Does 280E Still Apply? Breaking Down Cannabis Taxation and Rescheduling

For cannabis business owners and investors, the IRS tax code provision Section 280E has long been a major obstacle. This law prevents businesses that “traffic” in controlled substances from deducting ordinary business expenses, significantly increasing tax burdens for state-legal cannabis operators. But with evolving legal interpretations and rescheduling discussions, many in the industry are questioning whether 280E still applies.

Understanding 280E and Its Impact

At its core, 280E disallows deductions for businesses engaged in selling controlled substances classified as Schedule I or II under the Controlled Substances Act (CSA). This means that state-legal cannabis businesses, unlike other industries, cannot deduct standard business expenses like rent, salaries, and marketing costs.

However, the cost of goods sold (COGS) is still deductible, allowing companies to recover their basis in inventory. This distinction has led to complicated tax strategies where operators structure businesses to maximize their COGS and minimize non-deductible expenses.

Why Was 280E Created?

• Originated in the 1980s after a convicted drug dealer successfully deducted business expenses for illegal drug sales.
• Congress responded by enacting 280E to prevent such deductions for controlled substances.
• Initially intended as an enforcement tool in the “War on Drugs”, but now disproportionately affects state-legal cannabis businesses.

Legal Challenges and the Future of 280E

Several legal challenges and IRS rulings in recent years have raised important questions about whether 280E is still enforceable. Two main arguments have emerged:

1. The Commerce Clause Argument

• Based on a Supreme Court case, Gonzalez v. Raich (2005), which ruled that Congress could regulate state-legal cannabis under the Commerce Clause.
• However, Justice Clarence Thomas later suggested that this ruling may no longer be valid, given that the federal government has since taken a “hands-off” approach to state-legal cannabis.
• The case Canna Provisions v. IRS challenges the constitutionality of 280E, arguing that because the federal government no longer enforces prohibition in legal states, the tax burden is unlawful.
• If successful, this could invalidate 280E for state-legal cannabis businesses, significantly reducing tax liabilities.

2. The Rescheduling and Timing Argument

• In 2023, the U.S. Department of Health & Human Services (HHS) recommended rescheduling cannabis from Schedule I to Schedule III.
• 280E only applies to Schedule I and II substances, so rescheduling cannabis to Schedule III would eliminate 280E’s restrictions.
• Some legal experts argue that because HHS has determined cannabis no longer fits the criteria for Schedule I or II, 280E should have already been inapplicable as early as 2018.
• However, the DEA’s review and legal challenges could delay the rescheduling process until 2025 or 2026, leaving businesses uncertain about their tax obligations.

IRS Crackdowns and Risk Mitigation

• The IRS issued a notice in December 2023, warning cannabis companies against amending past tax returns to claim refunds based on the argument that 280E is no longer applicable.
• The agency is actively monitoring tax filings and may impose penalties on businesses taking aggressive tax positions.
• Cannabis businesses seeking to challenge 280E should consider obtaining a formal tax opinion from legal and accounting professionals to establish a reasonable basis for their filings.

What Should Cannabis Businesses Do?

It’s important for cannabis businesses to approach the 280E issue with caution. While legal challenges and potential rescheduling may indicate a future change, it is not yet guaranteed, and businesses should not assume they can simply take the 280E position without a formal tax opinion or disclosure. The IRS has been clear that they will scrutinize aggressive tax positions, and businesses that do not have a reasonable basis for their filings could face significant penalties.

Before considering amendments to past returns or making claims related to the applicability of 280E, cannabis businesses should seek advice from tax experts to ensure they have a sound, well-documented position. A formal tax opinion from a qualified professional is crucial to establish that the position is reasonable under current law. Simply relying on the bullet points or assumptions from legal arguments will not be sufficient.

Additionally, if challenging 280E, businesses should complete all disclosures as part of their tax return to mitigate potential risks and protect against IRS penalties.

Looking Ahead: Will 280E Go Away?

With increasing federal recognition of cannabis, 280E may not last much longer. However, the timeline for change remains uncertain. Whether through court challenges, rescheduling, or legislative action, the industry is moving closer to a future where cannabis businesses are taxed like any other legal industry.

For now, cannabis operators must navigate the complex tax landscape carefully, balancing risk with opportunity.