Over the last month, pot stocks have spiked higher. Some have doubled in price. The news that the U.S. Drug Enforcement Agency may reclassify marijuana from Schedule I of the Controlled Substances Act to Schedule III has given new hope to this beleaguered industry and investors.

 

The effort to reclassify started 10 months ago when the Biden administration directed the Department of Health and Human Services to review the scheduling of cannabis under federal law. As a result of that review, HHS sent a letter to the DEA recommending a proposed schedule change.

 

Currently, marijuana is listed as a Schedule I drug with no accepted medical use and a high potential for abuse similar to heroin or LSD. If the DEA were to reduce cannabis to a Schedule III drug, it would have the same profile as drugs such as Tylenol with codeine, anabolic steroids, or ketamine. That could be good news for pot companies selling medical marijuana. However, the new classification would only be available by prescription, and still be regulated by the federal government including possibly the FDA. And while medical marijuana might become broadly legal, most states would need to overhaul their legal and tax systems to align with the federal Schedule III restrictions.

 

It would not make marijuana legal. In addition, rescheduling the drug would do nothing to close the policy gap between state and federal cannabis laws. The reclassification is also completely different from the SAFE Banking Act, which would allow banks to provide financial services to the industry. That is still held up in Congress. Given the facts, why therefore would the stocks of some marijuana companies double in price in less than a month? The simple answer is taxes.

 

As a Schedule I substance, marijuana and the companies that produce and sell it are prohibited (by IRC Section 280E) from claiming deductions and credits for trade or business expenses that other legal businesses can claim. A rescheduling to Schedule III would be a large, and for some companies, a huge boost to their bottom lines. Expenses like rent, payroll, interest, depreciation, advertising, and so much more would be allowed to be deducted from taxes. For normal companies, these are all standard tax deductions.

 

Depending on the company, some players in the industry could see a 20-30 percent boost in their bottom-line after-tax profits, which explains why so many pot stocks have moved up in price. However, Canadian companies are not affected by these U.S. tax benefits. A potential buyer should understand that if interested in this sector.

 

Rescheduling would also allow cannabis companies to advertise in newspapers, magazines, and other media without worrying about crossing state lines. It would allow mailing advertisements as well. Research on the impact of marijuana and its many forms becomes easier and more widespread as well without the restrictions associated with a Schedule I drug.

 

On the state level, 20 states have already approved laws that exempt, or at least decouple, businesses from Section 280E of the federal tax code. These state exemptions have already saved millions for some large operators in state taxes. However, as it stands, the state-level exemptions do not affect the federal taxes owed by marijuana companies, and businesses are still not allowed to deduct these expenses toward their federal income taxes. 

 

For many states that still follow federal guidelines and therefore enforce Section 280E, a change of the federal level in scheduling would result in a cascade of changes at the state level, at least for the medical marijuana business. It is not known how, or if, a rescheduling will impact recreational marijuana use.  

 

A Schedule III designation does not need to go through Congress to become law. That is a good thing, but reclassifying marijuana would not broadly legalize, or even decriminalize the drug. The next obvious step toward those goals would be the passage of the SAFE Banking Act, which was introduced in 2017 and passed the House seven times with bipartisan support since 2019.

 

The Senate has been the holdup, but that may be changing. The Senate Banking, Housing, and Urban Affairs Committee is expected to hold a markup session for the bill sometime next week. This markup process is a key step in advancing the bill. It allows senators to debate and consider amendments to the bill. Scuttlebutt says both sides of the aisle on the committee support the bill and, if so, that would give the Senate at large a sign that progress toward passage is in the works.

 

One caveat to these positive developments is that we are dealing with the government here. Hopes have been dashed too many times in the past for investors to blindly step into these stocks with fingers crossed only to have them broken. The nation might see a full vote on the Senate floor by this fall, or it may not, and even then, there is no guarantee it will pass, so buyers beware.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.