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Time to Understand the Cannabis Supply Chain

Marcy Greenfield and Matthew Zwielich

8.16.21 | Industry Insights

The numbers don’t lie: Cannabis is big business.

The recent raft of legislation legalizing the recreational use of cannabis products in 19 U.S. states, plus the District of Columbia, has sparked a bull market in this budding industry. Although it is still federally illegal to grow and sell marijuana, cannabis is proving to be a recession-proof business similar to alcohol. Just look at the numbers: In Colorado, which legalized cannabis in 2014, the business has, in the course of seven years, grown into a $6 billion a year industry. Over the past year alone, cannabis sales throughout the U.S. reached a record $17.5 billion. According to one estimate, cannabis will be a $57 billion industry nationwide by 2027.

Given the history of legalization, there is little reason to doubt this: Growth is nothing short of exponential where legislation has been enacted. In 2018, the nine states that comprise the northeast U.S. had about 187 cannabis dispensaries. Three years later, there are 424. In California, which legalized in 2016, cannabis is now a $4.4 billion industry.

The success of the industry is not surprising if you consider the demand. According to a study by New Frontier Data, a Washington, D.C.-based cannabis researcher, an estimated 38.4 million Americans consume cannabis products.

The legalization measure that was passed by New York State (NYS) this spring means the New York City (NYC) metro area is on the precipice of the cannabis boom. NYS officials estimate that the legalization measure could bring in up to 600,000 jobs and add as much as $350 million a year to the state coffers.

Given the industry’s explosive growth, it makes sense to dig a little deeper into how exactly the cannabis supply chain works. But be forewarned: The process of bringing the product from the farm to urban and suburban retail outlets can be challenging.

Cannabis Supply Chain 101

On the most basic level, the cannabis supply chain is made up of five stages: cultivation, manufacturing, distribution, transportation, and retail.

    1. During the cultivation stage, the plant is grown and harvested. The players involved at this stage range from large farms to small backyard growers. And the landscape for operating a cannabis cultivation business is becoming more attractive and profitable. As states pass legalization legislation, obtaining a license to grow and harvest the plant means your business will be more secure and allows for long-term planning. Large investments in property, warehousing facilities, equipment, and operating costs are more practical. As the industry matures, it is thought that growing and harvesting cannabis may eventually be outsourced to countries with cheap labor markets.
    2. Manufacturing cannabis for retail sale involves several steps, including extraction, whereby the producer creates a number of by-products (such as the now nearly ubiquitous CBD oil) from the plant. During manufacturing, other products that will eventually hit the market (such as cookies, brownies, and even soap) are infused with cannabis. However, before any cannabis products can be sent out for distribution and hit the retail market, they must undergo tests at state-accredited labs, which screen the products both for potency and for the presence of unwanted pesticides and other contaminants.

      Given the flood of laws and new and forthcoming regulations, one must expect ongoing uncertainty. Testing requirements vary widely from state to state. Because the sale of cannabis products is still not legal on the federal level, there are no uniform federal standards from agencies, such as the Food and Drug Administration (FDA) or the U.S. Department of Agriculture (USDA), for cannabis as there are for meat, poultry, and dairy products.
    3. And now we get to the distribution stage, which is also the most complex part of the supply chain. This is due, in part, to ever-expanding amounts of product Stock Keeping Unit (SKU) numbers spread out across various categories, all while staying compliant in a federally illegal environment. Since cannabis is only legal in certain states, any freight vehicle regulated by the U.S. Department of Transportation will be prohibited from transporting cannabis products. From a distribution perspective, the lack of federal regulations remains a drawback and area of concern for investors.

      Federal Tax Law

      Federal income tax law has yet to treat cannabis as a legitimate business. Internal Revenue Code (IRC) §280E disallows certain deductions that would normally be permitted in the operation of a trade or business that does not involve the trafficking of controlled substances. Currently, cannabis is considered a Schedule I controlled substance pursuant to the federal Controlled Substance Act. The denial of tax deductions for otherwise legitimate business expenses can increase the tax burden on owners and investors prohibitively. Consequently, U.S. tax law may cause outside investors to shy away from a business that distributes, transports, and sells or resells cannabis for recreational use. Taxpayers who are interested in starting a recreational cannabis business are encouraged to consult their tax advisor regarding the scope of IRC §280E.On July 14, Senate Democrats released a legislative proposal that would federally decriminalize and regulate the sale of cannabis. Under this proposed legislation, the treatment of certain deductions denied by IRC §280E remains unclear.

      New York State Tax Law

      New York’s Marijuana Regulation and Taxation Act (MRTA) establishes the following taxes on the sale from a wholesaler to a dispensary, based on the milligrams of THC in the product. The tax rate would be based on the type of product, as follows:

      • Edibles: $0.03 per milligram of Tetrahydrocannabinol (THC);
      • Concentrates: $0.008 per milligram of THC; and
      • Cannabis flower: $0.005 per milligram of THC.
    4. As many industry experts see it, the biggest challenge facing cannabis wholesalers is transportation. Inter-state movement of cannabis products remains illegal under federal law, and investors may still shy away until all the regulations are sorted out. And often, figuring out the lay of the land within states that have legalized the manufacturing, distribution, and sale of cannabis products can be a challenge. In some states, only a small number of state-approved distributors are certified to move the product from farm to retail shelves. In other states, independent, third-party actors are the main modes of transportation between all parts of the supply chain.
    5. There are specific rules at the retail end of the chain as to where cannabis can and cannot be sold and consumed. For example, the newly signed legalization legislation in NYS prohibits the sale of cannabis products within 500 feet of a school or church. Similar regulations will also differ – not only from state to state – but from town to town, as localities have wide leeway in enacting zoning regulations. The tax each state will levy on the product at the point of sale will vary. In New York, the MRTA establishes a 13% excise tax (9% state excise tax and 4% local excise tax) on the retail sale of cannabis products to a consumer.

      Such high taxes may be a deterrent to some investors. Then there is the issue that cannabis is not legal at the federal level, and retail stores will likely need to operate on a cash-only basis. As a result, retailers must be particularly mindful of the various risks presented by running a cash-only business in a federally illegal industry, including:

      • Security risks, including theft and fraud
      • Customer inconvenience
      • Banking and Accounts Payable issues

      As such, before starting a cannabis business, you should assess the risks associated with the industry and develop a plan to help mitigate those risks from the start. For instance, working with an advisor to ensure that you have the proper internal controls in place can help reduce regulatory compliance risk as well as the risk of fraudulent activity. Additionally, it would be beneficial to identify a banking and point-of-sale (POS) option that enables the business to operate efficiently while successfully managing its federal illegality. Whether one is planning on starting a cannabis business or investing in one, it is essential that the business plan developed addresses these issues and remains mindful of the state and federal regulations and legislation changes that are sure to emerge in the near term as well as in the future.

In the end, while the cannabis industry has shown great financial promise, there are considerable challenges for those seeking to enter this burgeoning market.

Questions: Contact your Berdon advisor.