Top 10 Federal Tax Implications of Rescheduling Cannabis as a Schedule III Drug

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In a letter dated August 29, the Department of Health & Human Services made an official recommendation to the Drug Enforcement Administration (DEA) to move cannabis from its status as a Schedule I controlled substance to a Schedule III controlled substance. According to the DEA, Schedule III drugs are 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.”

While many hurdles remain for cannabusinesses, rescheduling the drug would be a significant step towards legalization and has the potential to impact FDA oversight and regulation, medical research opportunities, project funding, banking restrictions and the criminal system surrounding cannabis enforcement, among others. One of the most impactful aspects of rescheduling cannabis for cannabusinesses are the federal tax implications – specifically as they relate to Internal Revenue Code Section 280E which 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.

Currently, under Sec. 280E, cannabusinesses experience prohibitively high tax rates and bills. This causes many operators to forego making tax payments as part of their cash management strategy and opt to pay the government’s interest and penalties later so they can put their cash to use in the business instead. In addition, Sec. 280E has led to a number of court cases in which owners have sought to demonstrate they have separate businesses and split plant-touching activities that are subject to Sec. 280E and non-plant-touching activities.

As a Schedule III drug, Sec. 280E would no longer apply. This would put cannabusinesses on a more level playing field with traditional businesses. In addition, a whole new world of federal tax deductions and credits would become available. An overview of these tax implications are as follows:

  1. Deductions for all ordinary and necessary business expenses. This includes overhead costs such as marketing, back-office payroll, selling expenses and interest. 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.
  2. Accelerated depreciation, bonus depreciation and full expensing of qualified purchases under Internal Revenue Code Section 179.
  3. More flexibility of accounting methods, including cash basis reporting and inventory methods.
  4. Research Credit access for investment in technological or agricultural advances. This notably provides an election to claim the credit against payroll taxes for start-up companies.
  5. Clarity around whether investors in cannabis pass-through entities can claim the 20% Qualified Business Income deduction under Sec. 199A.
  6. Federal credits for hiring individuals from specified groups, including ex-felons, unemployed veterans and recipients of federal assistance programs.
  7. Access to federal clean energy related deductions and credits for investment in energy efficient buildings and green energy solutions.
  8. Farm-specific benefits for cultivators, including a credit for taxes paid on fuel used on the farm.
  9. Simplified structuring of plant-touching and other activities for tax reasons.
  10. Inclusion of federal level deductions when calculating state taxable income for states that have not already decoupled from Sec. 280E for cannabis.

Of course, cannabusiness operators will still have to contend with income taxes and will remain subject to state and locally imposed excise and sales taxes. However, the end of Section 280E’s hold on the cannabis industry would provide welcome fiscal relief for operators across the country. It would also open numerous tax planning opportunities while simplifying the complexity of tax reporting in the cannabis space.

 

Kristin is a Partner in the firm’s Tax practice. She has over a decade of experience providing tax compliance, consulting and advisory services to multi-state corporations and flow-through clients in the manufacturing, technology and real estate industries. Additional areas of interest include inbound international organizations, tax credits, accounting for income taxes and transaction planning. Kristin is also a member of Bonadio’s cannabis and industrial hemp team.

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