Cannabis Reclassification Would Trim Tax Burden, But Not Quickly

SIMON MENKES CPA AND RACHEL WRIGHT CPA

Reprinted with permission of Bloomberg Tax

• Menkes and Wright review DEA recommendation to reschedule marijuana

• Move would help trim cannabis taxation but will take time

The Drug Enforcement Agency has recommended that cannabis be transferred from its status as a Schedule I controlled substance to Schedule III under the Controlled Substances Act. This means cannabis has been found to have accepted medical use and low potential for abuse.

When this process is complete, the cannabis industry’s federal tax burden under Internal Revenue Code Section 280E will significantly decrease. There are also important implications for banking and interstate commerce with this decision.

Because the DEA is conducting its rescheduling process by the book, the expected benefits from this move may not happen any time soon. Advisers to the cannabis industry must counsel their clients to continue handling their federal tax obligations as if 280E will continue for the foreseeable future.

Tax Implications

Once cannabis is transferred to Schedule III, 280E will no longer apply, and cannabis businesses will be able to take the same federal tax deductions as any other business.

Also, any states that still follow the IRS in the calculation of their cannabis companies’ state income taxes, such as Alaska, Arizona, and Nevada, will also follow this change and allow full deductions. There will be significant tax savings on a federal level, as many retail cannabis businesses have experienced an effective tax rate in excess of 70%, while mainstream businesses pay closer to 21% tax on corporate income.

Timing of Rescheduling

Based on the political process and the legal hurdles involved, it appears that rescheduling won’t happen for at least a year. The DEA has chosen to follow standard procedure as described in the Controlled Substances Act, which involves publishing the proposed rescheduling in the Federal Register, followed by a review and approval by the Office of Management and Budget.

Section 811 then requires a hearing on arguments for and against the rescheduling. The hearing process has been estimated to take up to three months. Finally, an administrative law judge will hold hearings, and then the DEA will issue its final rule—which will go into effect some months later.

The transfer of hydrocodone combination products from Schedule III to Schedule II in 2014 can provide an approximate timeline. That process took almost eight months and didn’t include a hearing. It is quite likely rescheduling cannabis could take a year or more with the hearing, especially because it is a contentious topic.

From a tax perspective, this means that 2024 tax returns for cannabis businesses likely will have to be filed under 280E’s restrictions. When cannabis is finally moved to Schedule III, the IRS will likely remove 280E on a “go-forward basis,” not accepting the amendment of prior returns.

Banking and Commerce

The Federal Reserve and federal banks follow two primary pieces of guidance in their treatment of cannabis—the CSA and the Cole Memorandum. In its 2014 guidance to banks, the Treasury Department made it illegal to “manufacture, distribute, or dispense marijuana.” It also noted that Deputy Attorney General James Cole’s memorandum guidance to federal prosecutors concerning cannabis enforcement “reiterates Congress’s determination that marijuana is a dangerous drug,” referring to Congress’s creation of the CSA in 1970 with cannabis on Schedule I.

The CSA’s Schedule III classification of cannabis will make it no longer illegal to manufacture, distribute, or dispense marijuana, so both of federal banking’s primary reasons for denying banking services to cannabis businesses will disappear.

Regulation of interstate commerce is the purview of Congress. With its change in status, cannabis should eventually be free to travel across state borders in which it is legal, though such cannabis would need to be approved by the Food and Drug Administration and in compliance with the CSA (unless Congress makes a special exception).

Federal Rules

Unless a special carve-out is crafted by Congress (as has been done for alcohol and tobacco), when cannabis is moved to Schedule III, adult-use dispensaries and the manufacturers that serve them will still be out of compliance with the CSA. They may still be denied banking services and access to interstate commerce.

If no special exception is created, the CSA will saddle medical dispensaries and the manufacturers that supply them with additional FDA obligations that are currently the responsibilities of the nation’s pharmacies and drug companies, including FDA licensing, approved testing, and specialized labeling and packaging. The paths for medical and adult-use cannabis may diverge, possibly forcing adult-use businesses to obtain medical licenses to take advantage of banking and interstate commerce.

The cannabis industry and its advisers must continue to support the SAFER Banking Act, which would provide the banking industry with the protections it needs to serve cannabis companies if passed . Indeed, on April 30, 2024, the American Bankers Association called for passage of the bi-partisan bill, stating, “It’s important for policymakers to know that any potential decision to reclassify cannabis has no bearing on the legal issues around banking it. Cannabis would still be largely illegal under federal law, and that is a line many banks in this country will not cross. The solution is the bipartisan SAFER Banking Act.”

The SAFER Banking Act passed the Senate Banking Committee on September 27, 2023 with hearings last held on December 6, 2023. Though there has been no further movement since then, it is quite possible that rescheduling will push it further along the path to implementation.

Looking Ahead

Rescheduling is never a rapid process, and with cannabis being a political football, the hearing process may take even longer than expected.

If there’s a president elected this year who is unfavorable toward cannabis, they could appoint an attorney general who finds a way to prevent the approval of the rescheduling process. Rescheduling isn’t a “done deal” until it’s done.