The Internal Revenue Code, 26 U.S. Code §280E, is the bane of any business associated with the “trafficking” of Schedule I or Schedule II controlled substances.

It states that “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. (Added Pub. L. 97-248, title III, §351(a), Sept. 3, 1982, 96 Stat. 640.)

By forbidding the deduction of “ordinary and necessary” business expenses other than the cost of goods sold, 280E hamstrings the state legal cannabis industry.  Because marijuana is federally illegal and a Schedule I narcotic, a state legal cannabis business is taxed on gross income rather than net income.

The intent of 280E, way back at inception, was to prevent criminal drug dealers and syndicates from abusing the tax code and benefiting from ordinary deductions. It is a Reagan era law that is punishing unforeseen targets in the state legal markets. In 1982, no one could know that in 2023 only six states would ban cannabis altogether, that over 48% of Americans would live where recreational marijuana is legal, or that a large majority would live with access to medical marijuana, according to the Pew Research Center. The support for legalization is overwhelming.

If the August 2023 request from US Department of Health and Human Services (HHS) is successful in pushing the Drug Enforcement Administration (DEA) to reclassify cannabis from a schedule I to a Schedule II narcotic, then 280E sunsets for state legal cannabis operators. This reclassification is based on the idea that cannabis is less dangerous than drugs like heroin and LSD, and that it has medical uses that are generally recognized. Ever since the appearance of Epidiolex on the scene as approved by the FDA in 2018, and its descheduling by the DEA in 2020, the medical use seemed a forgone conclusion. We might be there before the end of 2024, if lucky.

If rescheduling of cannabis to Schedule III happens by year-end, there are still questions that state legal cannabis operators will need to know. Will the change apply to 2023, or only 2024 forward? Will it open up the possibility of refunds? Will it impact existing tax controversies between taxpayers and the IRS? Stay tuned.

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