Much has been written over the last week about the recommendation by Attorney General Merrick Garland to loosen restrictions on cannabis. That recommendation would, among other things, reclassify marijuana from its current status as a Schedule I substance, similar to heroin and LSD, to a Schedule III substance, similar to prescription drugs such as anabolic steroids, ketamine, and testosterone. Given that Schedule II substances include fentanyl, hydromorphone, meperidine, methadone, morphine, oxycodone, dextroamphetamine, methylphenidate, methamphetamine, pentobarbital, and secobarbital, it has long been questioned why marijuana would be subject to significantly greater regulatory scrutiny than these Schedule II substances that have been directly responsible for so many deaths, hospitalizations, addictions, and broken families in the U.S. and around the world over the last two decades.

Many of the articles and comments following the Attorney General’s recommendation have focused on the immediate federal income tax consequence of rescheduling marijuana. As the Washington Post noted:

Under Internal Revenue Code Section 280E, businesses that sell Schedule I substances cannot deduct business expenses, resulting in a substantially higher tax rate for companies that grow and sell marijuana. But with marijuana reclassified, they will be eligible for the tax breaks.

Industry groups say the shift could propel some businesses into profitability when they no longer have to pay an effective tax rate of roughly 70 percent or more.

Nirappil, Fenit. “What Marijuana Reclassification Means and the Effects of Rescheduling.” Washington Post, 1 May 2024. Available at: (Accessed: May 3, 2024).

While it is certainly true that cannabis businesses will be subject to a lower effective federal tax rate should the proposed rescheduling be implemented (and not reversed by a future occupant of the White House), there is another potential tax consequence that must not be overlooked.

Many cannabis businesses are classified as “C corporations” for U.S. federal income tax purposes.[1] A C corporation is subject to federal (and corresponding state and local) income tax at a flat rate of 21%. Distributions from a C corporation to its shareholders classified as dividends are subject to a further federal (and corresponding state and local) income tax of 23.8%. As a result, the full federal tax burden on the profit of a C corporation reaches 44.8% (plus state and local income tax, where applicable).

Section 280E of the Internal Revenue Code of 1986, as amended (“Section 280E”), generally limits the deductibility of operating expenses incurred by Schedule I and Schedule II businesses. As a result, the profitability of many cannabis businesses has been artificially reduced through excessive taxation. Such excessive taxation has also depressed the corresponding enterprise value of these businesses.

Given the highly punitive financial effect of Section 280E, it is understandable why commenters would be focused on the annual financial impact rescheduling would have on cannabis businesses. What is less emphasized is the impact rescheduling will have on the tax consequences of a future sale of such businesses.

It is common for owners of any business to have an exit strategy, which is simply an approach to selling or transferring ownership once the business reaches a certain milestone or value. Common exit strategies include, among other things, selling to a strategic buyer (a “Buyer”).

Generally, a Buyer typically prefers acquiring business assets and not the equity of the business. Such preference is primarily driven by two desires. First, a Buyer would logically be hesitant to assume the historical risks associated with the business, especially those risks that may currently be hidden from view, e.g., past regulatory infractions, labor issues, tax history, etc. Second, a Buyer generally prefers to acquire assets because the adjusted basis of the purchased assets is increased to fair market value (based on the purchase price) thereby allowing a Buyer to monetize its acquisition cost through immediate depreciation and amortization deductions.

The sale of assets by a C corporation results in the imposition to the seller of federal (and corresponding state and local) income tax on the resulting gain, as well as imposition of an income tax against the equityholders on a dividend of the after-tax sale proceeds.

Recognizing that depreciation and amortization are currently of no financial benefit to cannabis retailers (although of some benefit to growers and processors) as a result of Section 280E, and since a solid indemnity or representation and warranty insurance can overcome the first-mentioned risk above, a Buyer may currently be willing to enter into an equity purchase agreement.

However, following the proposed rescheduling the tax calculus will change significantly. A Buyer will want to immediately monetize its investment through depreciation and amortization deductions thereby preferring an asset purchase.[2] As noted, asset purchase transactions will result in the imposition of double tax at the federal, state, and local levels for cannabis businesses taxed as C corporations.

A tax-efficient asset sale requires the seller to be classified either as a partnership[3] or an S corporation for federal income tax purposes thereby resulting in a single level of tax at an overall lower effective tax rate than would apply in the C corporation context. Generally, transitioning from a C corporation to a partnership (or S corporation) can be accomplished fairly easily and with minimal or no tax cost. Such a transition may also be accomplished without changing the legal form of the operating business, e.g., as a limited liability company, or by a simple entity conversion, e.g., from corporation to limited liability company.

What is most critical is the timing of the change in tax classification. As current Schedule I businesses, the enterprise value of most cannabis businesses is artificially depressed given the significant financial burden imposed by Section 280E. With the (proposed) change in regulatory scheduling goes a corresponding change in enterprise value. In other words, as the profitability of a cannabis business increases following rescheduling, so will its corresponding enterprise value.

What is most important is to make the tax classification change from C corporation to partnership (or S corporation) before the enterprise value of the business increases significantly. A timely change in tax classification will cause future asset appreciation to be captured in a more tax-efficient operating structure thereby freezing (or potentially eliminating) the lower enterprise value associated with the historic C corporation.

A comprehensive discussion of the steps required to implement a more tax-efficient operating structure is beyond the scope of this Tax Alert. What is important to take away from this Tax Alert is the need to timely align the financial impact of the shift to Schedule III with the corresponding change in your exit strategy.

If you would like more information regarding the tax impact of the proposed rescheduling on your cannabis business, please contact, Lance Boldrey ([email protected] or (517) 374-9162), John Fraser ([email protected] or (517) 374-9140), Scott Kocienski ([email protected] or (248) 203-0868), Richard Lieberman ([email protected] or (312) 627-2250), or your local Dykema relationship attorney.

[1] For federal income tax purposes, a limited liability may elect to be classified as a C corporation by filing Internal Revenue Service Form 8832. The following discussion is intended to include entities organized under state law as either corporations or limited liability companies as “C corporations.”

[2] It should be noted that most of the purchase price would be allocated to intangible assets, including goodwill and going concern value, for which amortization deductions are spread evenly over a 15-year period. Although the immediate financial benefit arising from amortization expense is limited, the time value of money remains relevant to a Buyer.

[3] Such partnerships include a general or limited partnership, or a limited liability company that is classified as a partnership for federal income tax purposes.