What Are the Tax Consequences of Rescheduling Marijuana?

The Department of Justice (DOJ) recently announced that it would move to reschedule marijuana. This move doesn’t do as much for legal cannabis sales as proposed federal legislation like the States 2.0 Act, but rescheduling cannabis has major ramifications for cannabis businesses.

In the United States, the legal status of marijuana has long been a subject of political—and increasingly, economic—controversy. Different approaches have emerged among the states, with most legalizing cannabis for medical use and nearly half legalizing it for recreational use. States in which the sale of cannabis is legal in some form have generated meaningful taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. revenue from cannabis sales. The federal government has taken a more historically restrictive stance. At the federal level, marijuana has long been classified as a Schedule I drug within the Controlled Substances Act (CSA), which was passed in 1970, alongside other drugs like heroin and LSD.

Schedule I drugs are defined as having a high potential for abuse and no currently accepted medical use. However, the DOJ recently moved to reclassify marijuana as a Schedule III drug, recognizing its medical uses and concluding that it has a comparatively lower risk of abuse than other substances. This would mean marijuana would no longer be covered under Section 280E of the Internal Revenue Code (IRC), which dictates that operating expenses for businesses engaged in the cultivation, production, or sale of Schedule I drugs are ineligible for exemption from the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. , as operating expenses normally are.

Though short of full decriminalization, this development would still, if finalized, be highly significant to businesses engaged in the cannabis trade, bringing their income tax treatment more in line with that of other businesses.

Businesses in the United States pay corporate income taxes if organized as a C corporation, whereas, if they are structured as an S corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). or some other form of pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. , the income is taxed at the ownership level under the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. . Corporate income taxes in the United States are levied on corporate profits, and pass-through ownership income is also net income. In both cases, this begins with gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” and then subtracts operating expenses and cost of goods sold (COGS).

Expenses related directly to the production process, like the operating costs of a machine that trims cannabis flowers and leaves from stems, would fall under COGS. The salary of an accountant who works in the business’s internal auditA tax audit is when the Internal Revenue Service (IRS) conducts a formal investigation of financial information to verify an individual or corporation has accurately reported and paid their taxes. Selection can be at random, or due to unusual deductions or income reported on a tax return. department would be an operating expense. In a normal business, both expenses would be subtracted from total income and the end difference would be the business’s taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . But because cannabis-related businesses aren’t eligible to deduct operating expenses from their income, their tax burdens are drastically higher than nearly all other businesses.

Consider a C corporation making $100,000, with $45,000 apiece in COGS and operating expenses. This would ordinarily yield a federal corporate income tax bill of $2,100 (a 21 percent tax on net income of $10,000). But a cannabis business would need to pay 21 percent of $55,000 because it cannot deduct its operating expenses, leaving a tax bill of $11,550, amounting to an effective rate of almost 116 percent on net income (profits). The same analysis would apply to a pass-through business, except that it would be taxed under the individual income tax at the ownership level.

Tax Burden for Hypothetical Cannabis and Non-Cannabis Business

Source: Authors' calculations.

This example illustrates how otherwise profitable cannabis companies can become unprofitable due to heavy tax burdens. A 2022 survey of cannabis businesses found that less than 25 percent were profitable. In 2023, 20 of the largest publicly traded marijuana companies lost a combined $2.3 billion, with only one company in the group reporting a net profit.

Rescheduling marijuana would alleviate these disproportionate tax burdens by removing marijuana businesses from the jurisdiction of Section 280E of the IRC. This would vastly reduce the effective tax rates for existing dispensaries, allowing already-profitable dispensaries to lower costs and invest in their businesses and employees, and allowing unprofitable ones to eventually turn profits and be able to do the same.

Further, rescheduling, by making profitability much easier to achieve, would dramatically reduce a large, industry-wide barrier to entry and enable entrepreneurs/small business founders to gain a stable foothold in the industry. This would increase industry competition, driving innovation and investment. Rescheduling would also decrease tax code complexity and compliance costs, which are often so burdensome on their own that several cannabis companies have changed their entire business and ownership models (e.g., shifting to employee stock ownership plans) in attempts to qualify for different, more favorable tax treatment. At a more systematic level, granting cannabis businesses a more neutral status in the federal tax code will stabilize the industry, thereby stabilizing the federal and state tax revenues derived from it.

The federal tax rescheduling of marijuana would end a long era of harsh tax treatment of cannabis businesses. The tax treatment of marijuana no longer captured by Section 280E would better reflect the principles of sound taxation, simplifying the tax code by giving it neutral treatment and allowing for better stability of revenue and transparency for the public.

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