For most of us, tax season is over and we don’t want to even think about it for another year. But for cannabis businesses, the specter of the Internal Revenue Code hovers year round. That’s because they aren’t allowed to deduct normal business expenses from their taxes like everyone else. However, they might see some major tax relief if weed is rescheduled.
It’s an exciting moment in weed history right now: The U.S. Drug Enforcement Agency (DEA) has recommended marijuana be moved from Schedule I to Schedule III. If that goes through, the drug will officially be designated as having some medical uses and being less dangerous than drugs such as heroin, PCP or crack cocaine.
One big and exciting side effect of rescheduling will be that cannabis companies can finally be free of Section 280E of the revenue code, which prohibits anyone from deducting normal business expenses from their taxes if their business traffics controlled substances in Schedule I or II. Since marijuana is in Schedule I, state-licensed weed operators like dispensaries and producers are barred from deducting normal business expenses.
According to the IRS website: “While IRS Code Section 280E is clear that all the deductions and credits aren’t allowed for an illegal business, there’s a caveat: Marijuana business owners can deduct their cost of goods sold, which is basically the cost of their inventory. What aren’t deductible are the normal overhead expenses, such as advertising expenses, wages and salaries and travel expenses, to name a few.”
To add insult to injury, business expenses are taken out of income before it’s taxed, meaning legitimate businesses in other sectors are able to take advantage of a tax cut that isn’t available to weed companies.
Cannabis Law Attorney Carlos Martinez, Managing Partner and co-owner of Legal Solutions of New Mexico tells The Rolling Paper. that 280E was created to deal with an unusual tax case involving a dealer who got busted in 1974 for a massive illegal drug operation and received a visit from the IRS in 1981 when the agency realized just how much money he’d made.
“Edmondson vs. Commissioner,” Martinez says. “Edmondson was a self-employed drug dealer and he was assessed a tax. He obviously didn’t formally keep tax books, so he had to recreate his financial situation for the tax years that he was being investigated for.”
Edmondson claimed deductions for business trips, mileage, apartment office space, rent and even paraphernalia like scales.
“Ultimately, the court believed his testimony — gave him a lot of credence and accepted his numbers,” Martinez says. “They basically gave him a tax deduction for his drug dealing business.”
Congress ran to make sure that never happened again and in 1982 passed an amendment to include 280E in the tax code.
If the DEA succeeds in rescheduling marijuana as Schedule III — a category not listed in 280E — weed businesses would suddenly and immediately be able to begin making deductions.
The timeline on such a shift isn’t totally clear. Once the DEA posts the proposed rule to the Federal Register, there will be a period for public comment, which can last for months, after which the agency may decide if it wants to go through with posting a final rule. That timeline may be lengthened if anyone decides to file a suit to block the rule change.
“If it survives judicial scrutiny, then businesses can start taking those deductions for ordinary and necessary business deductions,” Martinez says. “It should have a pretty immediate effect on taxes. Now in regards to whether that’s going to solve the problem of conflicting state and federal rules: No. For all intents and purposes, manufacturing, distribution and trafficking of cannabis is still illegal federally.”
Martinez says there will probably be other unforeseen complications if the DEA successfully reschedules weed.
“You have to have a prescription to get Schedule III drugs, so I don’t know what that’s going to mean for dispensaries operating currently. There’s a lot of unknowns along with the tax benefits.”
Marijuana businesses can start getting prepared for the change now by keeping an eye on the rescheduling approval process. The White House has yet to confirm the current stage of the proposal. Martinez says staying informed on the process will help businesses get ready for the changeover.
“I would be talking to their tax planning professional, my tax attorney — whoever’s doing the tax planning — and make sure that my plan is airtight going into this. I’d make sure that they are taking as many deductions as they possibly can, without running afoul of the law.”
He says there are some businesses that anticipate the rescheduling will go through and they are taking aggressive approaches to their tax deductions. Other businesses, he says, don’t think the reschedule will pass, and they plan to maintain their conservative tax positions.
Rescheduling would ease some of the tax burdens faced by businesses, but it could lead to some unwanted attention from the IRS as well.
“Make sure that you’re still making your tax payments — both on the federal and state side,” he says. “Be ready to adapt, because although it’s a pretty momentous shift, there’s no guarantee that it gets through and there’s no guarantee that there won’t be litigation following it soon thereafter.”
In 2022, the IRS received $80 billion in federal funding thanks to the Inflation Reduction Act that it used to hire thousands of new workers. Earlier this month, the agency vowed to use the funding to increase audits this year.
“As soon as this change takes effect, the IRS can look at the last three years to make sure that your taxes were being paid according to the 280E prohibitions at that point,” Martinez says.