_{This article was originally published by Cannabis Business Executive}

As in many areas, people across the cannabis industry are wondering: What does the changing administration mean for my business? This area is still broadly unpredictable, as much will depend on who is chosen for the Cabinet and where they stand on cannabis. The DEA hearing to discuss the merits of rescheduling cannabis from a Schedule I to Schedule III drug had already been rescheduled twice and was just recently delayed for the third time. The hearing was set to begin on Jan. 21, 2025, but has now been pushed back for at least 90 days. There is some optimism in the industry that President-elect Trump will want to take President Biden’s progress across the finish line, which could bring an acceleration of reform. But in the meantime, we will need to wait and see.

In either event, the new potential for motion on rescheduling makes this a good time to explore again: What will tax compliance look like if the DEA indeed reschedules cannabis as a Schedule III drug?

Internal Revenue Code Section 280E 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.”

Put simply, this means that any person or company selling cannabis while the DEA has it listed as a Schedule I drug is unable to take deductions for its selling, general, and administrative (SG&A) costs and can only deduct cost of goods sold (COGS).  Section 280E does not differentiate between illicit operators and state licensed cannabis companies that are required to follow all of the rules and regulations of the state in which they operate. The result is that many of our clients have large book (GAAP) losses, but, with SG&A costs disallowed as a deduction for tax, large taxable income as well.

Many in the industry believe that if cannabis is rescheduled and Section 280E no longer applies to the cannabis industry, their income tax due will become substantially reduced, which it likely will.  They also believe that their income tax compliance will become more straightforward, which it likely won’t. In reality, Section 280E allows for shortcuts in the tax world, as the deductions and benefits related to items that will ultimately fall to Section 280E are not allowed. If cannabis is rescheduled, it would open up a great deal of additional allowable tax credits, benefits, and various compliance burdens that were previously disregarded.

Interest expense

Many cannabis companies have significant debt financing. Interest expense is not a component of COGS and therefore is nondeductible under Section 280E. This means that these companies were not affected by the interest expense limitation under IRC Section 163(j) because these interest expenses were already being disallowed under Section 280E. 

However, if Section 280E no longer applied, Section 163(j) likely will. The interest expense limitation allows a deduction for interest expense only to the extent of 30% of adjusted taxable income – a defined term. This will likely result in interest expense limitations – a temporary book to tax difference, meaning any amount disallowed can be carried forward and used to the extent that there is adjusted taxable income in a subsequent year.

Research and development

Cannabis is a research and development intensive industry. Starting in 2022, under IRC Section 174, companies are now required to capitalize and amortize their R&D costs (over five years for domestic R&D and 15 years for international R&D). What we have seen is that R&D costs are sometimes booked as SG&A costs. Like Section 163(j), R&D did not matter as much because these costs were mostly disallowed under Section 280E. However, if Section 280E no longer applied, companies would be required to capitalize their R&D costs and amortize them over time. This can reduce a company’s cash tax savings year to year depending on the amount required to be capitalized and how much carryforward it has.

However, there is good news: If you were no longer subject to Section 280E, you would be allowed to take advantage of the R&D credit. The R&D credit can reduce your income tax liability and, sometimes, your payroll tax liability. What the IRC allows as qualifiable for the R&D credit isn’t quite as expansive as what is required to be capitalized under Section 174; but while you are analyzing your R&D costs for purposes of Section 174, it makes sense to analyze your R&D costs for purposes of the R&D credit. Typically, the value of the credit can be 5-10% of actual R&D expenses, the largest single cost of which is typically salaries.

Inventory

If your average gross receipts in 2023 over the prior three-year period totaled $29 million or greater, you are subject to the Uniform Capitalization Rules (UNICAP) under IRC Section 263A. UNICAP was previously not as important to cannabis companies because all indirect costs were disallowed under Section 280E. However, if Section 280E no longer applied, you would be required to capitalize a portion of your indirect period expenses as they relate to inventory. These costs would then be deducted as inventory is sold over time. This can be a burdensome calculation and generally requires someone with UNICAP expertise.

Fixed assets/buildings/energy credits

Under Section 280E, taking bonus depreciation is not allowed. With Section 280E gone, you would need to strategize when to take bonus depreciation and when to place fixed assets in service. In order to maximize fixed asset deductions, you would probably want to undergo a cost segregation study/fixed asset review. A cost segregation study allows you to maximize the amount of fixed assets into a shorter-term fixed asset bucket, rather than depreciating over a longer-term leasehold/land improvement (15 years) or building (39 years). Given all the potential unfavorable book to tax differences, maximizing your fixed assets deductions would be important. If you are considering placing a facility into service during the year, it would be beneficial to place this facility in service after the potential rescheduling.

Furthermore, cannabis is an energy-intensive industry, so it is a good time to start exploring the applicability of renewable energy credits. These credits can apply to energy generated by renewable energy resources, such as solar or wind powered facilities. The tracking of renewable energy can be cumbersome but can result in significant income tax savings.

Labor

Cannabis is also a labor-intensive industry. Previously, much of your accrued bonus, vacation, wages, and commissions were allocated as SG&A costs and were therefore disallowed under Section 280E. If cannabis is rescheduled, these same costs would be subject to IRC Section 461, which can limit the deductibility of various wages from year to year as a temporary book to tax difference. Some of these indirect labor costs also may be subject to UNICAP as mentioned above.

The good news is that in this case, there would be certain credits you may qualify for. The Workers Opportunity Tax Credit (WOTC), for example, can be a significant credit in labor intensive industries.  You may be able to claim the WOTC if you hire employees who are in a WOTC-targeted group.

Net operating losses

Let’s say that, despite all these potential changes we’ve discussed, you were still generating taxable losses. We have seen a limited number of cases where prices declined so rapidly that operators sold product for less than the actual cost of acquisition or production. 

For C corporations, these losses need to be tracked, and it is important to pay attention because a change of ownership may limit future credits. If there has been a change in ownership, net operating loss and credit limitations can come into play under IRC Section 382 and 383, respectively. A study of Sections 382 and 383 would be required to determine if there has been a change in ownership, and calculations would need to be run to determine exactly how limited your losses and credits were.

Other Considerations 

• If cannabis is rescheduled in the middle of the year, we do not yet know how the IRS will handle this. There is a possibility they will allow the Section 280E applicability to be retroactive to the start of the year, but no one knows for sure. If they do not address the issue, it would be beneficial to incur more SG&A costs in the second part of the year.
• Our assumption is that any rescheduling will be solely on a prospective basis, except for the potential to apply to the beginning of the current tax year.
• We have mentioned just a few potential credits above, but there are other state credits that should be explored and considered if cannabis is rescheduled.
• Rescheduling may require accounting method changes to be filed with the IRS, and method change tax planning strategies should be explored.

The bottom line

Rescheduling of cannabis to a Schedule III drug would almost certainly increase a cannabis company’s cash flow. Would it result in the cash flow relief that the industry is hoping for? Maybe, but significant tax planning would be required. Would it simplify a cannabis company’s income tax filings? Not a chance.

CohnReznick provides audit, tax, and consulting to a wide array of clients in the cannabis industry. Contact our team to discuss how potential changes in cannabis regulation could impact your business’s taxation, and what you can consider now to prepare.  

_{Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.}