Reclassification of Marijuana Would Have Significant Tax Impact for Companies

The U.S. Drug Enforcement Agency (“DEA”) announced a notice of proposed rulemaking on May 16, 2024, which will reclassify marijuana (or cannabis) from a Schedule I substance to a Schedule III substance once finalized. This move will have an oversized impact on the cannabis industry, as these businesses are currently disallowed by the Internal Revenue Code (“IRC”) from taking most business deductions.

The Controlled Substances Act

Since the enactment of the 1970 Controlled Substances Act (“CSA”), cannabis has been classified as a Schedule I substance, meaning it is deemed to have no medical use and a high potential for abuse. The DEA is proposing to reclassify marijuana as a Schedule III substance, following recommendations by the Department of Health and Human Services and the Department of Justice. Schedule III substances are considered to have less potential for both abuse and physiological or psychological dependence than Schedule I and II substances, and have accepted medical use in the United States.

IRC Sec. 280E

Under IRC Sec. 280E, businesses are disallowed from taking any tax credit or deductions from gross income for any trade or business that “consists of trafficking in controlled substances,” defined as those classified as Schedule I or II under the CSA. Gross income is defined as revenues less inventory costs, commonly known as costs of goods sold (“COGS”). Therefore, cannabis companies are currently limited to deducting COGS to reduce their federal income tax liability.

Many states that have legalized cannabis, whether for medicinal, recreational, or any use,  have passed laws decoupling from IRC Sec. 280E. This decoupling allows cannabis companies in these states to deduct their ordinary business expenses for purposes of their state income tax.

Reclassifying cannabis to Schedule III will move it out of the purview of IRC Sec. 280E. In fact, the notice of proposed rulemaking explicitly addresses IRC Sec. 280E, and states that if cannabis is reclassified to Schedule III, “280E will no longer serve as a statutory bar to claiming deductions” for these businesses.

Outstanding Concerns

While the reclassification of cannabis will ease the tax burden for these companies, there are still several outstanding questions. For instance, it is unclear from the proposed rule if the reclassification will be retroactive or prospective. If retroactive, cannabis companies may be in a position to file for tax refund claims through amended returns or other appropriate action with the IRS. It is also unclear what steps, if any, states that have legalized cannabis and decoupled from 280E may wish to take in response. Conversely, states that have not legalized cannabis will need to pass their own restrictions to disallow deductions and credits.

Next Steps in Reclassification

The proposed rule must next go through a public comment period. The public will have 60 days from the date the notice is published in the Federal Register to submit comments, and 30 days to request a public hearing. The classification change is not final until the final order is published in the Federal Register.

It is important to note that the reclassification would not decriminalize cannabis, and it will still be heavily regulated as Schedule III substances are still controlled substances. Additionally, companies will still be required to register with the DEA if they are “plant-touching” businesses. It is also important to remember that rule changes can be halted or changed in the future.

If finalized, this change will be one of the biggest reclassifications since the CSA was enacted over 50 years ago. Taxpayers who think they may be impacted by this change should consult with a trusted tax advisor.