The cannabis industry knows well the economic burden imposed by Section 280E of the Internal Revenue Code of 1986 (Code). It substantially increases the cost of doing business because it disallows deductions for expenses related to "trafficking" in marijuana – expenses that other traditional businesses get to deduct, such as wages, rent, utilities, insurance, and more.
On May 16, 2024, the Drug Enforcement Agency (DEA), which is part of the Department of Justice, issued a Notice of Proposed Rulemaking (NPR) that proposes to transfer marijuana from Schedule I of the Controlled Substances Act (CSA) to Schedule III of the CSA. Rescheduling marijuana from Schedule I to Schedule III would make Section 280E inapplicable to a cannabis business. It would continue to apply, however, to marijuana's cellmates under Section 280E, such as heroin, LSD, and Ecstasy.
While the road ahead for rescheduling may be long and winding, the operating assumption is that it will happen. The big question is "when," followed by "what can I do now to be prepared when it happens?" The NPR makes no mention of when rescheduling would become effective or how it will affect the tax treatment of marijuana business expenses. Nevertheless, there are a number of steps cannabis businesses can take now to prepare for the future.
Taxes and Timing of Rescheduling
For tax purposes, the effective date of rescheduling marijuana is important because expenses related to a cannabis business paid or incurred after rescheduling will be deductible because Section 280E no longer will apply.
Section 162 of the Code provides that "[t]here shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business [...] ." Section 7701(a)(25) of the Code provides that the term "paid or incurred" shall be construed according to "the method of accounting upon the basis of which the taxable income is computed."
There are two general methods of accounting: the cash receipts and disbursement method (cash method) and the accrual method. Under the cash method, an expense is deductible in the taxable year in which the expense is actually paid. Under the accrual method, an expense is deductible in the taxable year in which: (1) all events have occurred that determine the fact of the liability; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred. Economic performance occurs when the property or service to which the accrual relates is actually provided or used.
Deductions for Marijuana-Related Expenses
The effective date of marijuana rescheduling will occur pursuant to final regulations issued by the DEA. The effective date for final regulations generally is the date they are published in the Federal Register, although the effective date of regulations sometimes is after the date of publication (e.g., thirty days after publication in the Federal Register).
For tax purposes, after the relevant effective date, Section 280E no longer will apply, and expenses related to a cannabis business paid or incurred after rescheduling will be deductible. (Note: It is conceivable that the effective date of rescheduling for Section 280E purposes could be different from the effective date of rescheduling for other purposes.)
What this means for a cannabis business is it may consider postponing paying or incurring expenses subject to the Section 280E disallowance, to the extent possible, until the effective date of the rescheduling for Section 280E purposes. In more practical terms, cannabis businesses using the cash method may consider postponing paying marijuana-related expenses; cannabis businesses using the accrual method may consider postponing incurring such expenses until the effective date of rescheduling.
Protective Refund Claims
While the effective date for rescheduling likely will be prospective, it is possible it could be retroactive with respect to the applicability of section 280E. This could mean that Section 280E would no longer apply to past taxable years. If this is the case, cannabis businesses will want to claim a refund for the additional taxes they paid in previous years because Section 280E denied a deduction for marijuana-related expenses during that same time period.
Generally, taxpayers must file a refund claim with the IRS within three years of filing the tax return to which it relates or two years of paying the tax, whichever is later. Once that period expires, the IRS is prohibited from issuing a refund or credit. Cannabis businesses may consider filing a protective refund claim to keep this period from expiring. A protective refund claim would suspend the refund statute of limitation until a cannabis business could file a complete refund claim if the rescheduling effective date for Section 280E purposes is retroactive.
The Bottom Line
The tax rules relating to when an expense is paid or incurred, as well as with respect to the filing of past or prospective claims, can be complicated. Once rescheduling occurs (or possibly even before), the IRS may publish guidance on how rescheduling affects Section 280E and the deduction of marijuana-related expenses. In the meantime, cannabis businesses may consider working with their tax professionals on how best to time paying or incurring marijuana-related expenses, as well as to submit all necessary documentation to preserve their rights to obtain refunds for taxes previously paid under 280E.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.