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By Steven Schain
Although the final decision rests with the DEA, if cannabis is reclassified to Schedule III, marijuana growers, processors, transporters or sellers (marijuana-related businesses or MRBs) will cease being encumbered by onerous operating and taxing obstacles to become significantly more profitable, federally funded cannabis research will finally occur, and investment in marijuana-related businesses should soar.
Causing a day-long, double-digit cannabis stock surge peaking at 40.56%, on Aug. 30, the U.S. Department of Health and Human Services (HHS) recommended that the U.S. Drug Enforcement Administration (DEA) reschedule marijuana from Schedule I to Schedule III of the Comprehensive Drug Abuse Prevention and Control Act of 1970, 21 U.S.C. Sections 801, Et. Seq (1970) (Controlled Substance Act).
Although the final decision rests with the DEA, if cannabis is reclassified to Schedule III, marijuana growers, processors, transporters or sellers (marijuana-related businesses or MRBs) will cease being encumbered by onerous operating and taxing obstacles to become significantly more profitable, federally funded cannabis research will finally occur, and investment in marijuana-related businesses should soar.
Impact of Cannabis Murky Legality and Scheduling
While legal in 38 states and projected to generate $33.5 billion in 2023 legal sales, the Controlled Substance Act currently lists marijuana next to heroin as a Schedule I controlled substance having “a high potential for abuse” and for which there’s “no currently accepted medical use in treatment” and “a lack of accepted safety for use” “under medical supervision.” See 21 U.S.C. Section 812(b)(1).
Tetrahydrocannabinol is marijuana’s psychotropic-effect producing component and, whether deemed “medical” (purchasable only with state-issued card to treat resident’s statutorily defined “covered medical condition”) or adult-use (purchasable by anyone over 21 from any state with a valid identification), cannabis takes four forms: flower that is smoked; oils ingested by vaporizing; concentrates only consumable after being heated to a high temperature; and infused products ranging from eye drops to edibles. With few exceptions, medical and adult-use cannabis items are identical and only delineated by their purchasers: medical card patients; or adult use consumers.
The Controlled Substance Act prohibits marijuana’s cultivation, distribution, dispensation and possession and, pursuant to the U.S. Constitution’s supremacy clause, state laws conflicting with federal law are generally preempted and void. U.S. Const., Art. VI, cl. 2; Wickard v. Filburn, 317 U.S. 111, 124 (1942)(”No form of state activity can constitutionally thwart the regulatory power granted by the commerce clause to Congress”).
Pursuant to The Controlled Substance Act, the DEA “schedules” drugs from most perilous— Schedule I—to least harmful—Schedule V—based on three factors: potential for abuse: how likely is this drug to be abused; accepted medical use: is this drug used as a treatment in the United States; and safety and potential for addiction: Is this drug safe, how likely is it to cause addiction and, if so, what kinds of addiction?
Beyond making cannabis 100% federally illegal and preventing it from being sold outside of each respective legalized-marijuana state (i.e., no “interstate cannabis commerce”), Schedule I classification both precludes any federally funded cannabis research and imposes heinous tax consequences on marijuana-related businesses.
Under Section 280E of the Internal Revenue Code, state-legal MRBs are forbidden from taking any tax deduction or credit other than “cost of goods sold.” See 26 U.S. Code Section 280E (1982). Specifically, Section 280E provides:
“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.”
Thus, unlike every other legitimate industry, MRBs are denied ordinary and necessary business expense tax deductions (e.g., wages, rent, utilities, and insurance) causing them to be vastly more expensive, and dramatically less profitable, to operate.
By way of background, domestic “contraband taxation” commenced with 1760’s Navigation Acts banning Dutch tea, requiring colonists to purchase British tea through the East India Co. (thereby conferring a trade monopoly) and taxing Dutch tea merchants and possessors at an exorbitant rate. Similarly, in 1919, Congress ratified the Eighteenth Amendment outlawing alcoholic beverages transportation and sale and enacted the Volstead Act assessing a $1,000 fine/tax per every unlawful alcohol trafficking transaction. Further, in 1937 Congress adopted the Marihuana Tax Act requiring those producing, possessing, or selling cannabis to obtain a tax stamp demonstrating the payment of a cannabis tax.
Up until California and Arizona’s medical use legalization in 1996, Section 280E had not been applied to state-legal cannabis causing a coalition of federal agencies to issue a federal directive that:
“To the extent that state laws result in efforts to conduct sales of controlled substances prohibited by federal law, the IRS will disallow expenditures in connection with such sales to the fullest extent permissible under existing federal tax law.”
Pursuant to this directive, the Internal Revenue Service (IRS) has strictly applied Section 280E against state-legal MRBs and the courts have supported the IRS’ “state-legal cannabis constitute federally unlawful drug trafficking” argument. See Patients Mutual Assistance Collective Corp. v. Commissioner, (9th Cir. No. 19-73078 2021); Standing Akimbo v. United States, 955 F.3d 1146 (10th Cir. 2020); and Feinberg v. Commissioner of the Internal Revenue Service, 916 F.3d 1330 (10th Cir. 2019).
To understand Section 280E’s impact on disallowing MRBs’ ordinary and necessary business expense deductions, below are contrasting tax calculations of a muffin shop and cannabis dispensary experiencing identical revenue:
ALM’s Muffins ALM’s Dispensary
Gross Revenue: $1,000,000 Gross Revenue: $1,000,000
Costs of Goods Sold: ($550,000) Costs of Goods Sold: ($550,000)
Business Expenses: ($350,000) Business Expenses: ($0.00 allowed)
Taxable Income: $100,000 Taxable Income: $450,000
Federal Tax: $39,000 Federal Tax: $175,500
Although the muffin shop would realize $61,000 of net income, after the $350,000 of “nondeductible” wages, rent, utilities and insurance costs is factored in, the dispensary would incur a $75,500 net loss.
Thus, through denying MRBs’ ordinary and necessary business expense tax deductions, Section 280E places MRBs at a ridiculous competitive disadvantage and virtually precluding them from achieving profitability.
Seismic Impact of Reclassifying Cannabis on Research, Operations and Investment
If the DEA reclassifies Marijuana from Schedule I to Schedule III, federally funded cannabis research will finally occur, MRBs will cease being encumbered by Section 280E, and investment in MRBs will skyrocket.
First, reclassifying to Schedule III indicates that the federal government deems cannabis to have “moderate to low potential for physical and psychological dependence” (and not Schedule I’s “no current medical use with high potential for abuse or addiction” stigma) opening the floodgates for federally-funded research. Use-in-treatment data from 38 state’s medical markets and a staggering body of international scientific literature already supports cannabis’ medical efficacy and treatment for conditions ranging from cancer and post-traumatic stress disorder to opioid use mitigation. Federally approved and funded research will both enhance public acceptance of cannabis medical application and deploy the Feds nearly infinite resources like those of the U.S. Food and Drug Administration (FDA).
Budgeted at $6.1 billion, the FDA protects and promotes public health through supervising food safety, tobacco products, dietary supplements, prescription and over-the-counter pharmaceutical drugs, cosmetics, animal foods and feed, and veterinary products. Federal Food, Drug, and Cosmetic Act, 21 U.S.C. 301, et seq.. Reclassifying to Schedule III will empower the FDA to regulate those growing, processing, selling or transporting cannabis and promulgate uniform standards and prohibitions.
Second, reclassifying to Schedule III will remove Section 280E’s prohibitions and allow marijuana-related businesses to take ordinary and necessary business expenses tax deductions resulting in cost reduction, ease of operations and an increase of profit.
Third, as a result of federally-funded research, wider public acceptance, and higher profitability, reclassifying to Schedule III will enhance cannabis investment. While not likely to mirror the “Aug. 30, 2023 cannabis stock surge,” reclassification will enhance the valuation of an industry beset by a lack of investment capital, a mishmash of 38 conflicting regulatory bodies, and an inability to meet exceedingly optimistic performance goals.
Path to Cannabis Schedule III Classification
While reclassification to Schedule III will not remove cannabis’ federal illegality, it is a significant step toward ending prohibition and bolstering a nascent industry.
The final determination rests with the DEA, which, based on an eight-factor analysis, will weigh whether the HHS scheduling recommendation, scientific and medical evaluation, and all other relevant data constitute substantial evidence that marijuana should be reclassified to Schedule III.
If determining that rescheduling is appropriate, the DEA will issue a proposed rule followed by a notice and comment period.
Although whether MRBs will receive a future “tax credit” for past Section 280E disallowed business expenses tops the list of rescheduling’s unanswered questions, the future remains uncertain pending the DEA determination and rule promulgation.
Reprinted with permission from the October 27, 2023 edition of the Legal Intelligencer © 2023 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or [email protected].
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