Cannabis Firms Challenge IRS on 280E Tax Penalties Amid Rescheduling

Cannabis companies may not need to wait for federal rescheduling to escape the burdensome 280E tax penalties that prevent them from deducting ordinary business expenses. This argument stems from the language of the Internal Revenue Code and recent actions by various government agencies.

The Internal Revenue Service (IRS) rule 280E disallows cannabis businesses from deducting normal expenses, which can lead to crippling tax liabilities. The critical part of the tax code states that deductions are prohibited for any trade or business that ‘consists of trafficking in controlled substances (within the meaning of schedules I and II of the Controlled Substances Act).’ This implies that if cannabis is no longer classified under these schedules, 280E should not apply, regardless of its official status.

Recent developments indicate that federal agencies are reevaluating cannabis’s classification. In August 2023, the Department of Health and Human Services (HHS) recommended moving cannabis to Schedule III of the Controlled Substances Act. This conclusion, based on a review by the Food and Drug Administration (FDA) and the National Institute on Drug Abuse (NIDA), indicates that cannabis has lower abuse potential, accepted medical use, and moderate dependence risk—criteria typical of Schedule III substances.

Additionally, the Department of Justice’s Office of Legal Counsel (OLC) reinforced this view in April 2024, suggesting a more flexible approach to defining accepted medical use. The OLC found that the Drug Enforcement Administration (DEA) had an overly narrow interpretation and supported HHS’s two-part test for recognizing medical applications of a substance.

However, the binding nature of HHS’s recommendations on the DEA remains uncertain. The OLC clarified that HHS’s determinations are binding until the DEA begins formal rulemaking, yet it must still give significant weight to HHS’s findings. Practically, this means that the DEA cannot overlook HHS’s conclusions regarding cannabis’s medical use and lower abuse potential, even if formal rescheduling has not yet occurred.

Despite this shift in expert opinions, the IRS has maintained a strict stance, insisting that 280E remains in effect until cannabis is officially rescheduled. In mid-2024, the IRS reminded cannabis companies that claims for refunds on 280E taxes were invalid, citing the unchanged Schedule I classification of marijuana. The agency’s position hinges on the formal label rather than the substance of the law, ignoring the critical language of 280E that refers to the characteristics of the substance.

The IRS’s interpretation raises questions about the application of tax law. If Congress intended for 280E to depend solely on the DEA’s scheduling label, it could have explicitly stated so. Instead, the law refers to the controlled substances’ definitions, opening the door to a challenge against the IRS’s rigid application of 280E.

Cannabis operators have also faced barriers in utilizing Internal Revenue Code Section 471(c), which allows qualifying small businesses to adopt inventory accounting methods aligned with their financial records. This provision could enable cannabis businesses to classify a wider range of expenses, such as rent and payroll, as inventory costs, allowing them to deduct these expenses from their taxable income. However, IRS guidance attempted to block the use of 471(c) for cannabis businesses, stating that it could not be used for expenses otherwise disallowed, a move that discouraged most accountants from applying this method.

Despite the IRS’s efforts to limit the applicability of 471(c), many tax professionals still advocate for its use, especially for smaller operators with gross receipts under $29 million. This strategy has proven effective in helping clients reduce tax liabilities while remaining compliant with the law.

While pursuing amended returns for tax refunds carries risks, the potential relief for cannabis companies could be significant. Alternatively, some may opt to move forward without revisiting past returns. Both approaches are valid but require careful consideration of the tax implications and risks involved. Navigating the complexities of the tax code, particularly with evolving cannabis regulations, remains a critical focus for cannabis businesses aiming to achieve tax fairness.