Podcast - DEA Plants the Seed for Rescheduling Marijuana: What's Next?

Michael Werner: Hello and welcome to the latest in a series of podcasts from the Holland & Knight Public Policy & Regulation team. I'm Michael Werner. I am the head of the firm's life sciences and FDA group. I'm joined by three of my colleagues today, Sara Klock, Josh Odintz and Ed Perlmutter. And we're going to be talking about the new proposed rule issued by the U.S. Drug Enforcement Administration on May 16 of this year that would move marijuana from its current classification as a Schedule I drug to a Schedule III drug. So under the Controlled Substances Act, the Schedule I drug has no currently medically accepted use and a high potential for abuse. Schedule I categorization means that not only is marijuana use — which would include sale distribution as well as ingestion — it's illegal federally, and also it means that researchers face strict restrictions regarding access to the product. And it means that businesses that manufacture, distribute or sell marijuana are unable to access the U.S. banking system, leaving businesses in the 31 states that have legalized marijuana unable to access safe banking. So as I noted, marijuana is scheduled as a Schedule I drug federally, but 38 states currently allow marijuana use for either medical, recreational purposes or both. So we're going to talk today about the new DEA proposal and its impact on federal regulation of marijuana, as well as the implications for state regulation. We're going to talk a little bit about the fact that the DEA action could have an impact on U.S. tax policy, as well as banking rules. And it's important to note at the outset of our conversation, this is a proposed rule from the DEA and it is absolutely subject to change. So why don't we start with you, Sara? Why don't you, if you would, provide a few more details about what the DEA proposal would do?

How Rescheduling Marijuana Would Affect Federal Regulations

Sara Klock: Thanks, Michael. Let me just back up really quick so everyone understands how marijuana/cannabis — I probably am going to use these two words interchangeably, but we'll define them shortly — how cannabis ended up as a Schedule I drug. So Congress actually enacted the Controlled Substances Act in 1970 and placed marijuana as a Schedule I drug then. So DEA has not rescheduled or de-scheduled marijuana as the plant since. DEA has taken steps to schedule specific drugs that either contain marijuana or are synthetic THC as a Schedule I drug, but otherwise hasn't really touched cannabis at large. So I just want to talk about some definitions before we go through the rest of this just because it is going to be very definition-specific. So, as everyone likely knows, in 2018 the Farm Bill removed hemp from the definition of cannabis, and therefore it is not a Schedule I drug. It's actually not even scheduled at all. And so for everyone's understanding, hemp is the plant cannabis and any part of the plant, including the seeds thereof and all derivatives, whether grown or not, that is not more than 0.3% THC. So anything that is 0.3% THC or less and is from the plant itself meets the definition of hemp and therefore is excluded from the Controlled Substances Act. Marijuana, which is currently a Schedule I drug which is the subject of this proposed rule to be a Schedule III drug, means the plant cannabis, whether grown or not, in the seeds thereof, the resin extracted from any part of such plant and every compound, manufacture, salt derivative, mixture and preparation of such plant, seeds or resin. So this proposed rule is really only talking about the plant and the derivatives of such plant. The proposed rule specifically calls out synthetically derived THC and how that is one outside of the definition of marijuana, because it's already scheduled as a Schedule I drug, but it is also not subject to the proposed rule. So really, the proposed rule is only talking about marijuana, cannabis, the plant itself. So what the proposed rule is doing is removing from Schedule I and placing it into Schedule III, meaning researchers, sponsors, drug sponsors have access to this product to conduct research and move it through the appropriate chain of approval. The proposed rule specifically states that the FDA process is still applicable. So typically a Schedule III drug gets to market because research has been done on it, a sponsor has submitted an IND and then submits a new drug application to the FDA, the FDA approves such application, and now, voilà, we have a drug on the market. What's going to be really interesting here, and what the proposed rule does not discuss, is what do we do about the 38 states that have a legalized marijuana system and what that means from an FDA standpoint. Because all of those products in those 38 states suddenly aren't going to have new drug applications before the agency, the agency being the FDA, and suddenly aren't going to be approved. One other note, I think here, is that this is really uncharted territory, to remove such a hot topic drug to a different schedule. And ultimately, the attorney general has the authority to reschedule a drug. However, the Controlled Substances Act defers this to DEA and to reschedule. DEA essentially defers to HHS, who defers to FDA. So there's a lot of agency interplay here. And a lot that is going to happen before this final rule gets, or this proposed rule, gets finalized. The comment period is open until July 22. As of this morning, there are over 7,200 comments submitted. We only expect more comments to be submitted, so the actual process here is going to take a long time. One other thing that I think is worth noting is that the proposed rule also leaves open the notion to request a hearing, so any interested party or person may request a hearing with the DEA to provide factual evidence and expert opinion on the specific issue. So there's really two routes to get your voices heard here. The first would be to issue or submit a comment, and the second is to go before a DEA administrative law judge on any evidence that you would like to enter the record. And both are unknown, so there's a lot that's going to happen here and a lot that we don't know.

So really, the proposed rule is only talking about marijuana, cannabis, the plant itself. So what the proposed rule is doing is removing from Schedule I and placing it into Schedule III, meaning researchers, sponsors, drug sponsors have access to this this product to conduct research and move it through the appropriate chain of approval.

Ability of Taxpayers to Deduct Marijuana-Related Business Expenses

Michael Werner: So thanks, Sara. To unpack some of what you said, there are a couple of different issues that I want to get back to. You talked about the comment period. So basically, stakeholders have the opportunity now to submit comments for the record to the DEA. The DEA, by law, is required to read all the comments and respond to them. So, number one, that means that any business, or really individual, that has a concern about this has the opportunity to comment, and those comments will be heard or will be read by the agency. And the second is where we started out, which is that we've got a long way to go. And this is just a proposed rule, which could be changed depending on lots of events, not the least of which is the public comment period. I want to turn to Josh here for a second. So we heard Sara talk about the proposal from DEA. The DEA is not the Internal Revenue Service, it is not a tax agency. DEA is deferring to HHS, which is deferring to FDA, but the IRS is not involved. And yet, if some of the provisions in this proposal become the law of the land, it could have tax implications for businesses. Can you explain what some of those are and perhaps even what some business might think about doing in the interim period?

Joshua Odintz: Yeah, absolutely. So there's a provision in the Internal Revenue Code, Section 280E, that denies a deduction or credit for any amount paid or incurred in carrying on a trade or business consisting of drug trafficking and controlled substances. And it defines "controlled substances" as meaning a substance within Schedule I or II of the Controlled Substances Act. And I think it's kind of important to understand the history of this provision, it's a rather interesting story. So there was a gentleman named Jeffrey Edmondson who was arrested for trafficking in a variety of drugs, including marijuana, cocaine, amphetamines and the like. And Mr. Edmondson recognized that he has taxable income. He learned the lesson from Al Capone: "Make sure you file your tax returns and report your illegal activities." When he did so, he also claimed that, look, not only did he have income, but he had deductions related to his trade or business. He rented an apartment, and that was his place of doing business and selling illegal substances. He also purchased a variety of equipment to conduct his business, including scales, packaging, a telephone and a car. And he successfully prevailed in the U.S. Tax court in 1981, claiming that he was entitled to these deductions. The tax court agreed. The tax court did not allow him his miscellaneous business expenses for meals and entertainment because those required STRIPS, substantiation or receipts. So then Congress responded. They were horrified that Mr. Edmondson was able to deduct these expenses. And so to any cap, he denies ordinary necessary business expenses other than cost of goods sold, for purposes of taking a deduction under the normal provisions in the tax code. So today those who are in a marijuana business who are either growing plants, manufacturing products or have a storefront have been unable to take those deductions and have had effectively a gross revenue tax. So now, going forward, if the regulation is finalized to reschedule marijuana from a Schedule I to a Schedule III drug under the Controlled Substances Act, that will change the ability of taxpayers to deduct these expenses. So, it makes sense at this point for taxpayers to begin collecting receipts, to begin tracking expenses, to, in the case of meals and entertainment, in dealing with potential customers or etc., it's important to retain those receipts to be able to verify that in fact that those expenses occurred. So taxpayers should also consider filing a protective refund claim in case they're close to a statute of limitations period running. And so those are all things that taxpayers should consider with their tax advisers. Hopefully, taxpayers will be able to claim these expenses in the very near future.

So now, going forward, if the regulation is finalized to reschedule marijuana from a Schedule I to a Schedule III drug under the Controlled Substances Act, that will change the ability of taxpayers to deduct these expenses. So, it makes sense at this point for taxpayers to begin collecting receipts, to begin tracking expenses.

Potential Implications for Safe Banking Legislation

Michael Werner: Thanks, Josh. So, Ed Perlmutter, you were a champion, if not, THE champion, of the safe banking legislation when you were in Congress. I wonder if you could give people a little bit of an overview of the banking issues here and discuss how this proposal might impact the banking laws and whether, if it were enacted, if this rule becomes final in its current form, what that would mean for safe banking legislation.

Ed Perlmutter: Thanks, Michael. Yes, I was a champion for quite a while. Never got it across the finish line. The issue here is, as Sara said, under Schedule I, cannabis is illegal for all purposes. You can't research for much, you can't smoke it, buy it, bank it. So we saw across the country this wave of states allowing for some level of cannabis use over the last 10, 15 years. We weren't going to put the genie back in the bottle. So one of the problems that arose was a lot of cash coming out of these businesses and people getting killed in dispensaries and getting robbed. That was a real public safety issue that came up in financial services. So we created this bill called the Safe Banking Act. That follows two guidances that came out during Obama. One was called the Cole Memo, the other was called the FinCEN Guidance. And requests had been made, during the Obama and during Trump and a number of other administrations, that de-schedule or reschedule cannabis. But they were only willing to go so far with these particular memos and said, if you keep the cannabis out of the hands of kids, if you keep it out, you show that there's no organized crime, that it's transparent, then it would be a very low level on the priority list for federal agents. So this rescheduling, if it goes through as is being proposed, will help on the banking side, on the margin. It still doesn't resolve it completely. But what it does if businesses go through the steps that Sara was talking about to have their particular thing approved by the FDA, then it will help a bank provide those services in a way that is beyond the FinCEN Guidance or what was the Cole Memo. So it helps on the margin. But at the end of the day, if you don't go through those steps, you still have an illegal substance that has to be approved in some fashion or another. And banks are going to have to be wary of this, but they still will be guided by this FinCEN Guidance approach that allows them to provide services, financial services. And this applies to insurance companies, real estate companies, anybody in the financial services arena. One, it'll help on the margin, but it doesn't get you there. Safe banking is still going to have to be passed by the Congress to make sure this is done completely.

So this rescheduling, if it goes through as is being proposed, will help on the banking side, on the margin. It still doesn't resolve it completely. But what it does if businesses go through the steps that Sara was talking about to have their particular thing approved by the FDA, then it will help a bank provide those services in a way that is beyond the FinCEN Guidance or what was the Cole Memo.

How Current Products Will Have to Be Regulated

Michael Werner: So let me now go back to a couple of things that was said by each of you. So a couple of you brought up this issue about the fact that we now could have marijuana as a Schedule III drug. And one of the implications of that is that for a Schedule III drug to be legally marketed in the U.S., it needs to be approved by the FDA with a new drug application, for a new drug application process. And in fact, the proposed rule makes it very clear that they're not changing FDA's rules about drug review and approval. With that, the DEA is not making those changes. So I'm going to ask Sara first. So that could be pretty significant, right? Because a Schedule III drug might mean a new drug application approved. The manufacturer might have to comply with all the FDA regulations that go along with that. That they're typically dispensed in a licensed pharmacy or not typically, legally, they have to be dispensed to a licensed pharmacy. So talk a little bit about that. Talk a little bit about the implications of if marijuana is rescheduled, what about all of those products that are out there now? How will they be regulated?

Sara Klock: So a Schedule III drug, to legally be on the market, will need a new drug application. So then the question becomes, what is happening in these states? So the 38 states that have some sort of legal system is either for recreation or medical use. There's no way the FDA is going to suddenly defer to 38 states as the expert for medicinal use of the drug. That's not going to happen. So I think there's a few potential pathways here. We can suddenly look at marijuana, once it's a Schedule III drug, as either the approved pathway just like any other drug. And then the black market diverted pathway, just like cocaine and heroin are on the market. I don't think it's going to be that way. It doesn't fully make sense. But I don't think the agency — the agency here again, being the FDA — is going to suddenly allow this federal preemption argument that the DEA has always had to set aside here. I think it's possible either legislation could occur or the Supreme Court could occur here. Some sort of legal authority outside of the AG here to try to figure out the nuance between the state markets that exist and the federal market. It's also possible that suddenly somebody could claim that all of these products are dietary supplements or food. But there's a whole issue as it relates to CBD, that there is a drug exclusionary rule in place that once a product is already on the market as a drug, it can't therefore be on the market as a food or dietary supplements. I think that's another avenue to at least consider, or a new dietary ingredient notification. But you can't make these claims about pain, cancer, sleep  —well sleep maybe, but [not] pain and cancer — if the product isn't a drug. So I think there's a lot to be unknown here. I am not aware of any other plant as a whole that FDA has approved for a drug. I think the best equivalent would be poppy. But poppy is heroin. And, heroin is still a Schedule drug, I think Schedule I or II. I think at the end of the day, we don't know how this is actually going to play out for a lot of the market. But right now, what we do know is what the law says, that any Schedule III drug on the market will need a new drug application and then approval by FDA to legally be on the market.

I think at the end of the day, we don't know how this is actually going to play out for a lot of the market. But right now, what we do know is what the law says, that any Schedule III drug on the market will need a new drug application and then approval by FDA to legally be on the market.

Will Congress Take Action?

Michael Werner: So Ed, I'm going to turn to you. It's hard to imagine Congress just stands on the sidelines here. You talked about, say, banking is still needed, and presumably the congressional allies and partners that agree with you, right, that that's still true. But what we just heard was that we might need Congress to sort of step in here, in terms of a pathway to approval for some of these products. We might need Congress to step in, in that sense that we've got all these states that have stepped forward. And you're from Colorado, which was right there at the beginning. So can you talk a little bit about what you see in Congress here in terms of how you think, when they get back from recess next week, how you think this proposed rule is going to play over the rest of the year?

Ed Perlmutter: Yeah, sure, Michael. I think the Congress is going to look at this closely and they might come up with some sort of language to expedite FDA approval or rulemaking, or they could do like — I say they, but we, I was part of Congress at the time that the agriculture bill was passed, and hemp was just defined out of cannabis. Just said, it's not cannabis, it's not a drug, forget about it. Now, there have been some troubles with that. There's been some need for regulation across the states. And there is some activity in the Congress with the Farm Bill right now on hemp and how to try to put some parameters to it. But I think Congress will look at two things. Are going to continue to look at the banking piece of this. There's no question about it, it needs to get resolved. And there are still a number of paths that Congress could follow. It's the bill itself, say, for safer banking is farther along than it's ever been, having passed Senate banking. It could be passed in the ordinary course through regular order, out of the Senate to the House and then on to the white House. So it's in a position to do that over the course of the next few months or 'til the end of the year. It could be attached to some big must-pass bill that's been problematic in the past, the NDAA. But this holds true for some kind of fix to what Sara was saying, to have the FDA approve new drugs in effect, because there's — I don't know how many compounds out of the cannabis, 560 or something like that — there will probably be some kind of move by Congress to either short cut, provide a short cut for the FDA or maybe make some new definitions. I don't know exactly what's going to happen, but clearly cannabis has been on Congress' radar now for a number of years. Nothing much has happened. But I think this year is the year for something to be done.

But I think Congress will look at two things. Are going to continue to look at the banking piece of this. There's no question about it, it needs to get resolved. And there are still a number of paths that Congress could follow.

Michael Werner: So, along the same lines, Josh,. we know that there'll be a tax bill next year, probably, you know, I guess there's often some kind of tax proposal, heading towards an election. But we haven't seen it, have we? The tax committee's talking about this issue yet, but it's possible that it comes up on their radar as well for the reasons you talked about.

Joshua Odintz: Yeah. So there have been several proposals to modify Section 280E to liberalize or to eliminate marijuana as a Schedule I or Schedule II for purposes of the tax code. I think Congress will have to consider large pieces. The 2017 law known as the Tax Cuts and Jobs Act, the TCJA, many provisions expire at the end of 2025, which will force Congress to pass some type of tax bill in either 2025 or 2026 to prevent tax increases on the middle class. And so that is an opportunity for Congress to weigh in on this issue. Look, I think if Congress makes a change, or alternatively, that marijuana is scheduled outside of Schedule I or II, it does open up the door for investment, and both cross-border investment of foreign companies making acquisitions of U.S. companies and U.S. companies having the cash to make acquisitions of foreign companies or make investments in foreign companies. It really does open the ability for businesses to also invest in research and get credit for that research as opposed to now. It allows for employers to provide more generous employment plan options. So it would be a huge game changer for the for the industry, if marijuana is scheduled outside of Schedule I or II, or alternatively, it's just completely removed from 280E.

Sara Klock: Josh, question there. What about if it's scheduled as a Schedule III but doesn't have FDA's approval?

Joshua Odintz: Well, the statute is pretty mechanical. It just says Schedule I or II, and if you're not in one of those two schedules, then the taxpayer can deduct ordinary, necessary business expenses and claim whatever applicable credits may exist. So I just pointed this out further. Suppose a marijuana farm decides to install solar panels and for it to generate clean energy and make it a true green facility. Pardon the pun. And in doing so, it may get two credits under the Inflation Reduction Act: a credit for installing a green energy product, solar panels, and second, a production tax credit for generating the energy. Those credits are not available right now to that marijuana business because marijuana is a Schedule I drug, which is absurd. So to allow a taxpayer to be able to claim these credits, we really do need marijuana to move off of Schedule I or II, and that would open up the ability to claim the credits. Whatever the FDA does on approval is not relevant. That certainly would be relevant for the ability to make products and sell those products, but as far as the tax code is concerned, at that point, we're out of the game.

I think if Congress makes a change, or alternatively, that marijuana is scheduled outside of Schedule I or II, it does open up the door for investment, and both cross-border investment of foreign companies making acquisitions of U.S. companies and U.S. companies having the cash to make acquisitions of foreign companies or make investments in foreign companies.

Predictions for Next Year and Final Thoughts

Michael Werner: So one thing we know for sure is that the landscape here is going to change, likely change either from a tax perspective, a financial services perspective or, of course, a regulatory perspective of the particular products. I think at the beginning we talked about that there was at least, as of today, 7,200 comments filed. I think, we could expect, the comment period is 60 days for now. Sometimes agencies extend those if there's kind of overwhelming interest in that. But I think the significance of that is that it's going to take the DEA quite some time to get through all of the comments, which means that, I think to me, it means that, number one, stakeholders have the opportunity to start planning now for some of these potential changes. They have the opportunity to go to Congress, or perhaps go to the agencies and try and influence how things go forward. And so it also means that nothing is likely to happen very soon. And that this is, I think we said the beginning, this is the first step in what's likely to be a very long, very long process. To close, I'm going to ask each of my colleagues here for kind of a prediction, if you will, and we'll just have some fun and say, if we were doing our podcast on January 4 of next year, what do we think the landscape will look like? In terms of all of these issues — the regulatory issues, the banking issues, the congressional issues, the FDA issues — where do you think we're going to be January 4? So about eight months from today, seven months from today. I'm going to start with Sara.

Sara Klock: Well, I think we'll be a lot colder. Because it'll be January. So the FDA issues aren't going anywhere. No matter what a Schedule III drug is still going to need a new drug approval to get on the market legally. But that doesn't mean that there are going to be alternative pathways to get all of the product that's currently on the market in those 38 states legally to the market through another legal pathway. However, January 4, 2025, we're going to be in the exact situation because nothing is going to have happened that drastically from now 'til then. But I think it's possible in a year or two years that the landscape will look a little bit different.

Michael Werner: Josh.

Joshua Odintz: So I'm not an FDA person. Will not play one on this podcast. However, as a tax lawyer, I'm going to look further ahead two or three years. I think we're getting close to the tipping point where something has to be done either legislatively or, alternatively, regulatory on marijuana. And so I think we're close, and I hope within two or three years those changes have been made. And then there's a big question that the IRS will have to address. How do you deal with all the open audits and the audits for open statute years? Congress could play a positive role and close off those years for purposes of denying ordinary, necessary business expenses. Alternatively, the IRS could issue helpful guidance on its own. But I think that is the next issue, is how do you eliminate the backlog, which frankly, I think would really, it would help a lot of businesses in the sector.

Michael Werner: Ed.

Ed Perlmutter: Well I've always been the eternal optimist on this because I think it's just something that is long overdue from happening. So I think, first of all, adding safe banking in some form will pass by the end of the year. Now, I've said that for a number of years and I haven't been right. But I think the pieces are there to get it done. I think this administration has shown a willingness to move this subject forward. I know Congress has been willing to move it forward. The Senate has actually taken some steps to move safe banking, I think, in conjunction with that, and I don't know exactly what it looks like. Sara would have a better idea. I think there will be some recommendation from Congress as a way to move the FDA process forward quicker. I don't know exactly what that is. Science is what it is, and it will take the time to study it and do it properly. But I think there will be some recommendation, similar to your question, Michael, about, is there a way to move this faster to shortcut some of the steps that ordinarily are taken in approval of a drug? So I think things are going to move forward. That's my opinion, and I'm sticking to it.

However, January 4, 2025, we're going to be in the exact situation because nothing is going to have happened that drastically from now 'til then. But I think it's possible in a year or two years that the landscape will look a little bit different.

Michael Werner: Well, I'm going to say, just part of my prediction, something that nobody said, which is that I do think that at some point during the presidential campaign this fall, we're going to see at least one of the candidates talk about this issue in some capacity. And I think that goes to what I think you said, which is that we're coming close to the point where national laws start to change on this topic. But I think the consensus amongst all of us is that there's a lot of moving parts. There's going to be a lot of activity over the next several weeks, months, maybe a year, at the various federal agencies, at state level, in Congress. So stakeholders really shouldn't sit on the sidelines. This is the opportunity to step up and step in, learn more about what's happening and try to influence that. And of course, our team here at Holland & Knight will be tracking all of these developments and will be significantly involved. So if anybody has any questions, you should please feel free to reach out. And with that, we'll close the podcast. Thanks everyone for listening and have a good day.