Tax Planning Opportunities in Light of Proposed Marijuana Reclassification

Article

July 25, 2024

On May 16, the Justice Department and Drug Enforcement Administration submitted a notice of proposed rulemaking, which begins the formal process to consider moving marijuana from a Schedule I to Schedule III drug under the Controlled Substances Act (CSA). Following the publication in the Federal Register on May 21, the proposed rule is now subject to public comment and hearing requests that government agencies must address before the rule is finalized. The comment period closes in July of 2024, but the actual rescheduling of marijuana may not be completed until the end of 2024 or early 2025.

The proposed rule would move marijuana from a Schedule I (a category of drugs and substances considered to have the highest risk of abuse) to a Schedule III controlled substance, a moderately restricted category. Marijuana would then be in the same category as anabolic steroids, ketamine and testosterone. Where marijuana is categorized with Schedule 1, it is with other drugs such as heroin, lysergic acid diethylamide (LSD), marijuana (cannabis), 3,4-methylenedioxymethamphetamine (ecstasy), methaqualone and peyote.

Moving marijuana to a Schedule III controlled substance does not fully legalize its production, distribution, sale, possession and use under federal law. It will continue to be subject to federal restrictions of the CSA and other federal laws.

Its rescheduling may bring new opportunities for cannabis businesses to conduct research and development, improve working relationships with the banking industry, and have a profound effect on cash flow by decreasing the income tax burden of companies operating in states where marijuana is legal.

Internal Revenue Code Section 280E

On June 28, the Internal Revenue Service (IRS) issued a reminder that until a final federal rule is published:

Section 280E disallows all deductions or credits for any amount paid or incurred in carrying on any trade or business that consists of illegally trafficking in a Schedule I or II controlled substance within the meaning of the CSA.

This applies to businesses that sell marijuana, even if they operate in states that have legalized the sale of marijuana. Section 280E does not, however, prohibit a participant in the marijuana industry from reducing its gross receipts by its properly calculated cost of goods sold to determine its gross income.

As marijuana is currently a Schedule I controlled substance, cannabis companies may not deduct ordinary and necessary business expenses on their federal tax returns other than the cost of goods sold.

Section 280E was put into place by Congress in 1982, shortly after a 1981 tax court ruled in favor of a convicted cocaine trafficker’s right to deduct ordinary business expenses under Section 162.¹ Following the tax court’s decision in Edmondson, Congress enacted Section 280E to prevent future drug traffickers from benefiting from the decision by deducting their ordinary business expenses. Consequently, Section 280E substantially increases the cost of doing business for taxpayers in the cannabis industry, as it disallows deductions for expenses that other traditional businesses can deduct — such as wages, rent, utilities and insurance, as well as available federal credits.

Federal Tax Planning Considerations

How the Rescheduling Effective Date Can Impact Companies Differently

The first consideration for taxpayers operating in the cannabis industry will be the effective date of the marijuana rescheduling to a Schedule I controlled substance, and therefore, the lifting of the Section 280E limitations. For tax purposes, the rescheduling effective date is important, because expenses related to a cannabis business paid or incurred after rescheduling will be deductible based on the taxpayer’s current method of accounting and no longer disallowed by Section 280E. Note: the rescheduling effective date may be the actual marijuana reclassification date, or the beginning of the tax year before reclassification, or the beginning of the next tax year following reclassification. Businesses in the marijuana industry will need to evaluate future IRS guidance related to the rescheduling effective date.

Depending on the taxpayer’s current overall method of accounting (i.e., cash or accrual), cannabis businesses may consider postponing paying or incurring expenses disallowed by Section 280E until the rescheduling effective date. From a practical perspective, cannabis businesses using the cash method may consider postponing paying marijuana-related expenses, while cannabis businesses using the accrual method may consider postponing incurring such expenses until the rescheduling effective date.

The following sections provide additional future federal tax planning considerations following the proposed marijuana reclassification and subsequent inapplicability of Section 280E.

Depreciation and Amortization: Questions To Consider

Pending future IRS guidance, taxpayers in the cannabis industry will need to consider any allowed or allowable depreciation evaluating the placed into service date for tangible or real property prior to the rescheduling effective date. For example:

Will businesses be allowed to recapture depreciation expenses that were not allowed under Section 280E, including bonus depreciation, for assets placed into service prior to rescheduling effective date?
Will companies with intangible assets acquired prior to the rescheduling effective date with unamortized basis under Section 197 be allowed to recapture the prior amortization, or will they simply take amortization deductions going forward for the period after the rescheduling effective date?
How will capitalized Section 174 research and experimentation costs be amortized?
Again, will there be a catch up for amortization deductions lost prior to the rescheduling effective date?
Will any of the recaptured depreciation methods require the filing of Form 3115, Application for Change in Accounting Method, to effectuate the accounting method change?
Alternatively, will the accounting method change take effect on a cut off basis and only those assets placed into service after the rescheduling effective date will be allowed to take depreciation or amortization for federal tax purposes?

R&D Tax Credit, Inventory Methods and Other Deductions

After the rescheduling effective date, cannabis businesses engaged in research and development (R&D) activities may be eligible to claim the R&D tax credit under Section 41. Again, cannabis companies will need further clarification to answer such questions as:

Will there be a requirement to account for the R&D expenditures incurred prior to the rescheduling effective date in the R&D tax credit base period calculation?
Alternatively, will there be additional guidance from the IRS on how to calculate the base period for the R&D credit?

Taxpayers may want to revisit their inventory methods used to determine cost of goods sold, as it’s currently unclear whether the IRS will allow taxpayers to change their inventory accounting method if there is a permissible and more favorable accounting method available.

Once tax deductions are no longer disallowed under Section 280E, cannabis companies should review their plans for compensation, benefits, retirement savings and all other costs to recruit, retain and reward employees.

Finally, businesses in the cannabis industry will need to evaluate their overall accounting methods for accrued expenses and liabilities, prepaid expenses, bad debts, and other accounts to ensure the business is using the most advantageous accounting method.

Final Thoughts

While taxpayers wait for the final ruling on marijuana rescheduling and future IRS guidance, the limitations of Section 280E to disallow deductions continues to apply. In anticipation of coming changes, taxpayers in the cannabis industry can review their accounting methods and overall federal tax planning to be ready for the rescheduling effective date. Planning now allows taxpayers the time to ensure they are ready to deduct expenses and claim tax credits on their federal income tax returns once Section 280E no longer applies.

Your Guide Forward

Please contact your Cherry Bekaert tax advisor with any questions and to discuss how the proposed marijuana rescheduling and future IRS guidance may affect your company’s federal taxes.