Department of Health and Human Services Recommends that Cannabis be Rescheduled as a Schedule III Drug Under the Controlled Substances Act

On October 6, 2022, President Biden pardoned all Federal offenses of simple possession of cannabis. On that same day, Biden directed the Secretary of Health and Human Services and the Attorney General to commence the administrative process for reviewing how cannabis is classified under federal law. That action has now led to the U.S. Department of Health and Human Services (“HHS”) recommending in an August 29, 2023 letter to the Drug Enforcement Administration (“DEA”), that cannabis, currently a Schedule I drug under the Controlled Substances Act (“CSA”), be reclassified as a Schedule III drug. Now the ball is in the DEA’s court. Should the DEA agree with HHS, we could be on the verge of the largest change in US policy on cannabis since 1970.

Schedule I vs. Schedule III: The Big Differences

The CSA consists of five schedules, with substances classified into a schedule based on whether they have a medical use and their potential for abuse. Since 1970, cannabis has been a Schedule I drug, meaning it has no accepted medical use and a high potential for abuse.¹ Examples of other Schedule I drugs are heroin, LSD, and MDMA (“ecstasy”). Schedule III drugs, on the other hand, have an accepted medical use and are considered to only pose a moderate risk for abuse or addiction. In this context, moderate potential for abuse means that the substance can lead to low or moderate physical dependence or high psychological dependence. Thus, it can apply to substances that do not possess physically-addictive qualities. Schedule III drugs are frequently prescribed by doctors and include drugs such as Tylenol with codeine and testosterone.

There are two ways a substance can be moved to a different schedule under the CSA. The first is by an act of Congress. The second way is through the Department of Justice’s (“DOJ”) regulatory rulemaking which, as an initial step, requires a determination that a substance has an accepted medical use by HHS. Many state legislatures have long recognized that cannabis has a medical use, but the federal government has not. While the letter to the DEA has not been made publicly available, the fact that HHS recommends cannabis be reclassified as a Schedule III drug means it is likely the first instance of the federal government recognizing cannabis as having an accepted medical use.² Thus, the HHS letter is a potentially significant initial step that would enable the DOJ to reschedule cannabis through its standard rulemaking process, without Congressional approval.

HHS’s August 29^th letter does not guarantee that cannabis will be reclassified as a Schedule III drug; rather, the DEA, as part of the DOJ, can now initiate its own review of cannabis and make a determination regarding whether it should be rescheduled. If the DEA agrees with HHS and seeks to reschedule cannabis, the DOJ would initiate rulemaking procedures, including providing public notice of the proposed changes and allowing for a public comment period.

Implications of Rescheduling for Cannabis Operators

If cannabis is rescheduled to Schedule III, there could be a number of important benefits for operators in the US cannabis industry. The most significant benefit would be the elimination of the “280E penalty.” Section 280E of the Internal Revenue Code generally disallows tax deductions for ordinary and necessary business expenses, other than those properly treated as cost of goods sold, incurred in connection with a business trafficking in Schedule I or Schedule II controlled substances. As a result, cannabis operators are generally subject to very high effective income tax rates and pay more cash income taxes than other businesses. Here is a simplified example of how the 280E penalty impacts cannabis operators today:

As demonstrated in the example above, a cannabis business with the same amount of revenue and expenses as a traditional business can realize an after-tax cash loss due to Section 280E while the traditional business realizes an after-tax cash profit. However, the reclassification of cannabis to Schedule III would mean that Section 280E would no longer apply to cannabis operators and they would be able to deduct their ordinary and necessary business expenses to the same extent as traditional businesses. For many cannabis operators, this would have a significant and positive impact on their cash flows and profitability.

In addition to the tax benefits, the rescheduling of cannabis could prove to be an economic boon for operators in other ways. It could lead more banks and payment processors to do business with cannabis operators. Presently, operators pay higher interest rates for loans and have limited access to financial services. Due to the inherent risk associated with a Schedule I substance, insurance policies, where available, provide less coverage and demand higher premiums than comparable policies for non-cannabis businesses. A rescheduling of cannabis could greatly reduce the business expenses of operators.

The rescheduling of cannabis would also remove federal hurdles to transporting medical cannabis across state lines. This could lead to states with better cultivation climates dominating the market and provide new sales territories for operators in states that typically grow more cannabis than their residents can consume (like Oregon and California), and that in turn could help curb the persistent illicit market in those states.

Practical Effects of Rescheduling

However, rescheduling cannabis would not eliminate all the challenges facing the cannabis industry today. Just because cannabis is deemed to have accepted medical uses does not mean all products currently offered at medical dispensaries would instantly become federally legal, allowing patients to use medical prescriptions to receive insurance coverage. The Food, Drug, & Cosmetic Act grants the FDA the authority to oversee pharmaceutical products, and rescheduling cannabis would still require FDA approval to be sold at traditional pharmacies. The rescheduling of cannabis to Schedule III would certainly increase the ability for medical studies to be performed, and lead to New Drug Applications (“NDAs”) being submitted to the FDA for approval of cannabis-based drugs which may look vastly different from currently-available medical cannabis products. Further, the FDA may seek to take action against non-FDA approved cannabis products marketing themselves as having medical benefits.

Rescheduling cannabis also would have implications for the adult-use market. Schedule III drugs generally require a prescription to obtain, and therefore adult-use cannabis would remain federally illegal absent additional steps taken by the federal government. Rescheduling may also disincentivize efforts to pursue federal legalization or descheduling of cannabis, resulting in a continued conflict between federal and state law related to adult-use cannabis.

Conclusion

Make no mistake: HHS’s August 29, 2023 letter is the most significant shift in the federal government’s position on cannabis in over 50 years. And, if the DEA follows HHS’s lead and cannabis gets rescheduled to Schedule III, there would be important implications for the US cannabis industry, especially with regard to 280E.

^[1] Cannabis appears in the CSA as marihuana. Previously, Congress elected to exclude hemp, defined as the plant cannabis sativa, and any parts of that plant, containing no more than 0.3% delta-9 THC on a dry weight basis, in the 2018 Farm Bill.

^[2] In 2018, the FDA approved Epidiolex, a cannabis-derived cannabidiol use for treatment of certain forms of intractable epilepsy in children. The FDA previously approved dronabinol, a synthetic delta-9 THC, for HIV-induced anorexia and chemotherapy-induced nausea. Despite the existence of these drugs, the federal government had maintained the position that cannabis did not have an accepted medical use.

^[3] For the purposes of this example, we have used a blended effective tax rate of 30% for illustrative purposes. The actual effective tax rate for a cannabis operator will depend on, among other things, where it does business and the tax classification of the business (e.g., corporation vs. partnership).