Cannabis Re-Classification to Schedule 3 - Q&A with Expert Cannabis CPA
A significant transformation in the cannabis industry may soon be realized with the potential reclassification of cannabis from a Schedule I drug to a Schedule III drug. This shift could drastically change the landscape for cannabis business owners by eliminating Section 280E of the Internal Revenue Code, which currently imposes hefty tax liabilities on the industry. Such a reclassification would allow cannabis businesses to deduct ordinary expenses, greatly reducing their tax burdens.
Today, we’ll address the most common questions about this potential rescheduling and its impacts, providing insights specifically for cannabis accounting and CPA considerations. If you have any questions about your specific business we highly advise you reach out to us and schedule a free consultation.
Q: What could be the immediate impact of a rescheduling on my cannabis business?
A: The dreaded section 280e very clearly applies exclusively to Schedule 1 & 2 drugs. The proposed move to a Schedule 3 drug would make cannabis businesses exempt from this very harsh federal income tax treatment. This will open up the door to many expenses that currently disallowed. Large noticeable line items will include advertising expenses, accelerated depreciation of buildout costs, salaries and wages for time allocated to Sales, General & Administrative tasks, professional and legal services and much more. Depending on where your cannabis business is in its lifecycle and how frugal you are with non-deductible expenses, our estimate of increased profitability per vertical range in the following:
Retail Dispensaries: 4 - 12% increased profitability
Retail Delivery / Distribution: 6 - 14% increased profitability
Cultivation / Manufacturing: 5- 8 % increased profitability
There are other factors to be considered as well - tax credits such as the research & development tax credit could now become available against income tax and investors will be more attracted to larger cash on cash returns as a result.
Q: Is this the end of cannabis for the little guy? Will Rite-Aid, Walgreens and Amazon take all my business?
A: A Schedule 3 drug is still an illegal drug under federal law, but the general restrictions around them are usually much looser.
I would say if your business makes the majority of its money from medicinal sales, its possible that a move to Schedule 3 could impact your profits. The case that has been made for rescheduling cannabis has heavily focused on its medicinal qualities and the roadblock that being a Schedule One drug has had on the ability for research and development from this perspective. It is possible that we see large, nation-wide chain pharmacies begin dispensing cannabis. At this time, everything is speculation; in the past the DEA and other drug authorities have rolled out a more controlled process of rescheduling.
For most cannabis owner operators, the majority of revenue comes from adult recreational use. A reclassification to Schedule 3 for the drug may be the best case scenario for these owners for two reasons:
Reduced Federal Tax Burden: The reclassification would eliminate the significant federal income tax burden imposed by Section 280E, allowing businesses to deduct ordinary expenses. This change would improve cash flow and overall financial health.
State-Level Licensing: The process of obtaining a license for adult recreational use cannabis operations will likely remain at the state level, many of which have remained dedicated to social equity programs and are at least attempting to keep large operators from dominating individual states.
The most likely increase in competition will come from fellow cannabis entrepreneurs who were unable to raise capital as a Schedule 1 drug due to the large federal income tax liability. With these restraints gone, more appealing investment opportunities will spring up. In other words, while it is unlikely you will be competing against Amazon in the near future, you may have a few new dispensaries in your town sooner than you think.
Q: What should cannabis businesses do immediately to prepare for this change?
A: There is two answers for this, one for cannabis operations that are pre-operations and those that have their doors open.
If you are in the middle of building out or still waiting for that final license approval you want to:
Ensure that your construction invoices are as detailed as possible. This will help potentially claim accelerated depreciation, Section 179 costs, De Minimis Safe Harbor costs etc. Under 280e as is stands now, depreciation can only be written off against machinery and equipment that directly improves cannabis product and it must be depreciated in the classical sense (ie; no bonus depreciation, see LORD v. COMMISSIONER OF INTERNAL REVENUE). If 280e goes away, construction invoice detail will allow for cost segregation studies, potentially leading to very large tax savings.
Re-run your financial forecasts to include Schedule 1 & Schedule 3 options. With most states taking years to get from initial application to final approval, the question on all cannabis owner operators mind’s is “how long will it takes to pay myself back?” This answer will change fairly dramatically depending on how the rescheduling process plays out - and indeed will determine the cost of capital when you are raising money.
If you are currently operating you will want to:
Re-examine the tax structure you currently have. Being able to deduct regular and ordinary business expenses will drive many hard questions regarding C-Corp, S-Corp and partnership elections as well as which entities own and hold assets, labor etc. Complexity may increase or decrease depending on your unique situation.
Perform a deep-dive on your advertising spend and Return on Ad Spend. Since pay-to-click services like Google and Meta are unlikely to change their position in the event of rescheduling, the life blood of cannabis sales will likely remain the same: personal connections, search engine optimization, Google reviews, Weedmaps, Leafly etc. If this expense is now deductible, it is up to you to find the combination of spend and content which allows you to make $5 for every $1 you put in to your advertising machine.Q: What should cannabis businesses do immediately to prepare for this change?
Q: When do you expect to see a final outcome on Cannabis being reclassified as a Schedule 3 drug?
A: Given this is an election year, it is probable we will get some sort of consensus on whether or not the cannabis rescheduling will go through before the end of 2024. As of today, the rescheduling of cannabis from a Schedule I to a Schedule III drug is in a critical phase. The Drug Enforcement Administration (DEA) has initiated a 60-day public comment period, which is set to end on July 22, 2024. This period allows stakeholders, including businesses, researchers, and the general public, to provide their input on the proposed rescheduling.
The proposal to reclassify cannabis reflects growing recognition of its medical benefits and aims to reduce the regulatory burdens associated with its current classification. This shift is expected to facilitate medical research and potentially ease some federal restrictions, particularly those impacting banking and business operations within the cannabis industry.
While there is significant support for the rescheduling, there are also efforts by some groups, including a Republican congressional committee, to block this change. These groups argue for maintaining the current Schedule I status, citing concerns about public health and safety.
The final decision on rescheduling will consider the public comments and any additional input from administrative hearings. The DEA aims to issue a finalized ruling by the end of September 2024, potentially as early as the end of August.
All that being said there are significant regulatory hurdles to pass to actually reschedule the drug and whether or not the IRS lifts 280e for the 2024 tax year for cannabis companies is still a huge question. We believe at this juncture it is more likely than not that 280e will be applicable for the 2024 tax year.
Q: When cannabis does get rescheduled, will it be apply retroactively to previous tax years?
A: There is already significant rumblings in the industry of positions top legal experts have taken which suggest the cannabis industry has not been beholden to 280e since 2018. The most recent and famous of these cases is the $113 million tax refund multi-state operator Trulieve Cannabis applied for. These positions vary, some rely on the commerce clause, some say the federal government has no congressional authority to tax cannabis in this fashion etc.
If, however, you are taking the conservative route and following 280e for your cannabis business, it is highly unlikely the IRS will offer and respite for any cannabis company for tax years prior to 2024. However, businesses may consider filing protective refund claims to preserve their rights should there be a favorable legal ruling in the future. Separate from the DEA’s actions, there are ongoing legislative efforts to amend or repeal Section 280E. The Small Business Tax Equity Act, reintroduced by Rep. Earl Blumenauer and supported by a bipartisan group, aims to allow state-legal cannabis businesses to take federal tax deductions. While this bill has not yet advanced to a hearing or vote, it represents another pathway toward relief from 280E.
You may have a stronger case for an offer-in-compromise negotiation if you have unpaid back taxes.
Q: Will cannabis businesses have better access to banking services after rescheduling?
A: Yes, rescheduling to Schedule III could reduce the legal and regulatory risks for banks, making them more willing to offer services to cannabis businesses. This change would potentially alleviate the current cash-only operations many cannabis businesses face and could provide access to loans and other financial services that are crucial for growth and stability.
Q: What impact will rescheduling have on cannabis research and development?
A: Rescheduling cannabis to Schedule III would significantly ease restrictions on research. Currently, researchers face considerable hurdles in studying Schedule I substances. Reclassification would allow for more extensive clinical studies and could lead to new medical cannabis treatments. This change would also enable pharmaceutical companies to apply for investigational new drug (IND) status and submit new drug applications (NDAs) for cannabis-based products, potentially leading to more federally approved cannabis medications.
Q: How will this change affect state-level cannabis laws?
A: While federal rescheduling to Schedule III would provide a more lenient framework for medical and scientific use, state-level laws would still govern the recreational use of cannabis. Many states have their own regulations and licensing requirements, which would continue to apply. The rescheduling could encourage states to align their policies with federal guidelines, but significant state-by-state differences would likely remain.
The potential rescheduling of cannabis to a Schedule III drug represents a significant shift in the industry, with far-reaching implications for taxation, regulation, and business operations. While there are still many hurdles to overcome, including legislative and regulatory approvals, staying informed and prepared can help your cannabis business navigate these changes successfully. At Greenbooks CPA, we are committed to keeping you updated on these developments and providing the guidance you need to optimize your business strategies in this evolving landscape. Stay tuned for more updates and insights as the situation unfolds.