It seems obvious, doesn’t it? A limited liability company operating agreement governs the relationships among a limited liability company (“LLC”), its owners (called “Members”), and the people running the LLC (who may be Members or “Managers” appointed by the Members). It often serves the same purposes for the LLC as stock subscription agreements, By-laws and a shareholders’ agreement collectively serve for a corporation. This important contract should not be imposed on any Member without that Member’s consent. While this may be true in Pennsylvania, the LLC laws in New York and Delaware have led courts to reach different results in those states.

New York. Shapiro, Ettenson and Newman organized ENS Health LLC as a Member-managed LLC in New York.  Each was to have a 1/3 interest in ENS Health. For two years the LLC had no operating agreement until Ettenson and Newman executed a partial written consent pursuant to which:

-the LLC’s formation document was amended to provide for management by Managers; and

-an operating agreement was signed (by Ettenson and Newman) providing for action to be taken by a majority vote of the Managers (Ettenson, Newman and Shapiro) or a majority in interest of the Members.

This operating agreement, never signed by Shapiro, thus gave Ettenson and Newman the authority to make decisions without Shapiro’s input.  They proceeded to do so, reducing Shapiro’s salary to zero and approving a $10,000 capital call. Under the operating agreement they had approved Shapiro’s failure to meet the capital call could have resulted in a reduction in his interest in the LLC.

Shapiro sued[1], seeking to void the amended formation document, operating agreement, salary reduction and capital call.  The New York courts sided with Ettenson and Newman.  The trial court relied on a provision of the New York LLC Act that states: “Except as provided in the operating agreement . . . the vote of a majority in interest of the members entitled to vote thereon shall be required to . . . adopt, amend, restate or revoke the articles of organization or operating agreement . . ..”[2]   Under this provision the Court held that the formation document and operating agreement were validly adopted by a majority of the Members, and thus Shapiro was bound by the operating agreement he had not signed, and the actions against Shapiro were validly taken.

Delaware. Seaport Village Ltd. (“Ltd.”) was a Member of Seaport Village Operating Company, LLC, a Delaware LLC (“Operating Company”). Operating Company managed a retail development in San Diego, California. Operating Company’s Operating Agreement, which was not signed by Ltd., contained a fee shifting provision requiring the non-prevailing party to cover the prevailing party’s litigation costs in any dispute under the operating agreement. On the losing end of such a dispute, and faced with a legal bill in the mid $300k range, Ltd. asserted in Delaware Chancery Court that it was not bound by the agreement it had not signed. The Vice-Chancellor disagreed[3], pointing to amendments to the Delaware LLC Law that make an operating agreement binding on the LLC and the LLC’s Members whether or not they have signed it.[4] The Vice Chancellor noted the following, somewhat disturbing, rationale:

“Basic principles of contract law support this reading. As a general matter, “only parties to a contract are bound by that contract.” Am. Legacy Found. v. Lorillard Tobacco Co., 831 A.2d 335, 343 (Del. Ch. 2003) (holding that an entity formed by operation of a settlement agreement, although not a signatory, was a party to the settlement agreement). Likewise, “only a party to a contract may be sued for breach of that contract.” Gotham P’rs, L.P. v. Hallwood Realty P’rs, L.P., 817 A.2d 160, 172 (Del. 2002) (citation omitted). By binding a Delaware LLC and its members to their operating agreement, Section 18-101(7) makes them parties to the operating agreement.” Seaport Village at 4.

The Vice Chancellor seems to be saying that the State’s interest in enforcing Delaware LLC governing documents can force an unwilling Member into an agreement they never contemplated. But doesn’t that beg the question of whether there was an agreement to begin with?

Pennsylvania’s New LLC Law. On November 21, 2016, the new Chapter 88 of Title 15 Pa. C.S. was adopted. On April 1, 2017, Chapter 88 became the law governing Pennsylvania LLCs.

Section 8812 of Title 15 defines “Operating agreement” as “The agreement, whether or not referred to as an operating agreement and whether oral, implied, in record form or in any combination thereof, of all the members of a limited liability company . . .concerning matters described in section 8815(a) (related to contents of operating agreement). The term includes the agreement as amended or restated.” (emphasis added).

The report of the Title 15/Business Associations Committee of the Section of Business Law of the Pennsylvania Bar Association, September 12, 2016 version (“PA Bar Report”), includes the following commentary on this definition:

“Unless the operating agreement itself provides otherwise:

“an operating agreement may comprise a number of separate documents (or records), however  denominated; and

“subject to 15 Pa.C.S. § 8816(b) (deeming new members to assent to the then-existing operating  agreement), a document, understanding etc. can be part of the operating agreement only with  the assent of all persons then members.

“An agreement among less than all the members might well be enforceable among those members as parties, but would not be part of the operating agreement. However, under 15 Pa.C.S. § 8815(a)(4), an amendment to an operating agreement can be made with less than unanimous consent if the operating agreement itself so provides.” PA Bar Report at 360.

So, under Pennsylvania’s new statute, although an operating agreement need not be in writing it must be agreed to by all Members (which is obviously easier to prove if the agreement is in writing and signed). A prospective minority Member of a Pennsylvania LLC will NOT be bound by an operating agreement it has not assented to, regardless of whether the majority has adopted it. Probably.

Why probably? Unlike New York, which requires LLC operating agreements to be in writing, Pennsylvania does not. The terms of an unwritten contract could be proved by evidence of the parties’ assent, including non-verbal assent by course of dealing. So with just the wrong facts one could find oneself a Member of a Pennsylvania LLC “by estoppel” despite one’s efforts not to be.

Is the Statute of Frauds any help?  The Pennsylvania Statute(s) of Frauds apply (i) to the sale of goods in excess of $500[5] (ii) to sales[6]  and certain leases[7] of real estate and personal property and (iii) to certain transactions with executors and trustees[8].  When applicable, there must be a writing supporting the subject contract. In most cases Pennsylvania’s Statute of Frauds will not apply to an LLC operating agreement because no transfers of goods or realty are contemplated between the Members.[9]

Prospective minority members of LLCs organized in any state, including Pennsylvania, New York and Delaware, would be well advised to insist on completion of the operating agreement before agreeing to any participation in the entity. In New York and Delaware, that is because other Members could possibly reach an agreement on your behalf that you might not like. In Pennsylvania, the concern is that a prospective Member not passively acquiesce in the terms of an unwritten operating agreement by course of dealing. The bar is thus a bit higher for imposing unagreed terms on a minority Member in Pennsylvania. On the flip side, parties desiring to control an LLC with less interference from pesky minority owners should prefer a Delaware or New York entity.

Strassburger McKenna Gutnick & Gefsky assists its clients in forming business and nonprofit entities in Pennsylvania, Delaware, New York and other jurisdictions, and in understanding the importance of both the form and place of formation of those entities. If you have a question about your business entity, or would like to create one, contact David L. Pollack, Julie I. Kline or any member of our Business Services group.

[1] Shapiro v Ettenson, 2015 NY Slip Op 31670(U) (Supreme Court, New York County, August 16, 2015); Affirmed, 2017 NY Slip Op 00442 (Ap. Div. January 24, 2017)

[2] New York Limited Liability Company Law §402(c)(3)

[3] Seaport Village Ltd. v. Seaport Village Operating Company, LLC, et al. C.A. No. 8841-VCL (Opinion letter of J. Travis Lastor, Vice-Chancellor, September 24, 2014)

[4] Delaware LLC Act, Section 101(7)

[5] 13 Pa. C.S. §2201

[6] 33 P.S. §1

[7] 68 P.S. §250.202; 13 Pa.C.S. §2A201

[8] 33 P.S. §4

[9] The New York and Delaware Statutes prohibit contracts that require more than a year to perform unless in writing. Pennsylvania does not have a parallel provision. The Delaware Chancery Court once held that the Delaware Statute of Frauds can apply to a Delaware Operating Agreement. Olson v. Halvorsen, Del. Ch., 2008 Del. Ch. LEXIS 156 (Oct. 22, 2008) The Delaware legislature promptly overruled it. 6 Del Code §18-101(7) (8/2/2010); “A limited liability company agreement is not subject to any statute of frauds . . . .”

by David L. Pollack, Of Counsel[1]

 NOTHING IN THIS DOCUMENT IS INTENDED OR SHALL BE CONSTRUED AS ADVICE TO PARTICIPATE IN, OR COUNSEL WITH RESPECT TO, CRIMINAL OR FRAUDULENT ACTIVITIES. POSSESSION, DISTRIBUTION AND SALE OF MARIJUANA IS A SERIOUS CRIME UNDER FEDERAL LAW, AND ENGAGING IN THOSE ACTIVITIES WITHOUT REGISTRATION UNDER THE PENNSYLVANIA MEDICAL MARIJUANA ACT, 35 P.S. §§ 10231.106 ET SEQ., IS A SERIOUS CRIME UNDER PENNSYLVANIA LAW. NOTHING HEREIN SHALL BE CONSTRUED AS ADVICE TO VIOLATE ANY SUCH LAW.

On December 10, 2016 the Pennsylvania Department of Health (the “Department”) published temporary regulations[2] (the “Regulations”) under the Pennsylvania Medical Marijuana Act[3] (the “Act”), which specify certain operating requirements for holders  of medical marijuana dispensary[4] permits under the Act. These regulations supplement the Department’s October 29, 2016 Temporary Regulations[5] covering the permit application process. In particular, these new regulations specify requirements for dispensary security (including security requirements for the security system), inventory control, sanitation and medical marijuana transport that are relevant to the planning of dispensary facilities. Persons who are contemplating entering this business should be advised of the following:

I.  The Department of Health continues to strongly regulate the actual handover of Medical Marijuana

How are the dispensaries expected to distribute medical marijuana?

 A dispensary will only be permitted to dispense medical marijuana to a patient or caregiver who presents a valid identification card to an employee who is authorized to dispense medical marijuana at the facility. The dispensary must also verify the validity of the patient or caregiver identification card using a prescribed electronic tracking system to access the Department’s database.

Additionally, relating to the facility itself, the dispensary may only dispense medical marijuana to a patient or caregiver in an indoor, enclosed, secure facility as approved by the Department. The dispensary must not be located within 1,000 feet of any property line of a school or day-care center.

A dispensary may not be located at the same site used for growing and processing medical marijuana.

What records must a medical marijuana dispensary keep when it dispenses medical marijuana?

Medical marijuana dispensaries are required to log the following information into the Department’s electronic tracking system:

  1. The name, address and any permit number assignment to the dispensary by the Department;
  2. The name and address of the patient and, if applicable, the patient’s caregiver;
  3. The date the medical marijuana was dispensed;
  4. Any requirement or limitation noted on the patient’s certification as to the form of medical marijuana that the patient should use; and
  5. The form and quantity of the medical marijuana dispensed.

Medical marijuana dispensaries are also required to provide the aforementioned information to the patient or caregiver in the form of a receipt.

Dispensaries are required to destroy and erase any copies of a patient’s certificate after generating the receipt.

Will patients be able to self-administer medical marijuana at the facility at which they acquire medical marijuana?

Generally, patients will not be permitted to self-administer medical marijuana at the facility where they acquire medical marijuana. However, it is at the facility’s discretion whether they permit their own employees, who are also patients, to self-administer medical marijuana while at the facility.

What are the limitations on dispensing medical marijuana?

A dispensary is not permitted to dispense an amount of medical marijuana greater than a 30-day supply to a patient or caregiver until the patient has exhausted all but a 7-day supply provided pursuant to the certification currently on file with the Department. A dispensary is also not permitted to provide a quantity or form of medical marijuana that is different than indicated on the patient’s certification.

As a dispensary permit holder, am I allowed to advertise medical marijuana at a discounted rate or as part of a giveaway?

No, a dispensary may not advertise medical marijuana as a promotional item, as a part of a giveaway, or as part of a coupon program. A dispensary is also not permitted to offer medical marijuana to a patient or caregiver free of cost unless the patient is approved for financial assistance by the Department. Additionally, a dispensary is not permitted to offer the delivery of or deliver medical marijuana to a patient’s or caregiver’s home or any other location.

II.  Medical marijuana dispensary operations will require certain expensive items and/or relationships as detailed in the regulations.

 What type of licensed medical professionals are required to work at the dispensary facility?

 Either a physician or a pharmacist must be present at a dispensary facility at all times during the hours the facility is open to dispense medical marijuana to patients and caregivers. If a dispensary is authorized to operate more than one facility under its permit, a physician assistant or a certified nurse practitioner may be present onsite at each of the other locations instead of a physician or pharmacist. As provided by the Act, each of the health professionals shall, prior to assuming any duties at the facility, successfully complete a 4-hour training course developed by the Department.

 What types of security and surveillance are required for a medical marijuana dispensary permit holder?

 A dispensary must have security systems that utilize commercial-grade equipment to prevent unauthorized entry and to prevent and detect an adverse loss. The security and surveillance systems must include a professionally monitored security alarm system that includes:

  1. Coverage of all facility entrances and exits; rooms with exterior and exits; rooms with exterior windows, exterior walls, roof hatches or skylights; storage rooms, including those that contain medical marijuana and safes; and the perimeter of the facility.
  2. A silent alarm system signal, known as a duress alarm, generated by the entry of a designated code into an arming station in order to signal that the alarm user is being forced to turn off the system.
  3. An audible security alarm signal, known as a panic alarm, generated by the manual activation of a device intended to a signal a life-threatening or emergency situation requiring law enforcement response.
  4. A silent alarm signal, known as a holdup alarm, generated by the annual activation of a device intended to signal a robbery in progress.
  5. An electrical, electronic, mechanical or other device capable of being programmed to end a prerecorded voice message requesting dispatch, when activated, over a telephone line, radio or other communication system to law enforcement, public safety or emergency services agency.
  6. A failure notification system that provides an audible, text or visual notification of any failure in the systems. The failure notification system must provide by telephone, email, or text message an alert to a designed security person within 5 minutes after the failure.
  7. Smoke and fire alarms.
  8. Auxiliary power sufficient to maintain security and surveillance systems for at least 48 hours following the power outage.
  9. Motion detectors.

Dispensaries are also required to have a professionally-monitored security and surveillance system that is operational 24 hours a day, 7 days a week and records all activity in images capable of clearly revealing facial detail. The security and surveillance system must be equipped with fixed camera placement that allows for a clear image of all individuals and activities in and around the following:

  1. Any area of the facility where medical marijuana is loaded or unloaded into or from transport vehicles.
  2. Entrances to and exits from the facility. Entrances and exits must be recorded from both indoor and outdoor vantage points.
  3. Rooms with exterior windows, exterior walls, roof hatches or skylights and storage rooms, including those that may contain medical marijuana and safes.
  4. Five feet from exterior of the perimeter of the facility.
  5. All limited access areas

The cameras in the medical marijuana dispensary facilities must also be able to take clear and still photographs and be able to display the correct date and time. The dispensaries must also be able to record all images captured by each surveillance camera for a minimum for 4 years. The recordings must be stored in a secure place and protected with a separate security system.

The temporary regulations further explains that medical marijuana dispensaries must designate an employee to continuously monitor the security and surveillance systems of the facility.

Medical marijuana dispensaries are also required to install commercial-grade, nonresidential doors and door locks on each external door of the facility.

What sanitation and safety requirements are required by the Department for a medical marijuana dispensary facility?

A dispensary shall provide its employees and visitors with adequate and convenient handwashing facilities furnished with running water at a temperature that is suitable for sanitizing hands. The following apply:

  1. Hand-washing facilities must be located where good sanitary practices require employees to wash and sanitize their hands.
  2. Effective nontoxic sanitizing cleansers and sanitary towel service or suitable hand drying devices shall be provided.
  3. A dispensary must provide its employees and visitors with adequate, readily accessible bathrooms that are that are maintained in a sanitary condition and in good repair.
  4. A dispensary shall comply with all other applicable State and local building code requirements.

What are requirements surrounding the transportation of medical marijuana?

Medical marijuana may be transported and delivered by a dispensary to a medical marijuana organization in the following circumstances:

  1. A dispensary may deliver medical marijuana to a medical marijuana organization only between 7:00am and 9:00pm for the purposes of transferring medical marijuana among the permitee’s dispensary locations and returning medical marijuana to a grower/processor.
  2. A dispensary may contract with a third-party contractor for delivery so long as the contractor complies with the regulations set forth in 28 Pa. Code §§1161 et seq.

Dispensaries will are not permitted to transport medical marijuana to any location outside of Pennsylvania. The dispensary must use a global positioning system to ensure safe, efficient delivery of the medical marijuana to a medical marijuana organization.

Vehicles permitted to transport medical marijuana must:

  1. Be equipped with a secure lockbox or locking cargo area.
  2. Have no markings that would either identify or indicate that the vehicle is being used to transport medical marijuana.
  3. Be capable of being temperature controlled for perishable medical marijuana, as appropriate.
  4. Be insured in an amount that is commercially reasonable and appropriate.

Each transport vehicle must be staffed with a delivery team consisting of at least two individuals. The dispensary is also required to notify the Department daily of its delivery schedule, including routes and delivery times.

How will the Department know whether I am in compliance with all these requirements?

At the time the Department determines a dispensary to be operational, the dispensary is required provide the Department with a full and complete plan of operation consistent with regulatory requirements for a review that includes the following:

  1. Employment policies and procedures;
  2. Security policies and protocols;
  3. A process for receiving, packaging, labeling, handling, tracking, transporting, storing, disposing, returning and recalling products containing medical marijuana in accordance with all applicable laws, rules and regulations;
  4. Workplace safety;
  5. Maintenance, cleaning and sanitation of the site or facility, or both;
  6. Inventory maintenance and reporting procedures;
  7. The investigation of complaints and potential adverse events from other medical marijuana organizations, patients, caregivers or practitioners; and
  8. The use of the electronic tracking system prescribed by the Department.

SMGG intends to stay at the forefront of legal developments in this area.  For questions, please contact Erica L. Laughlin or David L. Pollack of Strassburger McKenna Gutnick & Gefsky at elaughlin@smgglaw.com; dpollack@smgglaw.com or (412) 281-5423.

[1] The author would like to recognize the significant contributions of John Scialabba, University of Pittsburgh Law School class of 2017, to this post.

[2] Codified at 28 Pa. Code §§1161 et seq.

[3] Codified at 35 P.S. §§ 10231.106 et seq.

[4] The new rules and regulations define a dispensary as a person who holds a permit issued by the Department to dispense medical marijuana.

[5] As described in SMGG’s November 3 Blog.

by David L. Pollack, Of Counsel[1]

 NOTHING IN THIS DOCUMENT IS INTENDED OR SHALL BE CONSTRUED AS ADVICE TO PARTICIPATE IN, OR COUNSEL WITH RESPECT TO, CRIMINAL OR FRAUDULENT ACTIVITIES.  POSSESSION, DISTRIBUTION AND SALE OF MARIJUANA IS A SERIOUS CRIME UNDER FEDERAL LAW, AND NOTHING HEREIN SHALL BE CONSTRUED AS ADVICE TO VIOLATE THAT LAW.

On October 29, 2016 the Pennsylvania Department of Health (the “Department”) published temporary regulations[2] (the “Regulations”) under the Pennsylvania Medical Marijuana Act[3] (the “Act”), which outline the application process for obtaining and maintaining a medical marijuana grower/processor[4] permit or dispensary[5] permit under the Act. Persons who are contemplating entering one of these businesses should be aware of the following:

 

When can I apply for a grower/processor permit or dispensary permit?

The specific dates on which the Department will make the permit application available and begin accepting accept permit applications has not yet been announced. We are informed that this date may be in the first quarter of 2017.  However, the Department will publish in the Pennsylvania Bulletin notice of the initial permit application availability and the time frame in which initial permit applications will be accepted. An applicant’s initial permit application must be received during that time frame to be considered by the Department.

What form do I need to complete in order to apply for a grower/processor permit or dispensary permit?

The application form will be made available on the Pennsylvania Bulletin. Applicants must use the official form. Once the application is made available, applicants will be required to submit the permit application form electronically, either through the Department’s website or by mailing electronic media to the Department.

What are my chances of getting a grower/processor or dispensary permit?

The Department will not initially issue more than twenty-five grower/processor permits and fifty dispensary permits. Permits will be divided among six regions (coextensive with existing Department of Health Regions). The Department will consider the following factors about a region in which an applicant intends to do business in its determination to grant or deny an initial permit to an applicant.

  1. Regional population;
  2. The number of patients suffering from a serious medical condition;
  3. The types of serious medical condition in the region;
  4. Access to public transportation;
  5. The health care needs of rural and urban areas; and
  6. Areas with recognized need for economic development.

Note here that the regulations governing the demand side of this market, the physicians, patients and caregivers, appear to be last on the regulatory agenda at the Department of Health. The DOH may find it difficult to evaluate applications if it does not have data on qualifying patients.

What do I need to start assembling in order to apply?

1.  The physical address of the applicant’s proposed site and facility, including evidence satisfactory to the Department that shows the applicant owns or has the authority to use the proposed site and facility as a site and facility for, at a minimum, the term of the permit.

2.  Plans for the facility (after construction or renovation, if the applicant will build or build out its facility).

3.  Evidence that the applicant is or will be in compliance with municipal zoning requirements.

4.  Certified copies of the applicant’s organizational documents, if applicable, and, if the applicant was not organized in Pennsylvania, evidence that it is authorized to conduct business in Pennsylvania.

5. Evidence that the applicant is responsible and capable of successfully establishing and operating a facility. Evidence of this capability could include, e.g., demonstrated experience, running a for-profit or nonprofit organization or other business within Pennsylvania or any other jurisdiction.

6.  Evidence that the applicant and its directors and officers are in compliance with all the laws of the Commonwealth regarding payment of State taxes. (Tax clearance letters from PA Departments of Revenue and Labor and Industry; or certification by those departments that a Tax clearance letter has been requested.)

7.  A diversity plan that establishes a goal of equal opportunity and access in employment and contracting by the medical marijuana organization. A medical marijuana organization may demonstrate achievement of its diversity goals by employing diverse participants or transacting business with diverse groups.[6]

8.  Begin running background checks on owners and prospective employees. Each applicant will be required to submit fingerprints of its directors, officers, financial backers, operators and employees to the Pennsylvania State Police. The Pennsylvania State Police will then submit the fingerprints to the Federal Bureau of Investigation for the purpose of verifying the identity of the individuals whose fingerprints have been submitted and obtaining a current record of criminal arrests and convictions. The Pennsylvania State Police will provide the results of the record checks to the Department.

9.  Begin working with other service providers. To comply with the Act and Regulations, a medical marijuana organization will need to have commercial relationships with:

a.  a commercial bank;

b.  a property and liability insurer;

c.  an analytical laboratory;

d.  one or more physicians or pharmacists;

e.  a security specialist or specialists;

f.  IT specialists;

g.  accountants; and of course

h.  legal counsel.

10.  The Regulations require that the applicant adopt internal policies and procedures to address the requirements of the Act and Regulations. As part of the application, the applicant must provide a summary of its intended plan of operation that describes, at a minimum, how the applicant’s proposed business operations will comply with the Act and the Regulations (including new Regulations for grower/processors codified at 28 PA. Code §§1151.21 et seq.) relating to:

a.  Security;

b.  Employees qualification and training;

c.  Transportation of medical marijuana;

d.  Storage of medical marijuana;

e.  Labeling of medical marijuana;

f.  “Seed to sale” inventory management;

g.  With respect to grower/processor facility, nutrient practice;

h.  With respect to a grower/ processor’s facility, quality control and testing of medical marijuana;

i.  Recordkeeping;

j.  Preventing unlawful diversion of medical marijuana;

k. With respect to grower/processor’s facility, growing of medical marijuana, including a detailed summary of policies and procedures for its growth; and

l.  Establishment, implementation and monitoring of diversity goals.

What is the cost to apply for a permit?

When applying for a grower/processor permit the Department requires a $10,000 nonrefundable application fee and a $200,000 refundable initial permit fee. An applicant for a grower/processor permit must provide an affidavit stating that the applicant has at least $2,000,000 in capital, $500,000 of which must be on deposit with one or more financial institutions.

When applying for a dispensary permit the Department requires a $5,000 nonrefundable application fee and a $30,000 refundable initial permit fee. An applicant for a dispensary permit must provide an affidavit that the applicant has at least $150,000 on deposit with one or more financial institutions.

How long after I submit my application will I know whether or not I have been chosen to receive a Permit?

The information regarding the application process timeframe is unclear. The timeframe regarding the application release date, submission and evaluation period has not yet been addressed by the Department.  We do know that once a permit is granted the permit holder will have six months to become operational and forecast its production to the Department.

If I am granted a permit from the Department, for how long is it valid?

A permit is valid for one year from the date of issuance. A medical marijuana organization wishing to renew its permit shall submit a permit renewal application not more than 6 months, nor less than 4 months, prior to the current permit’s expiration.

What if the Department denies my application for a grower/processor or dispensary permit?

Once a decision is made, the Department will provide written notice of denial to the applicant. The applicant can request a debriefing from the Department within 30 days from the date of notice of denial, limited to a discussion of deficiencies in the application. A disappointed applicant can appeal the notice of denial under the Department of Health’s rules for administrative appeals, and should have an ultimate resort to Commonwealth Court.

SMGG intends to stay at the forefront of legal developments in this area. For questions, please contact Erica L. Laughlin or David L. Pollack of Strassburger McKenna Gutnick & Gefsky at elaughlin@smgglaw.comdpollack@smgglaw.com or (412) 281-5423.

[1] The author would like to recognize the significant contributions of John Scialabba, University of Pittsburgh Law School class of 2017, to this post.

[2] Codified at 28 Pa. Code §§1141.21 et seq; 28 Pa. Code §§1151.21 et seq

[3] Codified at 35 P.S. §§ 10231.106 et seq.

[4] The new rules and regulations define a grower/processor as a person who holds a permit from the Department under the act to grow and process medical marijuana.

[5] The new rules and regulations define a dispensary as a person who holds a permit issued by the Department to dispense medical marijuana.

[6] Under the new rules and regulations, the term diverse participants includes

a.  Individuals from diverse, ethnic and cultural background and communities;

b.  Women;

c.  Veterans; and Individuals with disabilities.

NOTHING IN THIS DOCUMENT IS INTENDED OR SHALL BE CONSTRUED AS ADVICE TO PARTICIPATE IN, OR COUNSEL WITH RESPECT TO, CRIMINAL OR FRAUDULENT ACTIVITIES.  POSSESSION, DISTRIBUTION AND SALE OF MARIJUANA IS A SERIOUS CRIME UNDER FEDERAL LAW (AS IS TAX EVASION), AND NOTHING HEREIN SHALL BE CONSTRUED AS ADVICE TO VIOLATE ANY LAW.

This is another in our series of occasional musings on the Pennsylvania Medical Marijuana Act, 35 P.S. §10231.101 et seq. This time, a California marijuana dispensary’s challenge to a 1982 Federal statute raises some questions about taxation of potential participants in Pennsylvania’s medical marijuana industry.

Harborside Healthcare Center is a large California medical marijuana dispensary with three locations, upwards of 225,000 patients, and $30 million in annual sales. Harborside is challenging a $2.4 million federal income tax bill.[1] The challenge turns on Section 280E of the Code, added to the tax law in 1982 in response to a tax court decision that had allowed a drug dealer to deduct his ordinary and reasonable business expenses in computing taxable income.  After enactment of 280E, “[n]o deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if such trade or business . . . consists of trafficking in controlled substances (within the meaning of Schedules I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any state in which such trade or business is conducted.” (IRC §280E)

As we are taking pains to remind ourselves, medical marijuana remains a Schedule I Controlled Substance, and the activities of a marijuana dispensary or grower would constitute trafficking. Harborside would like the tax court to read the statute so that the deduction is allowable if the substance is legal under state law – basically changing “or” to “and” in the final clause. We wish them luck, but, assuming they are not successful, what reductions, if any, can a participant in Pennsylvania’s medical marijuana market make to its federal taxable income?

First, the participant (either a dispensary or a grower/processor) can reduce its gross income by subtracting its Cost of Goods Sold (Treas. Reg. §1.61-3(a)), since this reduction is neither a “credit” nor a “deduction”. Cost of Goods Sold is generally limited to the cost of inventory consumed in producing products, but may include some labor or other costs incurred in a manufacturing or processing operation, depending on accounting method. Recall that Pennsylvania requires participants in the market to make expenditures for security, product tracking, analytical laboratory services, and on-site medical personnel. These are costs that are necessary to operate in Pennsylvania but may not qualify as “costs of goods sold”.

Second, a grower/processor can probably deduct the 5% Pennsylvania tax on sales of medical marijuana to dispensaries under 35 P.S. §10231.901. There is an IRS Chief Counsel Memorandum (No. 201531016)  addressing a Washington State tax on sales of marijuana, which treated that levy as an excise tax and as a reduction in proceeds received rather than a “deduction or credit”.

Third, to the extent an organization’s business involves other activities for which it earns revenue (counselling; sales of products that are not controlled substances), the organization may be able to establish that it has business activities that are not “trafficking” and that deductions may be taken against non-marijuana business revenue.[2]  This seems difficult to do given the structures for grower/processors and dispensaries mandated by Pennsylvania law.

There is also the question of Commonwealth taxation. Pennsylvania income tax will apply to the market participant on top of the 5% excise tax. Will Pennsylvania taxpayers have to follow the federal rule of non-deductibility for their medical marijuana business expenses?

Hopefully, the legislature will take action on this. Colorado has adopted a simple statute that basically reads 280E out of Colorado law for licensed participants in the Colorado marijuana market. (Colo. House Bill 13-1042 enacted May 28, 2013). If Pennsylvania’s legislature does not act, I would submit that the answer depends on whether the participant is organized as a corporation or a limited liability company/partnership.

Most states’ individual and corporate state income tax regimes start with the individual’s or corporation’s federal return, and make adjustments here and there. Pennsylvania does this for corporations. The starting point for Pennsylvania corporate net income tax is the corporation’s federal return. But for individual tax purposes, Pennsylvania does not follow Federal 1040s, but requires individual taxpayers to divide receipts into particular categories that do not offset each other. One of those categories is net income from a trade or business. So a medical marijuana distributor organized as a corporation would start with a federal return on which its business expenses from the marijuana business can’t be deducted. Absent legislative action to allow the deduction for state purposes, the taxpayer might not be able to just take that deduction.  On the other hand, individual Pennsylvania returns are not tied to Federal 1040s, so one might argue that to the extent business expenses are deductible in computing Pennsylvania taxable income of an individual with an interest in a partnership or LLC in any old business, there should be no restriction on taking a deduction for business expenses of a medical marijuana business.

So there seems to be at least one good reason to organize a Pennsylvania medical marijuana business as a limited liability company or as a limited partnership with a corporate general partner!

Strassburger McKenna Gutnick & Gefsky continues to monitor issues in Pennsylvania’s emerging medical marijuana market as well as issues in business taxation and tax planning whether or not related to medical marijuana. For questions about medical marijuana, please contact Erica L. Laughlin or David L. Pollack of Strassburger McKenna Gutnick & Gefsky at elaughlin@smgglaw.com; dpollack@smgglaw.com or (412) 281-5423.  For questions about business taxation and tax planning, please contact David, or S. John Kelly at jkelly@smgglaw.com.

[1] See Smalley, Craig W.; Marijuana Dispensary Takes on IRS in Tax Court; Accounting Today.com (accessed 9/15/2016)

[2] Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 TC 173 (2007)

Back in the 1980s, if a business owner wanted to transfer her business to her children at a reduced tax cost, she might start with a C corporation and recapitalize it. She would keep a class of preferred stock that entitled her to receive most of the business’ operating cash flow and that had the lion’s share of the voting rights. Junior family members would receive common stock entitled to residual cash flows and without much of a vote.  The value of the common stock transferred (and thus the business owner’s gift tax liability) would be reduced because of discounts based on the senior member’s entitlement to cash flow and control over distributions from the business.  On the death of the senior family member, the preferred stock would be cancelled, convert to common stock or otherwise lose many of its features. The business owner’s estate would take the position that there was no transfer of those features to the younger generation and therefore not much additional transfer tax liability, even though the younger generation was suddenly able to access the cash flows from the business.

Physics tells us that matter and energy are not created or destroyed, only changed in form. Congress and the IRS have a similar view about value: It can neither be created nor destroyed without tax consequences.  In order to guard against ( inter alia) the so called Estate Freeze Recapitalization summarized above (so called because it attempted to “freeze”  the value of the senior family member’s estate) Congress enacted Chapter 14 of the Internal Revenue Code, and in particular Sections 2701 and 2704. A discussion of 2701 is for another day. What 2704 did was to provide that some of those controls that the senior family member holds (and that might reduce value passing to the younger generation), particularly controls on the right to liquidate interests in a business entity, will be ignored if they lapse after the transfer.

The enactment of Chapter 14 did slow down Recapitalization activity. However, clever tax lawyers realized that a business organized as a partnership or limited liability company could achieve similar discounts without violating Chapter 14. With respect to the Section 2704 rules, there is a rule that allows you to take into account for valuation purposes restrictions on transfer consistent with state law, and another rule that allows you to respect restrictions that are the same as those accepted by third party investors.  With a little judicious lobbying so that state law required unanimous consent of all partners or LLC members to liquidate, and the granting of interests in family entities to charities or trusted colleagues, the estate planning bar had pretty much solved 2704.

On September 6, 2016, the IRS issued a set of proposed regulations under Section 2704 of the Code. Apparently intended to address some of the workarounds that have been developed for Section 2704, the regulations have four main effects:

  1. They treat a restriction on voting or liquidation rights that lapses within three years of death as having lapsed at death (facilitating an argument that the “control premium” is transferred at death);
  1. They require that any non-family interest be substantial (20%) or that the non-family member have a right to put its interest for a pro-rata portion of the entity’s fair market value, in order for a restriction applicable to non-family members to be respected for family members;
  1. They treat the “mere assignment” of economic rights in a partnership or LLC as a lapse of voting rights with respect to that interest; and
  1. They treat as a restriction to be ignored any provision that reduces the payment to any member on liquidation below the member’s share of fair market value.

The proposed regulations, if adopted (possibly in December of this year or early next year), could have a significant impact not only on estate tax and business succession planning, but also on transfers of interests in existing Family Limited Partnerships (FLPs) or Family Limited Liability Companies (FLLCs) that may have been created 20 years ago in reliance on the planning opportunities then-available under Section 2704.

Because the proposed regulations can appear to attribute control of an entity for some purposes to persons who do not in fact have control, they could also be argued to impact the valuation of family-owned businesses in the support and equitable distribution context.  In addition, if corporate attorneys are not aware of these proposed regulations when reviewing or preparing governing documents for family business entities, and sales or gifts of minority interests in family-owned businesses, they may be unwittingly creating problems for their clients in other contexts.

The regulations are merely proposed at this stage, but if they are adopted substantially as proposed, they could be effective retroactively to some extent.  Persons with existing FLPs or FLLCs or who are making planned transfers of discounted interests in family entities should consult their advisers and counsel. These folks might consider either accelerating planned transfers so they occur before the proposed regulations’ effective date, or reevaluating the plan in light of the expected reduction in valuation discounts.

Strassburger McKenna Gutnick & Gefsky is prepared to assist with estate and succession planning and estate administration for business owners and others. Please contact Jillian Zacks, jzacks@smgglaw.com or Dave Pollack, dpollack@smgglaw.com at 412 281 5423 to talk about your estate or succession plan.

Contributing Authors:  Erica L. Laughlin and Lydia A. Gorba

NOTHING IN THIS DOCUMENT IS INTENDED OR SHALL BE CONSTRUED AS ADVICE TO PARTICIPATE IN, OR COUNSEL WITH RESPECT TO, CRIMINAL OR FRAUDULENT ACTIVITIES.  POSSESSION, DISTRIBUTION AND SALE OF MARIJUANA IS A SERIOUS CRIME UNDER FEDERAL LAW, AND NOTHING HEREIN SHALL BE CONSTRUED AS ADVICE TO VIOLATE THAT LAW.

Pennsylvania’s medical marijuana program, known as Act 16, took effect on May 17, 2016. The implementation of the program, however, is expected to take between 18 and 24 months. In order to offer more timely relief to those, particularly children, in need of medical marijuana, the Pennsylvania Department of Health has been working to issue temporary regulations.

On June 24, 2016, the Department issued a temporary regulation that will allow the parents, guardians, or other caregivers of children with serious medical conditions, as defined by the Act, to obtain medical marijuana from another state, territory of the United States, or any other country to be administered to the minor without violating Pennsylvania Law.  In order to obtain out of state medical marijuana, an applicant must apply to the Department for a Safe Harbor Letter, providing specific information as detailed in the regulation, including documentation concerning the applicant’s relationship to the minor and a criminal background check.

The applicant must further complete two forms, the Minor Safe Harbor Physician Form (to be filled out in part by the applicant and in part by a physician), and the Applicant Form. The Physician Form can be found on the Department’s website at

http://www.health.pa.gov/My%20Health/Diseases%20and%20Conditions/M-P/MedicalMarijuana/Documents/Safe%20Harbor%20Letter%20Dr%20Form%20Final.pdf. The Applicant Form is currently being drafted, and according to the Department of Health is expected to be released sometime in early July.

The Applicant Form will include a list of required certifications and waivers noting an applicant’s understanding that marijuana remains illegal under Federal Law, and carries the potential for violations under state law under certain circumstances.

A potential applicant may be wary of the amount of personal information he or she must provide to comply with this regulation. The good news is that information obtained by the Department regarding a minor and applicant under this chapter is confidential and not subject to public disclosure, including disclosure under Pennsylvania’s Right-to-Know Law.

SMGG intends to stay at the forefront of legal developments in this area. For questions, please contact Erica L. Laughlin or David L. Pollack of Strassburger McKenna Gutnick & Gefsky at elaughlin@smgglaw.com; dpollack@smgglaw.com or (412) 281-5423.

NOTHING IN THIS DOCUMENT IS INTENDED OR SHALL BE CONSTRUED AS ADVICE TO PARTICIPATE IN, OR COUNSEL WITH RESPECT TO, CRIMINAL OR FRAUDULENT ACTIVITIES.  POSSESSION, DISTRIBUTION AND SALE OF MARIJUANA IS A SERIOUS CRIME UNDER FEDERAL LAW, AND NOTHING HEREIN SHALL BE CONSTRUED AS ADVICE TO VIOLATE THAT LAW.

Last week, I listened to a group of lawyers[1] discuss Pennsylvania’s new Medical Marijuana Act.[2]  There was a lot to discuss.  Whether you are concerned that the MMA is a gateway law to general reefer madness, or are proud that Pennsylvania is in the middle of the pack in addressing an unfounded prejudice that has been baked into the federal Controlled Substances Act (“CSA”), the MMA will impact many Pennsylvanians and their lawyers.

The MMA creates a new, highly regulated, market in the Commonwealth.  On the demand side, patients with certain conditions[3] who have been licensed by the Department of Health can obtain “recommendations” from medical professionals who have taken a class and been certified by the Department of Health that the patients would benefit from medical marijuana. Card-carrying patients will be able to purchase medical marijuana from licensed dispensaries. On the supply side, the Department of Health can license up to 25 growers/processors, who will produce medical marijuana in the forms allowed under the MMA (excluding, for now, smokeable leaves and flowers) and sell it to licensed distributors, of which 50 will be licensed for up to three locations each.  Distributors will sell only to card carrying patients.  For those counting, this is four permits or licenses already.  There is also a requirement that growers contract with quality control laboratories that are certified (presumably by the Department of Health), as well as provisions for permitted research by universities or “vertically integrated healthcare systems.”

All of the participants in the market are regulated.  Patients can only obtain a 30-day supply of medical marijuana at one time, and must renew their state license annually.  Physicians cannot advertise that they have been certified to “recommend” medical marijuana and face penalties for violating this and other provisions of the MMA.  Growers and distributors must account for medical marijuana “from seed to sale”.  The Commonwealth takes 5% of growers’ revenues (on top of other applicable taxes).

On the face of it, it is a mug’s game.  The limited market created by the MMA might seem too small to attract more than a few investors, given the expensive application fees, capital requirements and technology and security infrastructure requirements required for growers and dispensaries under the MMA.  The MMA is drawing attention, one speculates, because of the expectation that eventually, and sooner rather than later, marijuana will no longer be a Schedule I drug under the CSA.  In fact, the MMA anticipates some of the effects should that occur.

You would think that this all would be a bonanza for lawyers.  The MMA implicates (at least)  land use law, state and federal securities law, corporate and tax law, employment law, and administrative law and procedure.  Investors seeking to participate in the industry, physicians trying to understand their risks, parents seeking help for an untreatable child, all of these will demand and deserve counsel.

But wait.  There are two important issues to consider first.  The first problem is the aforementioned CSA.  As a Schedule I drug, marijuana (medical or not) is not prescribable (hence, “recommendations”), and possession, distribution and sale of the stuff are federal crimes, as is aiding and abetting those activities.  Under the current Administration, Federal enforcement authorities are leaving alone regulated marijuana market participants who color inside the lines.  On January 20, 2017, we get a new Chief Executive and enforcement priorities may change.

But that is not all.  Pennsylvania lawyers may have restrictions on what they can talk with clients about.  Rule 1.2(d) of our Rules of Professional Conduct provide that “a lawyer shall not counsel a client to engage, or assist a client, in conduct that the lawyer knows is criminal or fraudulent,” although the lawyer may discuss the legal consequences of any proposed course of conduct with a client, and may assist a client in making a good-faith determination of the validity, scope, meaning or application of the law. This might give pause to an attorney asked to assist a grower at a zoning hearing or structure an investment in the industry.

The Disciplinary Board of the Supreme Court has proposed an amendment to the Rules of Professional Conduct that would permit a Pennsylvania lawyer to counsel a client about conduct that is legal where it occurs, as long as the lawyer advises as to the effect of other laws.  In proposing this amendment, the Disciplinary Board stated that “once a jurisdiction makes the policy decision to authorize some form of marijuana-related activity, those who choose to engage in such activity are better served if the legal profession is able to advise clients engaged in such activities without fear of professional discipline”.[4]  Adoption of this amendment would allow Pennsylvania clients to be advised on the details of compliance by the MMA in the context of real businesses and real locations, by counsel who appreciate the “fear of professional discipline” and carefully evaluate their own and their clients’ risks.  Risks there are aplenty, at least until marijuana is re-Scheduled or de-Scheduled under the CSA.  That is why I’ll be working on a good disclaimer like the one that tops this essay, suitable for inclusion in engagement letters, prospectuses and opinions, once I’m allowed to show one to a client.

SMGG intends to stay at the forefront of legal developments in this area.  For questions, please contact David L. Pollack or Erica L. Laughlin of Strassburger McKenna Gutnick & Gefsky at dpollack@smgglaw.com; elaughlin@smgglaw.com or (412) 281-5423.

 

[1] Participants in the PBI presentation A New Reality:  Pennsylvania’s Medical Marijuana Act.  PBI Online Case #9512, presented June 8, 2016.  The panel provided a cogent overview of a complicated and uncertain topic and raised important ethical issues alluded to below.  This essay reports one business lawyer’s impressions.

[2] Codified at 35 P.S. §§ 10231.106 et seq.

[3] Cancer, HIV/AIDS, ALS, Parkinson’s disease, Multiple sclerosis, Damage to the nervous tissue of the spinal cord with objective neurological indication of intractable spasticity, Epilepsy, Inflammatory bowel disease, Neuropathies, Huntington’s disease, Crohn’s disease, PTSD, Intractable seizures, Glaucoma, Sickle cell anemia, Severe chronic or intractable pain of neuropathic origin or severe chronic or intractable pain in which conventional therapeutic intervention and opiate therapy is contraindicated or ineffective, and Autism.

[4] Proposed Amendments to the Rules of Professional Conduct Relating to Scope of Representation and Allocation of Authority between Client and Lawyer, 46 Pa.B. 2274, May 7, 2016