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.
Crowe observation
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.
Background
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.
What cannabis businesses can do now
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:
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Until the effective date of marijuana’s reclassification as a Schedule III substance, cannabis businesses remain subject to IRC Section 280E and need to meet their federal tax obligations taking that provision into account.
- Cannabis businesses that owe taxes, interest, and penalties as a result of IRC Section 280E need to think about how to resolve these outstanding tax debts.
- Cannabis businesses often did not take many federal tax positions that would have been advantageous to a similarly situated noncannabis business because the benefit of such positions was eliminated by IRC Section 280E. Cannabis companies should be prepared to review their entire tax posture and historical tax return positions, including accounting methods, to evaluate whether changes should be made and if accounting method changes will need to be filed with the IRS to effectuate these changes.
- As a result of IRC Section 280E, many cannabis businesses have complex legal entity structures. Eliminating the effect of IRC Section 280E would allow these businesses to rationalize and simplify these structures.
- Companies should plan for increased tax compliance costs as they transition from being subject to IRC Section 280E to being able to claim deductions and credits for business expenses, as well as for the potential for long-term cash tax savings if IRC Section 280E no longer applies.
- Cannabis businesses would have to evaluate the financial statement impact of no longer being subject to IRC Section 280E. The effect on a business’s income tax provision could be significant, as deferred tax assets and liabilities would have to be considered once they no longer are subject to Section 280E. In addition, any accounting method changes would need to be accounted for and treated properly for financial statement purposes.
Looking ahead
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.
