Why marijuana rescheduling means only limited tax relief for cannabis businesses

Jason Klimek (courtesy photo)

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The legal marijuana industry’s situation changed significantly on Thursday when the U.S. Justice Department finally rescheduled cannabis – but only some cannabis.

The Trump Justice Department placed U.S. Food and Drug Administration-approved drug products containing cannabis and marijuana produced by operators with a state-issued medical license in Schedule 3 of the Controlled Substances Act.

Notably, this move left all other marijuana, including unlicensed bulk marijuana and state-legal adult-use commerce, in Schedule 1.

The upshot is not “cannabis is moved to Schedule 3” in the broad sense. This is a medical-only action with immediate and uneven consequences across the industry.

For those hoping for rescheduling and tax relief from Section 280E, including those intently watching a key Internal Revenue Service challenge in tax court, this development isn’t likely to help.

Here’s why those hopes are likely headed for disappointment.

What cannabis operators still need to know after marijuana rescheduling

Both the legal and practical endgames are far from settled. The DOJ’s order itself anticipates severability (meaning certain parts of it may be deemed litigation. And it draws a bright line between state medical licensees, who the order states should no longer be subject to Section 280E, and the much larger adult-use market, which the order explicitly leaves in Schedule 1.

That split structure all but guarantees immediate challenges:

• From opponents who will attack the use of a particular section of federal law to implement a partial, medical-only rescheduling regime
• From cannabis industry stakeholders, who will argue that a substance cannot be treated as Schedule 3  for some channels while remaining Schedule 1 for others.

But questions of legal strategy should not obscure the separate questions:

• What cannabis taxpayers can and cannot do today based on the government’s current position?
• What exposure exists for positions already taken on past-year federal tax returns — particularly for operators whose core business remains Schedule 1 trafficking under federal law?

Why Trump marijuana rescheduling doesn’t solve the 280E puzzle

The cannabis industry’s severe tax problems are well known. Internal Revenue Code Section 280E disallows deductions for ordinary business expenses incurred in trafficking Schedule 2 or 3 controlled substances, while still permitting cost of goods sold. Many cannabis taxpayers are not able to pay the resulting tax.

Recent filings of the large publicly-traded cannabis companies reveal the magnitude of the federal income tax owed.

• Trulieve Cannabis owes $630.3 million
• Curaleaf Holdings owes $531.5 million
• Verano Holding owes $378.3 million
• Cresco Labs owes $171.4 million

These companies would face intense pressure to pursue restructuring or insolvency proceedings if they had to pay these taxes, so they have a strong incentive to fight.

The MSOs claim that Section 280E doesn’t apply to their operations for a number of reasons. Most of those reasons have been advanced by in a current Tax Court case, New Mexico Top Organics v. Commissioner.

Last month, the IRS filed its answering brief in the case, the first time that the IRS has responded in writing to taxpayer arguments about the non-applicability of Section 280E.

In plain English: the taxpayer is facing very long odds in Tax Court.

The current state of the fight against the IRS on 280E?

It seems clear from the IRS’ arguments that the government is likely to pursue punishment in the form of a 20% substantial understatement penalty under Internal Revenue Code Section 6662 against cannabis taxpayers taking those positions on tax returns.

However, many cannabis taxpayers, certainly the big MSOs, will deny the applicability of the penalty, contending they disclosed the relevant positions on their tax returns and have “a reasonable basis for the tax treatment of such item by the taxpayer” as required by law.

U.S. Treasury regulations explain that “[r]easonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim.”

There are a number of court cases discussing the reasonable basis standard.

When there are legitimate questions of tax interpretation, even if the taxpayer loses on the ultimate issue, the substantial understatement penalty is not applied. Where taxpayers are defending their participation in too-good-to-be-true tax schemes, they usually get the penalty applied, notwithstanding legal arguments they muster on their behalf.

What cannabis businesses challenging 280E need to know now

If a cannabis taxpayer has a legal opinion making the arguments used by New Mexico Top Organics, chances are the taxpayer will still lose on the penalty issue.

Further, it will be difficult for big MSOs — especially those with in-house legal counsel and sophisticated compliance teams — to claim they acted with reasonable cause and good faith.

These companies should know that opinions relying on the parenthetical “within the meaning of” are fundamentally flawed for the reasons cited above: the Controlled Substances Act vests scheduling authority in the Attorney General, not the Tax Court, HHS or a taxpayer’s expert.

The rescheduling debate has produced a cottage industry of confident predictions — and an even larger pile of legal opinions reading tea leaves.

But the hard constraint remains the same: until cannabis is actually moved off Schedule I or II through the Controlled Substances Act’s process (or Congress changes the rule), Section 280E remains the law the IRS will enforce and the Tax Court will apply.

Investors and operators can be optimistic about policy momentum, but optimism is not a legal argument — and it is a thin reed to lean on when penalties are in play.

Jason Klimek is co-leader of Harris Beach Murtha’s Cannabis Industry Team and James Mann is a member of that team. Both are also members of the firm’s Tax Practice Group.