Recent federal action by the Department of Justice (DOJ) to reschedule certain cannabis products approved by the Food & Drug Administration (FDA) and state-licensed medical cannabis programs from Schedule I to Schedule III under the Controlled Substances Act constitutes a significant shift in cannabis taxation. While most commentary has focused on the federal income tax implications, the state tax impacts are equally complex and, in many cases, detached from federal outcomes. In addition to being potentially decoupled from federal income tax rules, the hodgepodge of state tax rules varies across the country and can lead to some perplexing and costly outcomes that require careful planning and forecasting.

Income tax effects of rescheduling

Since most state & local corporate and pass-through entity net income tax codes are based on some version of the Internal Revenue Code (IRC) by reference to federal taxable income or adjusted gross income, consideration of the potential impacts of the DOJ’s reclassification order begins with an understanding of the taxing state’s conformity to the IRC. Since IRC § 280E prohibits businesses that deal in Schedule I or II controlled substances from deducting ordinary and necessary business expenses for federal income tax purposes, the state net income tax base should not permit IRC 280E expenses absent a specific state legislative modification.

Therefore, the question of whether the taxing state has decoupled from IRC § 280E (and specifically how and when) is a central inquiry that will impact the potential effects of DOJ rescheduling for state income tax purposes.

There is no consistent approach to decoupling from IRC 280E across the country. Several jurisdictions have broad decoupling language which applies to any taxpayer engaged in a cannabis business, while other states have more specific language which only applies to cannabis businesses licensed under the state’s medical and/or adult-use programs. Due to these differences in how a state may have conformed or decoupled from IRC § 280E prior to the DOJ’s rescheduling order, the proposed reclassification will create additional financial and compliance considerations on a multistate basis.

In addition, these conformity variations create distortive effects in relation to combined/consolidated reporting and expense allocation, while also raising a potential constitutional problem.

Distortion results from scenarios in which states that compel combined or consolidated filings, including all group members’ income in the taxable base, while simultaneously limiting IRC § 280E decoupling to only in-state licensed entities. Such a scenario potentially creates significant tax costs for multistate operators by limiting the benefit of rescheduling to the in-state group members while effectively preserving the § 280E prohibitions for the out-of-state group members, resulting in an outcome where the taxpayer is unable to fully benefit from the effect of rescheduling. This disparate treatment also raises a potential constitutional infirmity: whether such discrimination against out-of-state licensed entities violates the Dormant Commerce Clause.

In separate filing jurisdictions, taxpayers will need to mitigate the temptation to allocate more costs toward medical cannabis entities in an effort to reduce the tax burden in these jurisdictions. Expense allocations that go beyond the scope of reasonableness or that are the result of non-arm’s length intercompany agreements present the risk of state taxing authorities applying intercompany add-back, economic substance, or forced combination rules. The result of this is increased separate state compliance complexity and/or increased risk of post-filing exposure.

Additionally, states with broad uniformity clauses or provisions in their state constitutions – requiring uniform treatment of similarly-situated taxpayers – the disparate treatment that will be caused by the DOJ order and reclassification could be problematic from a legal perspective. Such legal issues increase the risk of litigation and compliance complexity and cost.

Beyond the scope of filing compliance and forward-looking risk, rescheduling heightens audit and refund activity risk to taxpayers. Rescheduling raises the prospect of taxpayers reassessing prior state positions taken under decoupling statutes and audit and controversy strategies. As a result, it may be necessary to evaluate ASC 740 uncertain tax position reserves posted in response to IRC § 280E exposures. The changes may require reassessment at both the entity and combined-group level as state conformity outcomes are realized and modeled.

Rescheduling impacts to indirect taxes

Cannabis legalization at the state level has had the benefit of increased revenue for states that impose a sales tax and/or excise tax on the sale of adult use cannabis and, to a lesser extent, on the sale of medical cannabis, due to most states adopting differing indirect tax schemes for medical versus adult-use cannabis programs. If states take steps to expand their medical cannabis programs or to limit the adult-use programs in response to federal rescheduling, this may have an unintended impact on state revenue. Shifts away from adult-use programs will create a need to make up the missed sales tax revenue by either imposing retail sales taxes on medicinal cannabis products or increasing/imposing new excise taxes on cultivators, processors, extractors, wholesalers, distributors, etc.

Another related point is that as cannabis cultivation, processing, and extraction activities continue to expand, gain regulatory approval, and become more synonymous with traditional agricultural, processing, and manufacturing activities, there are a number of potential tax incentives that may be available for investments in new equipment and hiring, training, or retaining employees engaged in these activities. These incentives may include sales & use tax exemptions for agricultural, processing, and extraction equipment in addition to utilities used in these processes, in addition to various income tax credits for hiring, training, and retention of employees engaged in a production and agricultural process.

Finally, from a local business privilege or license tax perspective, there are unique tax computations and exemptions available to businesses engaged in manufacturing, processing, agriculture, or extraction activities. These activities and applicable code definitions must be analyzed for tax savings or exposure items related to incorrect product/sales classification, expanded definitions of manufacturing and processing, and intercompany transactions between related cannabis entities engaged in separate agricultural, processing, or extracting activities.

What does CohnReznick think?

The DOJ’s order rescheduling cannabis from a Schedule I to Schedule III under the Controlled Substances Act creates significant state tax complexities and potential opportunities for medical and adult-use cannabis industry members. Since many of the associated income and franchise tax issues created by the reclassification may require legislation or corrective regulations and administrative guidance, the state issues caused by rescheduling will not likely be resolved quickly. In light of the potential for increased tax compliance and accounting considerations and heightened risks over uncertain tax positions, careful jurisdiction-by-jurisdiction analysis remains essential, particularly in mandatory combined reporting jurisdictions.

In addition to helping taxpayers navigate the changes to state tax law and mitigating against the negative income tax implications associated with the rescheduling, CohnReznick’s federal, state, and local tax professionals have been working with several cannabis companies to identify sales and use tax savings and applicable incentives on various cultivation, processing, and extraction ingredients, equipment and tools, packaging equipment and supplies, and certain utilities, in addition to job-related benefits.