May 30, 2024

Changing the Schedule, Changing the Game: How Cannabis Rescheduling is Transforming the Industry

By Neil Prasad, Partner, Midwest Capital Markets & National Cannabis Practice Leader

Changing the Schedule, Changing the Game: How Cannabis Rescheduling is Transforming the Industry Cannabis

In a potentially historic move, the Biden administration has formally proposed moving a policy change that could revolutionize the cannabis industry by upending decades of stringent drug classification. Rescheduling of cannabis from the restrictive Schedule I to the more permissive Schedule III category under the Controlled Substances Act promises to rattle the foundations of existing regulations, offering a glow of hope for businesses and patients alike.

The current Schedule I classification places cannabis alongside substances deemed to have “no currently accepted medical use and a high potential for abuse,” which imposes strict regulatory barriers, including restrictions on research, manufacturing, and prescribing. In contrast, transitioning to Schedule III, a category for drugs with “a potential for abuse less than substances in Schedules I or II and a currently accepted medical use in treatment,” would alleviate some of these restrictions.

Some believe that businesses could likely face less scrutiny and fewer risks, allowing for expansion and easier access to banking services, insurance, and investment or working capital, as financial institutions would no longer face the stigma and regulatory prohibitions with an industry associated with Schedule I substances; however, it should be noted that it may not be that easy if those businesses also operate in the recreational, or adult-use, markets. This could trend towards normalizing business operations for medical use, reducing the reliance on cash transactions, and increasing financial security and transparency. But it doesn’t come without a flurry of questions.

  • Will it extend to recreational or adult use?
  • If medical use products are paid for using electronic/digital payment mediums, do companies have secured IT platforms to mitigate the risk of cyberattacks or fraud?
  • Do companies’ software/technology-based vendors provide Service Organization Controls (“SOC”) reports to verify that an organization follows specific best practices before outsourcing a business or IT function to that organization?
  • Do companies have the proper internal resources or access to external resources to implement complementary user entity controls (CUECs) and to help ensure data security and maintain effective internal control operationally and over its financial reporting function?

Importantly, rescheduling could change the applicability of federal tax rules such as Section 280E of the Internal Revenue Code, which currently disallows cannabis businesses from claiming deductions and credits for business expenses that are allowable by businesses not deemed to be in the business of trafficking Schedule I or II substances. Could the relief of this business-level tax burden (potentially excise taxes) ultimately benefit consumer patients with lower prices? Could it also have ancillary benefits on prices for recreational users as well? Could the increased competition lead to a decline in the illicit market and increased enforcement?

Researchers could more freely investigate cannabis’ therapeutic potential, leading to a deeper understanding of its benefits and side effects. This could foster an influx of pharmaceutical investment and the development of new cannabinoid-based medications approved by the FDA, improving patient access to regulated, quality-controlled medicinal cannabis products. Will it revive or ignite a green rush in Biotech/Life Science businesses?

The medical use of cannabis would likely be subject to Health Insurance Portability and Accountability Act (HIPAA) rules. HIPAA provides federal protections for personal health information held by covered entities and gives patients an array of rights with respect to that information. Under HIPAA, “protected health information” (PHI) includes any information about health status, provision of health care, or payment for health care that can be linked to an individual. This means that healthcare providers who discuss, prescribe, or document information related to a patient’s use of medical cannabis must handle that information with the same care and confidentiality as any other medical information, ensuring it is not labelled or disclosed improperly. Many businesses, including MSOs, have invested significantly in systems and infrastructure, but will it be enough to meet the requirements under HIPAA?

If cannabis were rescheduled to Schedule III, the implications for Section 280E of the Internal Revenue Code may depend on whether the rescheduling applies to cannabis in all contexts or solely for medical use. Rescheduling cannabis to Schedule III recognizes at the federal level that it has an acceptable medical use, potentially allowing businesses involved in medical cannabis to claim their business expenses as income tax deductions or credits. It also appears that the move to Schedule III pertains to cannabis regardless of its use. Therefore, the successful rescheduling would arguably take cannabis entirely out from the restrictions of Section 280E. Because, however, recreational use would still remain illegal under Federal law, it may be that the Treasury Department will issue new regulations or other guidance to impose rules similar to Section 280E for federally prohibited uses of cannabis. Tax Notes recently reported in a May 8, 2024 article that IRS Commissioner Daniel Werfel has committed to working with the cannabis industry to understand how the pending decision to reclassify marijuana would affect the industry’s tax obligations and to clear up any ambiguity.

As discussed earlier, SOC reports and sound internal controls are imperative to understanding how good a company’s systems and controls are in reliably capturing and accurately delineating medical and recreational/adult use sales and expenses. Are controls adequate such that restrictions of Section 280E, or similar rules may be enacted, are easily captured and discerned when applied to recreational/adult use?

It’s important to note that any changes to the tax code or federal law regarding the recreational use of cannabis would require action by the U.S. Congress in the form of a new statute, by the Treasury Department in the form of regulations, or the IRS in the form of more informal guidance such as Notices or FAQs. Until such legislative changes are made, the application of Section 280E will remain a complex legal and tax issue for businesses in the cannabis industry.

In essence, rescheduling cannabis to Schedule III would mark a departure from an era of prohibition towards a more evidence-based, economically beneficial approach, acknowledging both the medical value and the need for responsible regulation of cannabis. But will it be more on the winning side or create more complications, making it more challenging for cash-strapped businesses?

We certainly hope that the changes positively impact and revitalize the industry with increased capital infusion and formation, better and safer banking, mergers and acquisition activity, and more research, acceptance, and medicinal benefits for patients.

Marcum has served businesses, funds, investors, and individuals for many years by providing assurance, tax, and advisory services. Please get in touch with us for any of your accounting, auditing, tax, or advisory needs. We don’t know what legislatures and governmental agencies may do given an election year and the effect of other higher-priority worldly events, but we are here to assist you.

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