Golden State Elixirs has hired you to provide professional guidance about the ethical and business aspects of continuing its business under the new regulatory regime. In partiCular, the company owners wish to understand the factors that would lead to making prots or incurring losses. 1. In your opinion, is it ethical to manufacture medical cannabis tinctures? 2. In your opinion, is it ethical to tax medical cannabis differently than other medical products? 3. Assuming that the appropriate licenses are obtained, write down a prot formula that takes into account the different local, state, and federal taxes. Do not include the license fees in this caICulation. Hint: Create a formula for each type of tax, then subtract the tax formulas from before tax income. 4. Using the numbers in the case and the formula from Question 3, what is the breakeven number of cases per month? It is easier to work with a batch of six cases of 60 bottles, and then divide. 5. Sales for 2018 are estimated to be 15 cases in January with an increase of 0.9 cases every month afterward. Assuming that the licenses are obtained, how many months will it take to recover the local and state licensing costs? 6. Should Golden State Elixirs purSue the appropriate licenses, wind down the business, or become part of the black market? Explain your choice. 7. Given the high tax rates and regulatory costs (time and money), most small medical canna-businesses will either shut down or move to the black market. What are the likely effects on medical cannabis product availability, product pricing, and quality? IMA EDUCATIONAL Case Journal Case Study The Association of Accountants and Financial Professionals in Business ISSN 1940204X Golden State Elixirs: Should We Obtain a Canna-Business License? Sispker: C. Hansen INTRODUCTION In 2016, Akasha, Skye, and Bob set up a California-based medical cannabis collective, called Golden State Elixirs.' Golden State Elixirs produces medical cannabis tinctures, small bottles containing cannabis extracts. Its bestselling products are liquid sleep, cheerful joints, and pain-free bliss, which help with insomnia, arthritis, and chronic pain, respectively.2 Golden State Elixirs has operated openly for two years. It has incorporated, paid state and federal taxes, and followed all regulations. But California has recently changed the regulatory environment. Golden State Elixirs will have to apply and obtain local and state licenses to continue. Complying with the new regulations will be costly, and management are considering whether to meet the restrictive new rules, shut down, or join the black market. HISTORY AND LEGAL ENVIRONMENT Canna-businesses operate in a complex legal environment. At the federal level, cannabis is illegal and is a Schedule 1 drug, like heroin and lysergic acid diethylamide (LSD).3 But many states, like California, allow cannabis use for medical purposes. There is a direct conflict between state and federal laws. Until recently, there was an informal truce between the Federal government and states allowing cannabis use. The federal government would not enforce the cannabis laws as long as the state created a regulatory environment that minimized the harmful impact. This truce fostered the growth of canna-businesses but required states to impose extensive regulations. FEDERAL LAW The U.S. Federal Government has a long and complex relationship with cannabis.4 Currently, there are substantial penalties for possession, manufacture, or use of cannabis.5 Although the Federal Government deems cannabis illegal, many states do not. In 1996, California passed the Compassionate Use Act and legalized cannabis for medical use for people with severe or chronic illnesses. This created a direct conflict between state and federal law. For several years the Federal Government targeted high-prole canna- businesses, leading to substantial push-back from the affected states. In August 2013, the Department of Justice issued a guidance memo (the Cole memo) that stated that prosecuting state legal medical marijuana cases is not a priority as long as the individual states regulate their local cannabis industries!\" California implemented regulations following these guidelines ,and the new licensing and regulatory structure went into effect in January 2018. By July 2018, all canna-businesses must have applied for a license, or they would have been subject to both state and federal prosecution. The truce between state and federal law was recently called off. In December 2017, Attomey General Sessions rescinded the Cole memo.8 At this point, the federal govemment had no clear policy on medical cannabis. They may or may not decide to enforce the federal law. IMA EDUCATIONAL EASE JDURNIL n VOL. 12, N0. 3, ART. 4, SEPTEMBER 2019 @2019 MA CALIFORNIA LAW In 1996, California passed Proposition 215, the medical marijuana law. Patient collectives were authorized to sell, produce, and distribute medical cannabis. Golden State Elixirs was formed as a medical marijuana collective in 2016. At that time, no state or local licenses to manufacture tinctures were required, merely registration with the state and payment of relevant taxes. Under the new California regulations, medical collectives had been phased out. All canna-businesses are now covered by the new state regulation and licensing system. Every canna-business must have completed an application for a state license by July 2018. If Golden State is to stay legal under California law, it will need a state permit. CITY LAW Although California has specic rules about licensing canna- businesses, each cityz'county is allowed to determine whether or not to have canna-businesses within their borders. Part of the state application process is to demonstrate that the company is operating in a locality that allows canna-business and that it has a local operating license. Golden State Elixirs operates in a small city that allows both cannabis manufacturing and distribution. Although both are allowed, the city's original regulations concentrated on licensing large dispensaries. Until December 2018, the city had no process in place to grant licenses to cannabis manufacturers" The city recently passed its new local regulations, and Golden State Elixirs can now apply for the local license. PRODUCTION OF TINCTUBES Golden State Elixirs' tinctures are produced in four steps: extraction, blending, testing, and bottling. The rst step is the extraction of cannabis oil from cannabis buds, also called cannabis ower. Only the buds contain the active ingredients. Golden State Elixirs has developed a propriety extraction technology that leaves minimal chemical byproducts in the oil. The purer the oil, the fewer potential side effects from the medicine. Depending on the cannabis strain, 8 oz. of cannabis ower costs between US$300 and US$900, with an average cost of US$460. For each 8 oz. of cannabis ower, the propriety process uses US$35 of materials. Depending on the strain, the extraction process generates between 3 and 14 oz. of cannabis extract, with an average of 8 oz. of cannabis extract. The second step is blending. Different cannabis strains have different effects. For example, ACIDC reduces pain, chocolate catatonic alleviates anxiety, and critical kush helps with insomnia. The master blender, Akasha, combines the extracts from several strains to create a tincture with the required effect. While each tincture is a blend, she always generates 8 oz. of the combined extracts. The 8 oz. of cannabis extract are mixed with 52 oz. of medium chain triglycerides (MCT) oil to generate 60 oz. of tincture extract.m A 64oz. bottle of MCT oil costs US$26. Once the blending is complete, the tincture batch is tested for levels of the two active ingredients: cannabidiol (CBD) and tetrahydrocannabinol (THC). The testing results are then added to the generic label. Testing costs US$60 for each set of 60 bottles. The nal step is bottling, labeling, and packing. One oz. of tincture mixture is poured into each bottle. The bottles are wiped, a dropper inserted, and a label added. Tinctures are then placed into boxes that hold 10 bottles. Bottles and stoppers cost US$0.25 each, while labeling costs US$0.40 a bottle. Each box costs US$1.25. A box lled with completed tincture bottles is termed a case. There are several monthly xed costs. Rent is US$400, amortization of tools is US$350, and marketing (i.e., website, t-shirts, magnets) costs US$250. While different products have different prices, on average, a bottle of tincture sells for US$30. The owners of Golden State Elixirs do not currently charge for labor. Their process takes about 10 hours to make a batch of six cases. Golden State Elixirs is a startup and has been growing Its sales by case for the previous 12 months are provided in Table 1. They conjecture that they could continue to grow at the same rate for three years before being running into problems. Table 1: Golden State Elixirs Sales for 2011r Month Salesin Cases January 5.0 February 5.1 March 5.4 April 7.5 May 7.7 June 7.5 July 10.0 August 10.5 September 12.3 Omoher 12.8 November 13.0 Deoemher 13.7 LICENSE INFORMATION AND TAXES There are two distinct sets of licenses required for Golden State Elixirs to be able to operate legally under California law: a local city license and a state license. There is no city license application fee, and the yearly cost of a local city license is US$50. Once a city license is obtained, the city levies a 5% excise tax This is not an income tax but rather a tax on gross revenues. The California cannabis regulations are similar to those governing wine production and sales. There is an audited \"chain of custody\" from the ground to the consumer with multiple sets of taxes collected along the way. Obtaining a state license involves many distinct steps, such as creating architectural drawings showing the security cameras and access restrictions, demonstrating that the company has an industrial safe that can hold the cannabis, and providing an audit trail for all purchases and sales of cannabis. Many of these requirements involve lling in forms and, given that the partners in Golden State Elixirs work for nothing, this part can be valued at zero. Yet roughly 90 hours would be required to ll in the forms. The additional costs shown in Table 2 would have to be incurred to obtain a yearly Califomia license. Table 2. Additional Costs to Golden State Elixirs Application fee $ LBW Micrehusiness license fee 5 5,000 Professional drawings 5 1.500 Surely bond 5 5.000 Liability insurance 5 BDl] Total Stale License 00513 $13,300 Although California levies additional taxes on cultivators and nal distributors, there are no additional excise taxes on cannabis manufacturers.'1 California, however, has an 8.8% business income tax. In California, all canna-business expenses are tax deductible. While canna-businesses are illegal under federal law, they still have to pay federal taxes. There is a special rule (Internal Revenue Code 280E) that governs calculating an illegal business' income. For illegal businesses, only cost of goods sold (COGS) is a federal tax-deductible expense. In particular, selling, general, and administrative expenses and interest expenses are not tax deductible. This restriction results in canna-businesses paying much higher federal taxes than other businesses. Currently Golden State Elixirs has a federal tax rate of 21%. GENERAL ISSUE Golden State Elixirs has hired you to provide professional guidance about the ethical and business aspects of continuing its business under the new regulatory regime. In particular, the company owners wish to understand the factors that would lead to making prots or incurring losses. 1. In your opinion, is it ethical to manufacture medical cannabis tinctures? 2. In your opinion, is it ethical to tax medical cannabis differently than other medical products? 3. Assuming that the appropriate licenses are obtained, write down a prot formula that takes into account the different local, state, and federal taxes. Do not include the license fees in this calculation. Hint: Create a formula for each type of tax, then subtract the tax formulas from before tax income. 4. Using the numbers in the case and the formula from Question 3, what is the breakeven number of cases per month? It is easier to work with a batch of six cases of 60 bottles, and then divide. 5. Sales for 2018 are estimated to be 15 cases in January with an increase of 0.9 cases every month afterward. Assuming that the licenses are obtained, how many months will it take to recover the local and state licensing costs? 6. Should Golden State Elixirs pursue the appropriate licenses, wind down the business, or become part of the black market? Explain your choice. 1. Given the high tax rates and regulatory costs (time and money), most small medical canna-businesses will either shut down or move to the black market. What are the likely effects on medical cannabis product availability, product pricing, and quality? ENDNOTES 1This case is based on a real company, but all names have been changed. 3The owners of Golden State Elixirs believe the primary benets of medical cannabis are to manage inammation, nausea, and psychiatric disorders such as post-traumatic stress disorder (PT SD). The Food and Drug Administration (FDA) has approved two drugs for the treatment of nausea from cancer treatment, while the United Kingdom has approved drugs for the treatment of pain and spasticity from multiple sclerosis. 3A list of all Schedule 1 drugs can be found at: L. Anderson, \"List of Schedule 1 Drugs,\" Drugs.com, May 18, 2018. www.dru gs.coma rticlec sa- so he dule- 1 .html. 4Medical uses have been known since the 1830s, and cannabis extracts for the treatment of illnesses such as cholera were widely sold in the United States in the late 1890s. But cannabis was not widely used for recreational purposes until Mexican immigrants who ed to the United States from the Mexican revolution introduced the practice. A combination of the fear of immigrants during the Great Depression and the lingering philosophy of prohibition led to a crackdown. The Marijuana Tax of 1937 imposed an excise tax on the sale, possession, or transfer of all hemp products, effectively criminalizing almost all uses; Hisory. com Editors, \"Marijuana,\" History.com, May 31, 2017, www.history.commpicslhistpry-of-marijuana. As part of the war on drugs, the \"Controlled Substances Act of 1970,\" the marijuana tax was repealed, and cannabis was listed as a Schedule 1 drug; Scott C. Martin, \"A Brief History of Marijuana in America,\" TIME, April 20, 2016, httptime, comf429803sfmarijuana-history-in-america. 5T he federal penalties for marijuana possession with intent to distribute are listed here: Brian T. Yeh, \"Drug Offenses: Maximum Fines and Terms of Imprisonment for Violation of the Federal Controlled Substances Act and Related Laws,\" Congressional Research Service, January 20, 2015, httpsfas.orgfsgpfcrsfmischL3072Lpdf. The lowest potential penalties are for having 1 to 49 plants or less than 50 kilos of cannabis: nes from US$250,000 to US$1,000,000 and up to ve years in prison. At the other extreme, having more than 1,000 kilograms or more than 1,000 plants can lead to nes from US$10,000,000 to US$50,000,000 and 10 years to life in prison. 6James M. Cole, \"Memorandum for All United States Attorneys: Guidance Regarding Marijuana Enforcement,\" US. Department of Justice, Ofce of the Attorney General, August 29, 2013, www.justice.govisoopa resourcesf3052013829132756857467.pdf. For example, this memo says states should prevent the distribution to minors, prevent diversion to states where cannabis is still illegal, and prevent drugged driving. TIn addition, Congress passed the Rohrabacher-F arr amendment in 2014, which prohibits Justice Department funds from being used to try cases involving medical marijuana in states where medical marijuana is legal. 8The Rohrahbacher-F arr amendment expired in January 2018. 9The city manager said, \"Don't worry about not having a license. We will clear that up when we implement the new regulations. Just stay under the radar until our new rules show up.\" 1\"Many tinctures are made with an alcohol base. Golden State Elixirs uses MCT oil so that its products can be used by recovering alcoholics. 11The cultivation tax is US$9.25 per dry-weight ounce of cannabis owers. There is a 15% excise tax on all nal users. ABOUT IMA" {NSTH'UTE 0F WEMEHT ACCOUNTANTS} EMA\