Currently, the Pennsylvania House of Representatives is considering legalizing recreational marijuana. This comes on the heels of the U.S. Drug Enforcement Agency proposing to reclassify marijuana as a Schedule III drug in April 2024. What does this mean for those currently operating dispensaries in states where recreational use is legal or those interested in starting up a new venture? And, what are the implications for banks and financial institutions exploring lending to or holding deposits for these businesses? Here’s what you need to know about launching a cannabis business.
Entity Formation Matters
A question for any prospective business owner or entrepreneur to consider is what type of business they will form. While an LLC is a popular choice, it may not be the best for a cannabis business. Why? As a pass-through entity—like a sole proprietorship, S Corp, or partnership—an LLC that operates a cannabis business puts its owners at higher risk of an audit by the IRS. In these types of businesses, income and loss flow through to the owners tax returns, possibly making them personally liable for cannabis business-related tax deficiencies. 
Unfortunately, the IRS heavily scrutinizes cannabis businesses, knowing the only legal way for these businesses to deduct expenses is by deducting expenses as Costs of Goods Sold (CoGS). Until marijuana achieves its Schedule III status, a cannabis business cannot claim deductions for ordinary and necessary expenses like other businesses due to Section 280E of the Internal Revenue Code. Leaving cannabis businesses’ only available deduction for CoGS, the IRS limits their ability to reduce their taxable income and liability, i.e. a higher tax bill.
Of course, there are a lot of considerations for entity formation, so be sure to work with accounting, legal and tax specialists to determine your eligibility.
Have proper operating agreements and governance in place for your business is vital, notably when having multiple owners or business partners. While not all states require operating agreements, these documents help formalize and legitimize your business operations, making your business more appealing to possible lenders, as well as serving as guidance for future business sales or disputes.
Whatever you do, be sure to avoid DIY formation documents which likely do not account for state-specific laws, especially those relating to cannabis, and may be invalid, causing issues down the road.
Lending and Financing Options
Should you decide to move forward in forming a cannabis business, another hurdle you may face is securing startup loans or financing. Traditional institutional lenders (banks) face regulatory issues with lending to cannabis businesses or even allowing them to have a business account. This can further complicate an IRS audit, as the business may not have banking relationships to help substantiate large amounts of cash or expenses. Additionally, to offer a loan, banks typically require collateral to have some measure of recovery should you default on your loan. Banks can’t accept cannabis as collateral, so this may mean using your home or other business assets as collateral. A number of state-chartered banks and credit unions may choose to offer financing, but expect deep due diligence on their behalf.
Due to lack of federal constraints, private equity (PE) firms often lend to cannabis businesses. However, in doing so, PE firms don’t need to offer competitive loan repayment rates or terms of conventional financing. While this may be your only option, you may face higher interest rates.
Regardless of where you are able to secure a loan, be prepared to have proper business documentation in place, as noted above, as well as legally compliant formation records.
Best Business Practices
To make your business more desirable for lending and to ensure your cannabis business is legally compliant, there are several best business practices you can implement:
- Maintain good recordkeeping and systems – ensure you maintain proof of receipts, bills paid, and invoices using a good bookkeeping system, especially in lieu of a bank account; also invest in a cost-accounting and inventory systems; being able to show revenue growth and profitability, reflections of cash flow, are strong indicators of business success
- Hire an experienced accountant/tax attorney – as noted above, cannabis businesses cannot deduct typical business expenses, but utilizing smart tax strategies, your business can lower its taxable income by maximizing its CoGS (Beginning Inventory + Production Costs/Purchases – Ending Inventory)
- Build a strong management team – having competent leaders, especially those who know the industry and may have worked together previously, can showcase a track record or synergy endearing to investors
Legal Support for your Cannabis Business
Beyond formation and financing/taxation, there are a myriad of other legal issues which may come into play for those in the cannabis sector, including real estate, healthcare, employment, M&A, IP and more.
When forming your business, be sure to work with experienced attorneys who remain up-to-date on state and federal statutes that may impact your operations and success.
Please contact our cannabis attorneys in Allentown, PA if we can be of service!
This blog was co-authored by Alexandra M. Rozzi and Colin J. Keefe.
