Understanding Federalism: A Foundation for Cannabis & Alcohol Regulation: A Three-Part Blog Series
Why This Matters
If you’re working in or advising cannabis businesses, you already know the rules are complex. Even in states where cannabis is fully legal, federal law still classifies it as a Schedule I controlled substance, putting businesses in a legal gray zone. This conflict creates problems for:
- Compliance
- Taxation
- Advertising
- Investment
Without federal reform, cannabis operators are left navigating a patchwork of state permissions and federal prohibitions, with very real consequences.
The cannabis industry has grown as an increasing number of states have relaxed state law prohibitions on the use of cannabis for medical and adult-use purposes. States like Minnesota, Colorado, and Vermont have established regulated markets with their own licensing systems, compliance standards, and enforcement frameworks; all operating alongside, but not beneath, ongoing federal prohibition.
Most states, U.S. territories, as well as the District of Columbia, have enacted laws relaxing in some capacity criminal prohibitions on the use of cannabis, from qualified medical use to adult-use.
Cannabis industry sources project that the marijuana industry experienced $11 billion in sales in 2018 and will reach $25 billion in sales by 2025. While more and more states have allowed cannabis businesses to operate legally under state law, the federal Controlled Substances Act (CSA) continues to classify cannabis as a Schedule I controlled substance.
State Legalization vs. Federal Prohibition
Most U.S. states, territories, and the District of Columbia have enacted laws that decriminalize, legalize, or regulate marijuana for medical or adult use. Examples include Minnesota, Colorado, and Vermont.
Yet under federal law, cannabis remains illegal. The Controlled Substances Act (CSA) lists marijuana as a Schedule I drug, alongside heroin and LSD.
Schedule I classification means:
- High potential for abuse
- No accepted medical use under federal standards
- Lack of accepted safety under medical supervision
- Severe criminal penalties for possession, production, or sale outside narrow scientific research exemptions [1]
The Schedule I status of marijuana means that cannabis businesses are treated differently from many other businesses for tax purposes. As a result of this classification, Section 280E prohibits cannabis businesses from taking tax deductions and claiming tax credits.
Section 280E denies deductions and credits for amounts paid or incurred in carrying on the trade or business of trafficking controlled substances in violation of federal or state law. As a result of marijuana’s current classification as a Schedule I controlled substance, Section 280E disallows taxpayers from taking tax deductions and claiming tax credits attributable to marijuana businesses.
Nonetheless, for reasons related to constitutional concerns raised at the time of Section 280E’s enactment regarding the scope of Congress’s Sixteenth Amendment power to tax “income,” businesses subject to Section 280E may offset gross receipts by the cost of goods sold when determining their gross income.
The Tax Trap: Internal Revenue Code Section 280E
Because cannabis is federally illegal, cannabis businesses face harsh tax treatment under Section 280E of the Internal Revenue Code.
What does Section 280E do?
It prohibits businesses trafficking in Schedule I or II drugs from:
- Claiming normal business deductions
- Taking tax credits
- Deducting costs associated with advertising, rent, payroll, and more
The only allowed deduction is cost of goods sold (COGS), a narrow category that doesn’t account for the majority of operating expenses.
Legal Challenges to 280E
Cannabis businesses have tried, unsuccessfully, to challenge 280E on several fronts:
- Constitutional arguments (e.g., violation of the Sixteenth Amendment’s income tax authority)
- Attempts to reinterpret “trafficking”
- Appeals for more IRS guidance
Courts have consistently upheld 280E, reaffirming Congress’s original intent: to codify a strong policy stance against drug trafficking. Cannabis businesses have generally been unsuccessful in challenging the Internal Revenue Service’s application of Section 280E and likewise have not succeeded in their attempts to challenge Section 280E on constitutional grounds.
Recent legislative proposals aim to relax federal restrictions on cannabis or to mitigate the disparity between federal and state cannabis regulations. Many of these proposals would alter the tax treatment of cannabis businesses by re-scheduling or de-scheduling cannabis under the CSA or by making marijuana-specific exceptions. Under these proposals, Section 280E would no longer prohibit cannabis businesses from taking deductions and credits. To date, all these attempts have been unsuccessful. For a detailed breakdown, see the Congressional Research Service report on 280E.
Legislative Efforts to Fix the Gap
Several bills have been introduced to:
- De-schedule or reschedule cannabis under the CSA
- Create exemptions for state-legal marijuana businesses
- Eliminate 280E treatment for cannabis operators
So far, none have passed. Without federal reform, cannabis businesses continue to operate under double standards: legal under state law, penalized under federal tax law.
Congress certainly has the authority to alter the tax treatment of cannabis businesses. The legislative history of Section 280E indicates that Congress enacted the provision to codify a sharply defined public policy against drug dealing.
Final Word
Until federal cannabis law catches up to state policy, operators remain trapped in a legal tug-of-war. Issues like taxation, advertising, and interstate commerce can’t be resolved without addressing cannabis’s federal status under the CSA.
The cannabis industry is moving forward, but without federal reform, state-legal businesses still face major obstacles. From tax penalties to advertising restrictions, the tension between federal prohibition and state legalization creates constant uncertainty. Understanding the legal architecture is the key to building a business that lasts.
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Missed the foundation? Read Part 1 to understand the basics of federalism and how it structures U.S. law.
Need a breakdown of federal preemption in alcohol regulation? Read Part 2 to see how federal and state power collide.
