Because marijuana is currently classified as a Schedule I substance under the Controlled Substances Act (CSA), IRC Section 280E prohibits cannabis businesses from claiming deductions and credits for trade or business expenses that other legal businesses can claim. HHS recently sent a letter to the Drug Enforcement Administration (DEA), a component of the Department of Justice, recommending that marijuana be reclassified as a Schedule III substance under the CSA. If the DEA adopts this recommendation, cannabis businesses no longer would be subject to the prohibitions under IRC Section 280E, which would significantly lower the income tax burden for cannabis businesses and lead to greater profitability and equity with other legal businesses.
While the HHS’ recommendation is a positive development for the cannabis industry, even if the DEA agrees to reclassify marijuana as a Schedule III substance, it could take time for the decision to take effect.
IRC Section 280E provides that “[n]o 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 [S]chedule 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.”
Even though marijuana is legal in many states, it currently is classified as a Schedule I substance, which prevents cannabis businesses from being able to deduct all expenses including rent, payroll, interest, depreciation, and advertising, among many others. This creates an effective tax rate that often is higher than an average company’s, and operating under the higher tax rate is unsustainable in the long term. If the DEA adopts HHS’ recommendation, IRC Section 280E no longer will apply to cannabis businesses in states where marijuana is legal.
If the DEA decides to reschedule marijuana, it is unclear when the decision would be effective, but cannabis businesses should consider the following in the meantime:
Although many businesses are excited about the HHS’ recommendation, a lot of uncertainties remain, including whether and when the recommendation will be adopted by the DEA and how such a change would affect the operations and tax decisions of cannabis companies. Cannabis businesses should consult their tax advisers to keep abreast of future developments and to understand how these transformative changes could affect their tax position.
Crowe disclaimer: Qualified organizations only. Independence and regulatory restrictions may apply. Some firm services may not be available to all clients. Given the continued evolution and inconsistency of various state and federal cannabis-related laws, any company should seek competent legal advice relating to its involvement in the cannabis industry, including when considering a potential public offering as a cannabis-related company.
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