The Times, They Are a-Changin’: Maximizing Tax Benefits from Cannabis Rescheduling

Schedule I drugs are defined as drugs with no currently accepted medical use, a high potential for abuse and a lack of accepted safety for use of the drug under medical supervision. Schedule III drugs are classified as having a potential for abuse less than the drugs or other substances in schedules I and II, a currently accepted medical use in treatment in the United States, and a potential for moderate or low physical dependence or high psychological dependence in the event of drug abuse.

Section 280E Background
By way of background, Code § 280E is a tax rule that supplements criminal tax laws against drug dealing. Specifically, Code § 280E disallows any trade or business expense incurred in “trafficking in controlled substances (within the meaning of schedule I and II of the [federal] Controlled Substances Act) ….”^[4] The federal Drug Enforcement Agency (DEA) has designated cannabis as a schedule I controlled substance.^[5] The IRS has successfully asserted that Code § 280E applies to cannabis businesses even when operating in states that have legalized cannabis usage.^[6]

The cost of goods sold is not a deduction and, therefore, is not subject to Code § 280E.^[7] Thus, amounts properly added to inventory in a cannabis business are effectively deductible as these amounts reduce gross income. This dichotomy between expenses categorized as trade or business expenses (which are non-deductible) and the cost of goods sold (which is effectively deductible) has created a strong incentive on the part of cannabis businesses to expansively apply the inventory capitalization rule contained in Code § 263A. One significant challenge to this approach is that Code § 263A(a)(2) does not permit the capitalization of nondeductible costs. Code § 263A, however, does not apply to businesses with annual average gross receipts of less than $25 million.^[8] Thus, smaller cannabis businesses can benefit from the application of Code § 263A.

In addition to taking an expansive view on inventory capitalization, cannabis businesses have adopted two strategies to mitigate the impact of Code § 280E. First, cannabis businesses have segregated business activities that directly involve cannabis production, distribution or sale from other parts of their businesses. These other parts include ancillary services and cannabis-related products. Many cannabis businesses rely heavily on the Tax Court decision in Californians Helping to Alleviate Medical Problems, Inc. v. Comm’r^[9] in implementing this strategy. In this case, the taxpayer established that its medical marijuana dispensary business was separate from providing health care services to AIDS victims.^[10] Accordingly, the taxpayer was permitted to deduct the costs of providing health care.

The possible successful application of these strategies has been highlighted by the announcement by Trulieve, a publicly-traded multistate cannabis business. At the end of February 2024, Trulieve reported that it had received federal tax refunds of $113 million attributable to claims that Code § 280E did not apply to all business expenses incurred by the company. Trulieve’s chief financial officer stated:

Given the uncertain position of the claims as they sit today, we do view that as ‘trade secret’ and in large part specific to our position and our organization. We are not going to be sharing that information publicly given the fact that it is in or could be in a litigation posture, and specifically that information would become available if and when we actually get to a court filing.^[11]

Accordingly, while it is not possible to know exactly how Trulieve determined that it was entitled to a federal income tax refund, it felt comfortable enough to file the claim.

The Trump Executive Order and Section 280E
While the executive order does not address federal income tax, rescheduling to schedule III should eliminate the application of Code § 280E for cannabis businesses. Once Code § 280E is no longer applicable to cannabis businesses, those businesses could realize substantial reductions in federal income tax liabilities and access deductions and credits that have been unavailable to them. A key issue for cannabis businesses is the timing of when Code § 280E would cease to apply—whether relief would apply (i) upon publication of a final rescheduling rule, (ii) retroactively to the beginning of the year in which rescheduling occurs (or earlier), or (iii) only to tax years beginning after the close of the taxpayer’s tax year in which the final rescheduling occurs (the “Deferred Rescheduling Approach”).

If the IRS’ position is that the Deferred Rescheduling Approach should apply, then taxpayers are likely to miss out on many additional months of deductions and credits. For example, it is possible that the final rescheduling rule is effective as of January 31, 2026, and the IRS specifies that Code § 280E ceases to apply to tax years beginning on or after February 1, 2026. If a taxpayer in the cannabis business has a tax year that matches the calendar year, Code § 280E will not cease to apply until 2027. Such a rule would mean that the cannabis business will not be able to take advantage of tax deductions and credits for its business until 2027—effectively losing out on almost an entire years’ worth of tax deductions.

The Planning Instinct
If relief begins only in the year following rescheduling, a taxpayer may ask: Can I change the tax year for the business so my “next” year begins sooner? Using the example above, the taxpayer would desire to change its tax year to February 1 through January 30, beginning in 2026. In concept, yes—a taxpayer could create a short period ending shortly after the reclassification event (January 30, 2026), so that the first post-reclassification tax year begins earlier than it otherwise would (February 1, 2026, instead of January 1, 2027). However, the federal tax rules governing changes in annual accounting periods impose meaningful constraints. Two categories of limitations are most significant: (i) business purpose requirements, and (ii) structural limitations that apply specifically to S corporations and partnerships.

Business Purpose
A taxpayer generally must establish that there is a “business purpose” for a taxable year change. Deferral of income and improving tax outcomes generally are not treated as valid business purposes.^[12] However, if a C Corporation is allowed an automatic approval (as described below), then it is treated as having established a business purpose.

C Corporations
For C corporations, automatic approval requests are governed under Revenue Procedure 2006-45, as modified by Revenue Procedure 2007-64. The automatic approval request is generally allowed as along as the C corporation seeking a tax year change files a Form 1128, complies with the procedure’s conditions, and does not fall into an “inapplicable” category. Helpfully, the request for an automatic change can be filed by the due date (including extensions) for the federal income tax return for the first effective year of the change.^[13]

A C corporation is not permitted to use the automatic approval rules if it falls within an inapplicable category, including (among others): (i) the corporation changed its annual accounting period within the prior 48 months, (ii) the corporation has an interest in a pass-through entity, (iii) the corporation is a controlled foreign corporation (CFC), or (iv) the corporation is leaving a consolidated group. If the corporation qualifies for and complies with the automatic approval rules, it is automatically treated as having established a business purpose. Accordingly, for a C corporation that is not within an inapplicable category and can comply with the procedural requirements, a taxable year change should be feasible.

S Corporations and Partnerships
In contrast, S corporations face additional constraints. Under Revenue Procedure 2006-46, an S corporation generally can only change to a “permitted year.” Generally, a permitted year includes: (i) a year ending on December 31, (ii) a taxable year elected under Code § 444 (which generally only allows for September 30, October 31 and November 30 year-ends); (iii) natural business years meeting a 25% gross receipts test; (iv) an ownership taxable year; (v) certain 52–53 week taxable years; or (vi) any other accounting period for which the S corporation establishes to the satisfaction of the IRS has a “business purpose.”

Thus, as a practical matter, unless an S corporation qualifies for one of the listed permitted-year categories (or can establish a business purpose acceptable to the IRS), it may be difficult to implement a taxable year that begins only a few months after rescheduling for purposes of accelerating the first post-rescheduling year.

Similarly, a partnership generally must use its “required taxable year.” Under Revenue Procedure 2006-46, the required taxable year is usually determined by reference to the taxable years of the partners. As with S corporations, these constraints typically make it less likely that a partnership can adopt a taxable year beginning only a few months after 2026, absent a favorable taxable year of the partners or a business purpose.

If an entity is able to change its tax year, additional considerations are warranted, including considering operational and accounting implications.

Concluding Thoughts
If the IRS adopts the Deferred Rescheduling Approach when cannabis is rescheduled from schedule I to schedule III, cannabis businesses operating in partnership and S corporation structures may become highly incentivized to elect to become taxable as C corporations. Partnerships that choose to make this change by way of election will be able to do so up to 75 days prior to the date on which the election is effective.^[14] S corporations can effectively elect to be taxed as C corporations at any time by deliberately taking an action, such as transferring any amount of stock to a disqualified shareholder, that results in the S corporation failing to meet the requirements to be taxed as such.^[15] In the current rate environment, unless the partnership or S corporation expects to recognize significant long-term capital gains, there may not be significant federal income tax downsides for such businesses to operate in C corporation formats. C corporations may desire to ensure that they are eligible for automatic change elections, including revisiting partnership structures, in the near term in order to be prepared for a Deferred Rescheduling Approach.

Pillsbury is closely monitoring these federal policy developments, and proactive planning will be increasingly important as the federal tax landscape continues to evolve.

^{[1] Executive Order on Increasing Medical Marijuana and Cannabidiol Research, The White House (Dec. 18, 2025), https://www.whitehouse.gov/presidential-actions/2025/12/increasing-medical-marijuana-and-cannabidiol-research/.}

^{[2] All “Code §” references are to the Internal Revenue Code of 1986, as amended.}

^{[3] See Statement by the Senator Budd Opposing Marijuana Rescheduling https://www.budd.senate.gov/2025/12/18/senator-budd-releases-statement-opposing-marijuana-rescheduling/ (Dec. 18, 2025).}

^{[4] The Controlled Substances Act is codified as P.L. 91-513. Code § enacted in response to the Tax Court decision in Edmondson v. Comm’r, 42 TCM 1533 (1981).}

^{[5] See Congressional Research Service (CRS) Report R44782, The Evolution of Marijuana as a Controlled Substance and the Federal-State Policy Gap (Updated April 7, 2022).}

^{[6] Oakland Cannabis Buyer’s Co-op, 532 US 483 (2001); Canna Care, Inc. v. Comm’r, TC Mem. 2015-206, aff’d 694 F. App. 570 (9th Cir. 2017); California Small Bus. Assistants Inc. Comm’r, 153 TC 65 (2019); See IRS, Cannabis Industry Frequently Asked Questions, I operate a business that consists of selling marijuana. Can I claim deductions to determine my taxable income?}

^{[7] Treas. Reg. § 1.62-3(a).}

^{[8] Code § 263A(i)(1). In addition, Code § 471(c) provides businesses with annual average gross receipts of less than $25 million to apply an expansive view of cost capitalization provided that the capitalization comports with the company’s books and records. In a 2021 Chief Counsel Memorandum, the IRS opined that a taxpayer electing to capitalize costs under Code § 471(c) could capitalize certain purchasing costs, certain storage and handling costs, and costs of preparing the goods for resale (including inspection costs, packaging costs, and the labor associated with these activities) and of reselling the goods (selling expenses, including associated labor costs) even though these costs would not be capitalizable for a corporation that did not meet the $25 million gross receipts test.}

^{[9] 128 TC 173 (2002).}

^{[10] Other taxpayers, selling cannabis paraphernalia, have not received similar results. See Alterman and Gison v. Comm’r, T.C. Mem. 2018-83.}

^{[11] Simakis, Trulieve Reports Receiving Refund For 280E Taxes Paid (Cannabis Business Times) (February 29, 2024).}

^{[12] See, e.g., IRC Section 1378; Rev. Proc. 2002-39.}

^{[13] Rev. Proc. 2006-45, § 7.02(2)(a).}

^{[14] Treas. Reg. § 301.7701-3(c)(1)(iii).}

^{[15] Code § 1361(d)(2).}