Maybe you are one of the OG Arizona marijuana license holders, perhaps you won a rural license earlier this year, or you are considering applying for a social equity license this coming December. However you came into the fortuitous ownership of one of these limited licenses, there are many ways to use that license to make money. The most obvious method is to commence a cannabis operation: retail, manufacturing, cultivation, or vertically integrated. Unfortunately, doing so requires upfront and ongoing capital of millions of dollars.
For those license holders who are not independently wealthy and do not intend to undertake a massive capital raise, there is a comparably “easier” option through leasing out the rights for a third party to operate under your license. There are a lot of upsides to such an arrangement, like substantially lower capital requirements, little need for growing or retail knowledge, and an immediate income stream. Indeed, leasing your license can seem like a tempting alternative considering lease payments can be upwards of $70,000 per month. Some might think it all sounds a little too good to be true, and they would be right. While the monetary benefits seem obvious, it is essential to understand that this “easy” option comes with significant risks.
Reporting Risks
As the law currently stands in Arizona, 100% of cannabis purchases and sales must be reported through a state-issued cannabis license. This means that when you lease your license to someone, 100% of the sales revenue they generate under that license is attributable to you and needs to be reported on under your license to AZDHS. Similarly, plant-touching costs associated with generating those sales (such as purchases of cannabis flower, feedstock, or trim) must be reported under said license to AZDHS as well. If your licensee does not provide you with the necessary information or access to track these sales, you could very easily fall out of compliance with the reporting under your license.
Tax Risks
It stands to reason that if all sales of cannabis products must be reported under a state-issued cannabis license for AZDHS, that revenue is also attributed directly to the license holder for state and federal tax purposes. This means 100% of the related tax liabilities (both income and sales tax) belong to you. Suppose a licensee properly reports 100% of their cannabis sales and purchases to the state but refuses to pay the related tax liability. In that case, the license holder is still on the hook for the balance due.
Additionally, properly maintaining all the documentation necessary to defend your tax positions (and what little deductions you are allowed) places another heavy burden on license holders. Staying compliant with 280E is difficult enough within your own business. Relying on a third party to maintain all the necessary documentation for tax support is another heavy burden to consider when weighing the risks and benefits of leasing your license.
Audit Risks
To remain compliant with state regulation, cannabis license holders must submit their operations to periodic audits by AZDHS. Deficiencies found during these audits can result in suspension and revocation of the cannabis license. When a third party leases a license, they often operate in facilities that are not directly under the control of the license holder. This lessee may have their operations off-site and in a remote location, making oversight exceedingly tricky. In addition, they may be operating in a shared space with other lessees, making segregation of operations confusing and unclear. However, the burden of meeting audit requirements lands on the license holder, not the lessee. Considering that AZ licenses can go for as much as $20 million or more, the dire impact of losing a license because of audit deficiencies is evident.
Remedy and Recommendations
While the risks above are not intended to be taken lightly, there are options for reducing the risk to the license holder. A legally detailed, specific, and thoughtful management service agreement (MSA) between the lessor and lessee is necessary. This MSA should include requirements around required reporting, documentation, and standard operating procedures. The MSA should also allow the license holder access to the operational facilities of the lessee as desired and without advance notice. Additionally, the MSA should very clearly state which party is responsible for tracking/maintaining all cash inflow and outflow and who is responsible for the resulting tax liability.
It should be noted that the risks above are just a shortlist of the many pitfalls that abound when considering whether to enter into a license lease arrangement. At Rebel Rock, we highly recommend consulting with a seasoned cannabis attorney and tax accountant before entering into such a management service agreement. But don’t fear! The CPAs at Rebel Rock are ready and waiting to assist with your questions regarding cannabis license leases.