By Daniel Shortt
As “Tax Day” looms near, most of us are getting somewhat familiar with U.S. tax law. Regarding cannabis businesses, a provision in the tax code may be important in light of a recent letter regarding federal cannabis policy.
Last week, the cannabis industry went into a flurry after the Huffington Post obtained a letter from the Drug Enforcement Agency (DEA) to lawmakers stating that the agency would consider rescheduling cannabis this year. The letter does not indicate that the DEA will reschedule, it simply states that the DEA will consider rescheduling. If cannabis was rescheduled, the impact would be significant as it could open research pathways to study its medicinal effects. While reasonable minds may debate the likelihood of rescheduling, if it were to happen it would impact businesses that currently distribute cannabis in compliance with state law.
Cannabis is listed as a Schedule I substance under the Controlled Substances Act (CSA). The Schedules are used to classify drugs and other substances. See 21 U.S.C. § 812(b). Schedule I classification means a substance has “no medical use and a high potential for abuse” and that there is no accepted way to study the drug or substance, even with medical supervision. Schedule II substances have a high potential for abuse but have accepted medical uses. Schedule III, IV, and V substances are used to classify drugs or substances that have a risk for psychological dependency but a low risk for physical dependency. See Schedule table here.
Rescheduling cannabis would not remove the criminal penalties associated with its distribution. Even if cannabis were rescheduled to Schedule V, the least restrictive standard, its distribution would still be a crime under the CSA. See 21 U.S.C. § 841(a). But if cannabis is removed from Schedule I there will be major tax implications.
Section 280E of the Internal Revenue Code has been a huge hurdle for cannabis businesses to overcome. The provision reads as follows:
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.
This section was added to the tax code by Congress in the 1980s to prevent drug dealers from deducting expenses relating to the sale of illicit drugs. The government did not feel comfortable knowing a criminal drug dealer could deduct the costs of transporting an illegal substance into and around the country.
Over three decades later, this provision means that cannabis businesses are unable to take regular deductions. The impact of this provision is described in the following excerpt from Canna Law Blog:
Since cannabis is a Schedule I controlled substance, the IRS has used section 280E to disallow marijuana businesses from deducting their ordinary and necessary business expenses. The result is that marijuana companies face much higher federal tax rates than similar companies in other industries. There are differing opinions on the level of tax rates imposed on marijuana companies – from 40% to 70% to as high as 90% – all of which are higher than the 35% corporate tax rate paid by most other businesses in the United States.
It is clear that 280E is a significant financial thorn in the side of the marijuana industry. But rescheduling could change that.
If the DEA reschedules cannabis from Schedule I to Schedule II, there would be no change to the current tax situation. However, if the DEA reschedules to Schedule III, IV, or V, then 280E would not apply because that section is restricted to businesses that traffic controlled substances listed in Schedule I and Schedule II. That would mean that cannabis businesses could take ordinary business deductions. Not only would this reduce the tax liability of a cannabis business but it would also save time and money allocated to ensuring that no improper deductions are taken in light of 280E.
At this point attempting to predict how the DEA will act would be nothing but pure conjecture. The DEA may elect not to reschedule, or to reschedule to Schedule II. Any action by the DEA would impact the cannabis industry, but only rescheduling to Schedule III or lower would impact 280E. While we try to refrain from speculation on this blog, we encourage our readers to give us their “two-cents” in the comments. Regardless, this story is worth keeping track of and expect more blog posts on the rescheduling saga in the future.