A Look at the Tax Implications of Rescheduling Cannabis

By Kristin Kowalski, on September 7th, 2023

The cannabis industry is abuzz with the announcement that the Department of Health and Human Services made an official recommendation to the Drug Enforcement Administration to move cannabis from its status as a Schedule I controlled substance to Schedule III. This would mean that Sec. 280E would no longer apply. The DEA defines Schedule III drugs as those that “have a moderate to low potential for physical and psychological dependence” as opposed to Schedule I drugs “that have no currently accepted medical use and a high potential for abuse.”

With this news has come a variety of opinions across the spectrum, ranging from those who believe rescheduling would be harmful to health and society, to many who feel that while a move to Schedule III is an important step along the path to full legalization, it does not go far enough. There are also detailed analyses of what a cannabis industry on Schedule III will look like, considering things like potential Food and Drug Administration oversight and regulation similar to the FDA’s current involvement in CBD and hemp, medical research opportunities and availability of funding for such projects, potential impacts to existing state adult use and medical programs, possible loosening of banking restrictions including Congressional movement of the SAFE Banking Act, changes to the criminal system surrounding cannabis enforcement, and the effects on social equity and legacy industry participants, among many other topics. The focus of this article, however, is the federal tax implications of rescheduling cannabis.

Internal Revenue Code Section 280E is so familiar to cannabis operators and their accountants, that many can recite it. It states:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule 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.

It is this section that causes cannabis businesses to experience prohibitively high effective tax rates along with tax bills so large that many big operators forego making tax payments as part of their cash management strategy – opting to pay the government’s interest and penalties later in favor of putting their cash to use in the business. This section has also led to a number of court cases where owners sought to demonstrate (with varying degrees of success) that they have separate trades or businesses, splitting plant-touching activities that are subject to Sec. 280E and non-plant-touching activities.

In short, moving cannabis to Schedule III means that Sec. 280E would no longer apply, putting cannabis businesses on a more level playing field with traditional business. A whole new world of federal tax deductions and credits will become available; to list a few of the changes:

  • Deductions for all ordinary and necessary business expenses, including overhead costs like marketing, back-office payroll, selling expenses, interest, etc. For retailers this includes rent, utilities, labor, and other operating costs that cultivators and processors have more flexibility to include in cost of goods sold under the Sec. 280E rules.
  • Accelerated depreciation, bonus depreciation, and full expensing under Sec. 179.
  • More flexibility of accounting methods, including cash basis reporting, and inventory methods.
  • Access to the Research Credit for investment in technological or agricultural advances, which notably provides an election to claim the credit against payroll taxes for start-up companies.
  • An end to uncertainty over whether investors in cannabis pass-through entities can claim the 20% Qualified Business Income deduction under Sec. 199A.
  • Ability to claim federal credits for hiring individuals from specified groups, including ex-felons, unemployed veterans, and recipients of federal assistance programs.
  • Access to federal clean energy related deductions and credits for investment in energy efficient buildings and green energy solutions.
  • For cultivators, farm specific benefits including a credit for taxes paid on fuel used on the farm.
  • The end of complex structuring of plant-touching and other activities for tax reasons.
  • States that have not already decoupled from Sec. 280E for cannabis would now include the federal level deductions when calculating state taxable income.

Of course, there will still be income taxes to contend with and skilled accountants and tax preparers will be needed. Cannabis will remain subject to state and locally imposed excise and sales taxes. There is also the far-future possibility of a federal level excise tax.

What also remains to be seen is the effective date – presumably, Sec. 280E will no longer apply as of the date rescheduling becomes official. It is doubtful that the IRS or Treasury Department has authority to change this, and only legislative action could provide retroactive implementation. The IRS does however have authority over how it directs its agents and enforcement initiatives. Cannabis is a high audit area, but with rescheduling, the IRS could be inclined to decrease those efforts in the coming years.

Certainly, the end of Section 280E’s hold on the cannabis industry would provide some fiscal relief, coming at a time when only 25% of operators across the country report profitability. It would also open numerous tax planning opportunities while simplifying the complexity of tax reporting in the cannabis space.

If you have any questions about the current requirements of Sec. 280E or the potential implications of this change, please reach out to me at kkowalski@bonadio.com.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.

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Jess LeDonne
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