Weeks after the U.S. Drug Enforcement Administration (DEA) announced that it would move to reclassify cannabis as a less dangerous drug, the IRS is reminding taxpayers that marijuana remains a Schedule I controlled substance and is subject to the limitations of the tax code. In other words, the federal tax laws related to cannabis sales have not changed.
Legalization Of Cannabis
While still prohibited by federal law—possession can lead to fines and jail time—most states and the District of Columbia have legalized cannabis for medical or recreational use (or both). Under federal law, however, it’s classed as a Schedule I drug—on par with heroin and LSD—which means that it is not legal in any form. It is against federal law to grow, sell, or use cannabis for any purpose, including medical reasons.
The recent proposal would move marijuana from its current classification as a Schedule I drug to a Schedule III drug alongside ketamine and some anabolic steroids. The proposed language, which is subject to public comment, has been published in the Federal Register—you can read it here.
After the public comment period and a review by an administrative judge, the DEA will publish the final rule.
(The move follows other efforts to decriminalize cannabis, including a proclamation by President Biden last year to pardon those with certain convictions related to marijuana under federal and D.C. law.)
Taxation
When the move happens, it will impact the taxation of cannabis—but not yet.
Currently, cannabis sellers must report their income even though the sale remains criminal under federal law. Interestingly, it was the taxation of cannabis in the 1930s that led to criminalization in the first place. In the early part of the 20th century, during Prohibition, booze was illegal, but cannabis was not.
Under the 1937 Marihuana Tax Act (yes, with an “h”), cannabis was legal—and taxed. There was a two-part tax on sales, one which functioned like a sales tax and another more akin to an occupational tax for licensed dealers. Failure to comply resulted in severe consequences.
In 1969, Timothy Leary challenged his arrest for possession of cannabis under the Act. Leary v. United States made it to the Supreme Court, where part of the 1937 Act was invalidated as a violation of the Fifth Amendment against self-incrimination. The result was a new law, the Controlled Substances Act, passed in 1970, which criminalized the possession or sale of cannabis for federal purposes—it has remained so to this day.
IRS Weighs In
The IRS was fairly quiet about the taxation of cannabis until 2011, when it made clear that it would disallow expenses for medical dispensaries. The justification? Section 280E of the Tax Code which states:
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.
In 2015, the IRS indicated it might be softening. As the popularity of cannabis increased, IRS Memorandum 201504011 took another look at the tax deduction question. The memo didn’t reverse course on the issue of the deductions, but it did suggest that, by looking at section 263, careful consideration of the characterization of certain activities might result in legitimate reductions in tax.
Today, for the most part, only the cost of goods sold (COGS) is deductible for cannabis businesses for federal tax purposes. In most cases, traditional business costs, like employee payroll and marketing, remain non-deductible. The result can be an effective tax rate of between 40% and 70% for cannabis-based businesses.
What’s Changed?
In 2021, the IRS took steps to resolve confusion—and lost tax dollars—by addressing tax implications for the cannabis industry. Today, the IRS maintains a cannabis industry page on its website focusing on section 280E, income reporting, and cash payment options. The latter is a serious concern for the industry since banking regulations can make it challenging to be an unbanked industry—remember, cannabis is still illegal for federal purposes, which typically limit banking options.
As we creep closer to decriminalization, some taxpayers are filing amended returns and seeking a refund of taxes paid related to section 280E. According to the IRS, the grounds for filing such claims vary, but these claims are not valid since “[t]he law with respect to the schedule or classification of marijuana has not changed.” That means, according to the agency, that taxpayers seeking a refund of taxes tied to section 280E are not entitled to a refund or payment.
The IRS has also clarified that the treatment of cannabis under section 280E applies even if businesses operate in states that have legalized sales. The agency’s stance related to COGS also hasn’t changed, meaning it remains deductible.
For more information, check out the IRS list of frequently asked questions and other information related to the cannabis industry on its website.
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