Rescheduling Marijuana: Tax Consequences | Tax Foundation
The Department of Justice (DOJ), announced recently that it would move towards rescheduling 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. Across the United States, different approaches have been taken. The majority of states legalize cannabis for medical purposes and nearly half for recreational use. States where the sale of marijuana is legal has generated significant
taxAn tax is a mandatory payment collected by local, national, and state governments from individuals and businesses to cover costs of government services, goods, or activities.
Revenue from cannabis sales. The federal government has a more restrictive approach. Schedule I drugs have a high abuse potential and no accepted medical use. The DOJ has recently moved to reclassify cannabis as a Schedule II drug, recognising its medical uses and concluding it has a lower risk of abusing than other substances. This would mean that marijuana would no longer qualify for the exemption under Section 280E (Internal Revenue Code) which states that businesses engaged in the production, cultivation, or sale Schedule I drugs will not be eligible for the exemption. Many companies are exempt from the CIT, as they are taxed under the individual income taxes.
, 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. S corporations are business entities that elect to pass on their income and losses. S corporations (S Corp) are not subject to corporate income tax, unlike subchapter C companies.
or other forms of pass through businessA pass through business is a sole-proprietorship, partnership or S corporation which does not pay corporate income tax. Instead, it reports its income to the individual income taxes of the owners, and is taxed according to individual income tax rates.
the income is taxed by the owner under the individual tax. An individual income tax is levied against the wages, salaries or other types of income that an individual or household earns. The U.S. has a progressive income-tax system where rates increase as income increases. The Federal Income Tax was created in 1913, with the ratification 16th Amendment. Individual income taxes, which are only 100 years old but are the biggest source of tax revenue for the United States, have been around since 1913.
. In the United States, corporate income taxes are levied based on profits. Pass-through ownership income also counts as net income. Both cases begin with gross IncomeFor individuals, the gross income is their total pre-tax earnings, including wages, tips and investments. For businesses, it is total revenue less cost of goods sold, 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 the accountant who works for the business’s internal audit A tax audit is conducted by the Internal Revenue Service to verify that an individual or corporation accurately reported and paid its taxes. The IRS may select a person or company at random or based on unusual deductions or income.
In a normal business, both expenses would be subtracted from total income and the end difference would be the business’s
taxable income. In a normal business setting, the total income would be subtracted and the difference would be the taxable business income. Taxable income is the income that is subject to tax after deductions and exclusions. Taxable income is lower than gross income for both individuals and corporations.
. 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 normally result in a federal income tax bill of $2,000 (a 21 percent tax based on a net income of $10,000). A cannabis business, however, would have to pay 21 percent because it can’t deduct its operating costs. This leaves a tax bill for $11,550 which is an effective rate of almost 116% on net income. The same analysis would also apply to a pass through business, but it would be taxed at the owner level under individual income tax. In 2022, a survey of cannabis companies found that less than 25% 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 competition in the industry, which would drive innovation and investment. Rescheduling will also reduce tax code complexity and compliance cost, which can be so burdensome that many cannabis companies have changed the entire business model and ownership structure (e.g. shifting to employee stock ownership plan) to qualify for a different, more favorable treatment. The federal tax rescheduling would end the harsh treatment of cannabis businesses for a long time. 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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