The federal government has started to reclassify cannabis. When, and if, that reclassification is finalized, licensed cannabis businesses should see dramatically higher after-tax income and access to services from credit card companies and other financial institutions.

The United States Drug Enforcement Administration (“DEA”) has initiated the process to recategorize cannabis from a Schedule I drug to a Schedule III drug under the Controlled Substances Act (the “Act”). Under the Act, Schedule I substances are defined as those with no currently accepted medical use and a high potential for abuse. In contrast, Schedule III substances are considered to have accepted medicinal value with a relatively low potential for abuse.

Schedule III drugs are still controlled substances that are subject to federal regulation. Schedule III drugs must be prescribed by a physician and distributed by an entity registered with the DEA. Before physicians can prescribe it, cannabis must be approved by the United States Food and Drug Administration. Cannabis dispensaries must register with the DEA like regular pharmacies and will be subject to strict reporting requirements.

Easing federal regulations will help relieve the significant tax burdens on cannabis businesses. Internal Revenue Code Section 280E prohibits sellers of Schedule I and Schedule II substances from deducting ordinary and necessary business expenses – such as rent or payroll – on federal tax returns, resulting in tax burdens reaching upwards of 70% for some cannabis businesses. One industry research firm estimates that state-compliant cannabis businesses paid over $1.8 billion in excess taxes compared to non-cannabis businesses in 2022.

If cannabis is recategorized as a Schedule III drug, Section 280E will no longer apply to state-licensed cannabis businesses. Cannabis companies in states already allowing them to make 280E deductions on their state taxes will be able to make the same deductions on their federal taxes. Cannabis businesses in the majority of states whose policies mirror the federal code will be able to make 280E deductions on both their state and federal taxes post-rescheduling. This will result in annual savings of hundreds of thousands to millions for some businesses.

Reclassifying cannabis as Schedule III should also reassure banks and major credit card companies that currently consider it legally and financially too risky to service the cannabis industry. Although rescheduling cannabis will not completely legalize cannabis businesses under federal law, classification as a Schedule III drug would mean cannabis operations are not per se illegal. The federal government should, therefore, be less likely to penalize much less prosecute banks and credit card companies for working with such businesses. The reduced threat of federal enforcement combined with the increased income from reduced taxes should mean that credit card companies will be more likely to process credit card transactions and financial institutions more likely to provide loans and capital.

The timeline to reclassify cannabis could take months. Once the White House Office of Management and Budget reviews the rescheduling recommendation from Attorney General Merrick Garland, the Justice Department will publish a proposed rule in the Federal Registrar. The DEA will then take public comment on its rescheduling plan and interested parties may request a formal administrative hearing. Following public comment and administrative review, the DEA must review the entire record, respond to every comment submitted during the notice period, and publish its final order based on its analysis. The DEA’s final order will be effective 30 days after its publication in the Federal Registrar. This process may draw lawsuits that may further delay reclassification efforts. Additionally, if control of the White House and Justice Department changes hands, the proposed reclassification might be withdrawn or further delayed by personnel changes.

While the federal government’s move to make cannabis a Schedule III drug is a modest step toward the goal of descheduling and fully legalizing cannabis, it will take some time before cannabis businesses benefit from rescheduling efforts.

Nicole Matsuda

Cannabis Reclassification: Timeline and Impact

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