What You Need to Know About the DEA’s Plan to Reschedule Cannabis – A Focus on Taxation
In a landmark move, the Drug Enforcement Administration (DEA) announced on April 30, 2024, that it will initiate the process of rescheduling cannabis from Schedule I to Schedule III under the Controlled Substances Act (CSA), effectively recognizing its medical value and opening the door for more research and legal access.
The decision comes after years of pressure from advocates, lawmakers, and scientists who have argued that the current classification of cannabis as a highly dangerous, addictive substance without any medical benefit is outdated and unjustified.
The DEA’s announcement has major implications for the cannabis industry, which has been operating under a patchwork of state laws and federal prohibitions. Most notably, Internal Revenue Code (IRC) Section 280E, which has been the culprit of imposing onerous effective tax rates on industry operators, will no longer apply after such rescheduling to a Schedule III substance under the CSA. Additionally, rescheduling cannabis would not only reduce the legal risks and barriers for businesses and consumers, but also create new opportunities and challenges in terms of taxation and regulation.
While unanswered questions remain at the top of everyone’s mind, let’s focus on how this change will affect cannabis businesses and what can be done to stay ahead of the curve given what we know now. From a tax perspective, we should be focusing on several opportunities to optimize tax positions post rescheduling. The following tax mitigation opportunities are just a few to mention:
- Ordinary and necessary business expenses would be deductible to cannabis companies as IRC Section 280E would no longer apply
- Property and equipment (including cultivation, manufacturing, and retail related activities) would be eligible for bonus depreciation and/or Section 179 expensing
- Inventory costing methodologies –
- Applications for changing current Inventory methods under IRC Section 471
- Under the application of IRC Section 280E, the industry focused on “stuffing” as many costs into inventory as possible to avoid disallowance of expenses. Now, the opposite focus needs to be considered while still maintaining compliance with IRC Section 471
- The industry will now be subject to Unicap Rules under IRC Section 263A. A taxpayer subject to the uniform capitalization (UNICAP) rules must capitalize all direct costs and an allocable portion of most indirect costs that are associated with production or resale activities
- IRC Section 471(c) opportunities may allow for exclusion of certain expenses from cost of goods sold and immediate deduction through operating expenses. Such position is only available to taxpayers with less than $30M in average annual receipts (subject to certain aggregation rules with related parties)
- Applications for changing current Inventory methods under IRC Section 471
- Availability of the Research and Development Credit – the credit is worth approximately 7-10% of qualified research expenses. A credit is a dollar-for-dollar reduction against taxes owed. What are qualified research expenses? How should you modify your accounting systems to easily track these expenses to take full advantage of this new benefit for cannabis companies?
- Availability of Clean Electricity Investment and/or Production Credits under the Inflation Reduction Act of 2022
- Opportunities to delay operating expenses in the 2023 tax year to deduct them in 2024 and later years. These may include the following:
- Section 174 research and experimental expenses
- Section 461 unpaid accrued expenses
- Section 267 unpaid related party expenses
- Capitalization of start-up costs
- Capitalization of soft costs and carrying costs during construction periods
This historic change will reshape the market dynamics and legal framework of the cannabis industry, and now is the time to start thinking about how you can adapt your business strategy to take advantage of the new possibilities and avoid the pitfalls.
With more than a decade of experience serving cannabis operators, Withum’s Cannabis Services Team is here to advise you on the next dimension of opportunities and complexities to promote enhanced free cash flow.