Source: JD Supra
https://www.jdsupra.com/legalnews/tax-considerations-and-the-4737724/
Author
Louis Vlahos
Help Us Forget
Having been swept along for nine days “by the force of the hostile winds on the fishy sea,” Odysseus and his crew came to a strange land. After securing their ships, Odysseus sent some of his “companions ahead, telling them to find out what men . . . might live here in this country.” They came upon the Lotus Eaters, a people “who live upon . . . the honey-sweet fruit of the lotus.”[i] Those crew members who ate of the fruit were left in a state of bliss, forgetting all else, including an urgency to return home to Ithaca.[ii]
I’m certain that the events of the last few days . . . weeks . . . months . . . years have left many of our fellow citizens wondering whether there was something they can do to help them forget, at least momentarily, all that has transpired and, perhaps just as importantly, to make themselves impervious or indifferent to all that is yet to occur during the remainder of this election year.
Fortunately, the lotus it is not listed as a controlled substance under federal law, notwithstanding the government has not yet approved it for human consumption.[iii]
There is Another Way
That said, some state and local governments have approved, or are considering the legalization and expanded use of, hallucinogenic substances, like magic mushrooms, for medical and other purposes, though these may be difficult to come by if you’re not on the west coast.[iv]
Of course, many parts of the country[v] have already legalized the adult use of marijuana for “recreational” (self-medicating?) purposes, notwithstanding it is still listed as a schedule I controlled substance under the federal Controlled Substances Act; meaning its manufacture, distribution, dispensation, and possession is prohibited, except for federal government-approved research studies.[vi]
Speaking of which, in October 2022 the President asked the Attorney General and the Secretary of Health and Human Services (HHS) to review the classification of marijuana under federal law. Following this review, in May of this year the Attorney General exercised his authority to initiate the rulemaking process to transfer marijuana from schedule I to schedule III.[vii]
According to the Department of Justice, the rescheduling of a controlled substance follows a formal rulemaking procedure[viii] that requires notice to the public, an opportunity for comments, and an administrative hearing. The Attorney General’s proposal[ix] starts the process through which the Drug Enforcement Administration will gather and consider information and views submitted by the public in order to make a determination about the appropriate schedule.[x]
Tax Implications
Such a rescheduling will be significant for federal income tax purposes because the Code disallows deductions for businesses that consist of “trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act),” including marijuana.[xi]
But first, it is worth noting that the continued federal treatment of the sale of marijuana as an illegal activity does not relieve a business from liability for income taxes attributable to its illegally generated income. After all, income “from whatever source derived” is taxable and, thus, must be reported to the IRS on a federal income tax return.[xii]
What’s more, the federally illegal marijuana business is not relieved of its tax withholding and collection obligations; for example, employment taxes.
Just as a cannabis business remains subject to federal income tax, so it remains subject to the imposition of penalties for the late filing of tax returns and the late payment of taxes.[xiii]
Small business taxpayers often need to make quarterly estimated tax payments to cover their tax obligation.
By moving marijuana to schedule III, the above prohibition on the deduction of business expenses disappears. As a result, many cannabis businesses that organized as C corporations, in order to take advantage of the flat 21 percent federal corporate income tax rate, may consider electing to be treated as S corporations,[xiv] instead; even though the top federal rate applicable to individuals is 37 percent, the ability to deduct business expenses affords the shareholders of an S corporation the opportunity to reduce the applicable effective rate.[xv]
Not So Fast
However, during the above-referenced rulemaking process, and until a final reclassification rule is published, marijuana will remain a schedule I controlled substance, which means that a taxpayer operating a marijuana business will continue to be denied any tax deductions for expenses paid or incurred in carrying on its business.[xvi]
The conclusion set out in the immediately preceding sentence seems pretty obvious, but apparently not to everyone.
In fact, it appears some marijuana business owners are filing amended federal income tax returns on which they are claiming refunds attributable to the reclassification of the substance.
There must be a not insignificant number of such taxpayers because a couple of weeks ago, the IRS reminded the public that the law with respect to the schedule or classification of marijuana has not changed. “Until a final federal rule is published,” the IRS stated, “marijuana remains a Schedule I controlled substance and is subject to the limitations of Internal Revenue Code Section 280E.”[xvii]
The IRS advised those taxpayers filing amended returns seeking a refund of taxes paid – related to Section 280E of the Code – that they are not entitled to a refund.
The agency explained that “Section 280E disallows all deductions or credits for any amount paid or incurred in carrying on any trade or business that consists of illegally trafficking in a Schedule I or II controlled substance within the meaning of the federal Controlled Substances Act,” even if the business operates in a state that has legalized the sale of marijuana.[xviii]
Don’t Forget
However, the IRS also reminded taxpayers that Section 280E “does not prohibit a participant in the marijuana industry from reducing its gross receipts by its properly calculated cost of goods sold to determine its gross income.”[xix]
Generally, this means taxpayers who sell marijuana may reduce their gross receipts by the cost of acquiring or producing marijuana that they sell, and those costs will depend on the nature of the business.[xx]
Parting Thoughts
I suppose it’s possible that the rulemaking process for the reclassification of marijuana will be completed before the end of the year, perhaps even before the federal elections this November.
Then again, it’s not out of the question that the process may not run its course until next year.
At that point, depending upon the outcome of the elections, it is not inconceivable that businesses focused on the sale of marijuana for recreational use[xxi] may find themselves back at square one.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] At high doses, a plant extract from the blue lotus may cause euphoria and even hallucinations. (No, I am not speaking from personal experience.) Interestingly, the plant is not listed as a controlled substance.
[ii] Book IX of Homer’s Odyssey.
For an interesting take, see Alfred Tennyson’s poem, “The Lotos.” A sampling:
Branches they bore of that enchanted stem,
Laden with flower and fruit, whereof they gave
To each, but whoso did receive of them,
And taste, to him the gushing of the wave
Far far away did seem to mourn and rave
On alien shores; and if his fellow spake,
His voice was thin, as voices from the grave;
And deep-asleep he seem’d, yet all awake,
And music in his ears his beating heart did make.
In retrospect, Odysseus would have been better off remaining with the Lotus Eaters – his next stop was the island of the Cyclops.
[iii] However, its use is prohibited under Army regulation. Turns out it is not detectable by urinalysis. https://home.army.mil/wiesbaden/application/files/7016/4336/9082/Blue_Lotus_IP.pdf
[iv] On January 1, 2023, Oregon became the first state to legalize the adult use of magic mushrooms. https://www.nytimes.com/2023/01/03/health/psychedelic-drugs-mushrooms-oregon.htmlb
[v] Maine, Vermont, Massachusetts, Rhode Island, Connecticut, New York, New Jersey, Maryland, Delaware, Virginia, Ohio, Illinois, Missouri, Michigan, Minnesota, Colorado, New Mexico, Montana, Arizona, Nevada, California, Oregon, and Washington.
[vi] P.L. 91-513. Schedule I drugs, substances, or chemicals are defined as drugs with no currently accepted medical use and a high potential for abuse. Marijuana is listed on Schedule I. https://www.dea.gov/drug-information/drug-scheduling
[vii] https://www.justice.gov/opa/pr/justice-department-submits-proposed-regulation-reschedule-marijuana
Schedule III drugs, substances, or chemicals are defined as drugs with a moderate to low potential for physical and psychological dependence.
[viii] https://www.federalregister.gov/uploads/2011/01/the_rulemaking_process.pdf
[ix] https://www.dea.gov/sites/default/files/2024-05/Scheduling%20NPRM%20508.pdf
“The Department of Justice (“DOJ”) proposes to transfer marijuana from schedule I of the Controlled Substances Act (“CSA”) to schedule III of the CSA, consistent with the view of the Department of Health and Human Services (“HHS”) that marijuana has a currently accepted medical use as well as HHS’s views about marijuana’s abuse potential and level of physical or psychological dependence.”
[x] Query the impact, if any, that the U.S. Supreme Court’s decision overturning the Chevron Doctrine will have on this regulatory process. See Loper Bright Enterprises v. Raimondo and Relentless Inc. v. Department of Commerce, 603 U.S. ___ (2024); Docket nos: 22-451; 22-1219.
[xi] IRC Sec. 280E.
[xii] IRC Sec. 61.
[xiii] IRC Sec. 6651.
[xiv] IRC Sec. 1361 and Sec. 1362.
[xv] A particular tax rate is applied upon a particular bracket of taxable income; by deducting business expenses from gross income, the S corporation may reduce the taxable income of its shareholders. IRC Sec. 1366.
It would also improve cashflow and make more funds available for reinvestment in the business.
[xvi] There is the issue of how these expenses are paid. Because the sale of marijuana remains illegal under federal law, funds that can be traced back to marijuana operations may be considered money laundering, which exposes financial institutions legal and regulatory risks.
Senate Bill S.2860 provides protections for federally regulated financial institutions that serve state-sanctioned marijuana businesses. See also House Bill H.R. 2891. These bills were introduced in 2023. The two bills are sitting in committee.
[xvii] IR-2024-177, June 28, 2024.
[xviii] Note that some states and municipalities have decoupled their tax laws from IRC Sec. 280E to allow such deductions for purposes of determining state and local income tax. New York State did so in 2022; NYC in 2023. https://www.rivkinradler.com/publications/in-nyc-cannabis-business-expenses-now-deductible/
[xix] Many of the federal tax cases that have addressed the tax treatment of cannabis businesses involve the determination of whether certain expenses are included in cost of goods sold.
[xx] Good records assist in monitoring a business’s revenues and expenses, and can help substantiate items reported on tax returns.
[xxi] https://www.pewresearch.org/politics/2024/03/26/most-americans-favor-legalizing-marijuana-for-medical-recreational-use/
