tax-saving benefits, will flow from the use of an accrual method of accounting for a CCA engaged in commercial cannabis activity. The establishment of an accrual basis system of accounting for a distributor engaged in business in California’s cannabis industry requires the services of an experienced CPA.

For the gamblers among our readers, the use of a CCA for the conduct of business in California’s cannabis industry is the equivalent of playing with “house” money. For the investors among our readers, the use of a CCA for the conduct of business in California’s cannabis industry is the equivalent of an “all up-side, no down-side” financial arrangement.

Sources & Footnotes

[i] See IRC Sec 280E – Escrows

[ii] See CCA’s Good or Better, California Cannabis Collective the Sky Is Falling and Dead – Alive – Comatose

[iii] IRC Secs. 1381-1383

Sean Hocking

Sean Hocking


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