• Internal Revenue Code Section 280E prevents cannabis operators from taking ordinary business expense deductions because cannabis is currently classified as a Schedule I drug.
• However, the United States Drug Enforcement Agency and Department of Health and Human Services have recommended cannabis be reclassified to a Schedule III drug, which would expand permitted deductions for cannabis operators.

As the state legalization of medicinal and adult-use cannabis spreads across the United States, cannabis producers and retailers are experiencing a rapid increase in production and
sales. However, despite this boom in business, producers and retailers are struggling to stay afloat. This is due in part to the inability of these producers and retailers to take ordinary business expense deductions on their tax returns. Unlike every other type of business in the United States, Internal Revenue Code (“IRC”) Section 280E prevents the cannabis industry from taking ordinary business expense deductions because cannabis is classified as a Schedule I substance under the Controlled Substances Act of 1970 (“CSA”).

However, the Internal Revenue Service (“IRS”) may be forced to turn over a new leaf. Just last week, the United States Drug Enforcement Administration (“DEA”) submitted a proposal to the Department of Justice to reclassify cannabis from a Schedule I to a Schedule III drug under the CSA. The United States Department of Health and Human Services has also recommended that cannabis be re-classified to a Schedule III substance. These recommendations are the first step in getting Congress to initiate the formal rulemaking process to officially re-schedule cannabis under the CSA.

IRC Section 280E bars deductions for businesses that traffic Schedule I or II controlled substances, which means cannabis operators cannot take gross income tax deductions for ordinary business expenses, including, salaries, rent or other expenses associated with the business’ property, and travel expenses. Therefore, cannabis businesses can only deduct the costs of goods sold to reduce their gross income. Producers and retailers keep costs in their inventory and once sold, this amount is deducted as a cost of goods sold. As such, producers and retailers use expansive inventory accounting methods, which sees them maximizing the cost of goods sold by capitalizing a cost that would otherwise be an ordinary business expense deduction under IRC Section 162.

If cannabis is re-classified, cannabis businesses may be inclined to switch to an accounting method that minimizes their inventory costs. This would most benefit the producers who are not able to take their deductions as quickly and have more costs to defer in inventory than retailers.

Operators in the cannabis industry see IRC Section 280E as unconstitutional and simply want the same tax treatment as other businesses. Although the industry has not taken any action yet, some of the multi-state operators in the cannabis space have threatened to not pay their income taxes in an effort to force the government’s hand. Nevertheless, in light of the recommendations from the DEA and Department of Health and Human Services, Congress will soon have to address the growing support for the cannabis industry.