Hidden Liabilities in Cannabis Investments: What CEOs and Investors Need to Know in 2025

The MedMen disaster still baffles financial experts. Despite having no proven track record, the company's founders convinced sophisticated investors to pour hundreds of millions into what would become one of the Cannabis industry's most spectacular implosions. Sexual harassment claims, allegations of fraud, questionable accounting practices, and ultimately a $411 million bankruptcy filing—the warning signs were flashing in neon, yet the checks kept flowing.

The allure is understandable. Cannabis revenues have climbed steadily for 15 consecutive years, approaching $40 billion annually without counting hemp and CBD products. With federal rescheduling potentially imminent, the market appears poised to rocket toward the $100 billion threshold faster than anyone anticipated.

In this post, we examine the critical factors that Cannabis CEOs and investors must understand to avoid becoming the next cautionary tale in this rapidly evolving industry.

Strategic Vertical Selection for Cannabis Investments

Not all Cannabis industry segments present equal long-term potential. Understanding the strategic positioning of different verticals is crucial for making informed investment decisions.

Cannabis Product Manufacturing: The Most Promising Long-Term Play

Among Cannabis verticals, product manufacturing—particularly foods and beverages—represents the most attractive long-term investment opportunity. Similar to the alcohol industry, Cannabis-infused product manufacturing offers sustainable profit potential even as the market matures.

The product manufacturing vertical offers several advantages:

• High gross profit margins (especially in beverages)
• Sustainable demand even in mature markets
• Opportunity for brand differentiation
• Long-term viability (50+ years)

Cultivation and Retail: Strong Medium-Term Opportunities

While cultivation and retail operations present attractive investment opportunities in the 5-8 year timeframe, their long-term positioning may become more challenging as the industry matures.

Retail/Dispensaries: In the long term, Cannabis dispensaries will likely follow the liquor store model—geographically distributed by population, largely undifferentiated, and eventually product sales will migrate to mainstream retail channels.

Cultivation: As the Cannabis industry expands, cultivation will likely see significant consolidation with large corporations entering the space and increasing price pressure on smaller cultivators.

Critical Tax Considerations for Cannabis Investments

The tax implications of Cannabis investments remain one of the most significant factors affecting profitability and valuation.

Section 280E Impact

The Cannabis industry continues to operate under IRC Section 280E, which prohibits businesses trafficking in Schedule I substances from deducting ordinary business expenses.

Key misconceptions about 280E:

1. Entity structuring doesn't circumvent 280E The Harborside case made it clear—complex entity structures don't shield Cannabis operations from 280E restrictions.
2. 280E applies to "trade or business," not just formal entities The law specifically targets any Cannabis business activity, regardless of formal business structure.

Maximizing Tax Efficiency Through Cost Accounting

Despite 280E limitations, Cannabis businesses—particularly cultivators and manufacturers—can reduce their tax burden through proper implementation of IRC Section 471.11 cost accounting methods.

This approach allows Cannabis businesses to properly allocate costs to inventory, which becomes cost of goods sold (COGS) when products are sold. Unlike business deductions, COGS is considered a return of capital and remains deductible even under 280E.

Premature Tax Refund Claims: A Dangerous Strategy

Some Cannabis companies have filed tax refund claims anticipating rescheduling to Schedule III—a high-risk strategy that the IRS has explicitly warned against, noting these claims "do not constitute reasonable basis."

Entity Structure Considerations for Cannabis Businesses

C-Corporation vs. Flow-Through Entity Analysis

While Cannabis businesses have traditionally debated between flow-through entities and C-Corporations, current tax policy shifts favor C-Corporation structures, especially with potential reductions in corporate tax rates.

Advantages of C-Corporation structure for Cannabis businesses:

• Reduced corporate tax rate (potentially 15%)
• No "double taxation" issue if profits are reinvested rather than distributed
• Possible Section 1202 benefits at exit
• Audit protection for investors

Investor Protection Issues in Flow-Through Entities

For Cannabis investors, flow-through entities create significant risks:

K-1 tax liabilities without distributions: Investors in flow-through Cannabis businesses often receive K-1s showing taxable income without corresponding cash distributions, creating "phantom income" tax obligations.

Audit risk exposure: When the IRS audits a flow-through Cannabis entity, the examination can extend to individual investors, potentially triggering broader audits of their personal finances.

Risk Mitigation Strategies for Cannabis Investors

To protect Cannabis investments from both operational and regulatory risks, implement comprehensive due diligence:

1. Evaluate management team track record and integrity
   Before investing, thoroughly investigate the background of key executives. The Cannabis industry has attracted both experienced business leaders and opportunists with questionable histories. Verify previous business experience, regulatory compliance records, and reputation within the industry. Look for evidence of successful exits or sustainable business growth rather than just Cannabis-specific experience.
2. Verify financial controls and reporting systems
   Inadequate financial systems are a red flag in Cannabis operations. Ensure the business has implemented robust accounting software, established clear financial policies, and created separation of duties for cash handling. Review recent financial statements for accuracy, consistency, and transparency. Cannabis businesses handling large cash volumes are particularly vulnerable to theft and mismanagement without proper controls.
3. Ensure proper GAAP-level cost accounting implementation
   Given the tax implications of 280E, proper cost accounting isn't just good practice—it's essential for financial viability. Verify that the Cannabis operation has implemented formal GAAP-compliant cost accounting methods, particularly for cultivation and manufacturing. This should include detailed tracking of direct materials, direct labor, and proper allocation of indirect costs to inventory. Request documentation of their cost accounting methodology and evidence it's being consistently applied.
4. Confirm appropriate entity structure for tax efficiency
   The entity structure directly impacts investor returns and risk exposure. Review the operating agreements, tax status elections, and corporate governance documents. For flow-through entities, ensure tax distribution provisions are clearly defined. For C-Corporations, verify they're positioned to take advantage of potential tax benefits like Section 1202 qualified small business stock exemptions. Consider how the structure impacts potential exits and consolidation opportunities.
5. Verify regulatory compliance across all operations
   Cannabis operations must navigate complex and often contradictory regulatory frameworks. Confirm all licenses are current and in good standing. Review compliance with seed-to-sale tracking requirements, advertising restrictions, packaging regulations, and testing protocols. Examine any regulatory violations or settlements, as these can indicate systemic compliance issues that could threaten the business's viability and create unexpected liabilities for investors.

Conclusion: Positioning for the Coming Cannabis Boom

As the Cannabis industry approaches potential federal rescheduling, investors have an unprecedented opportunity for significant returns. However, success requires navigating the industry's unique challenges and hidden liabilities.

The most successful Cannabis investments will combine strategic vertical selection, appropriate entity structuring, tax optimization, and robust operational oversight. By addressing these factors proactively, investors can minimize risk while maximizing potential returns in this dynamic market.