Impacts of Cannabis Rescheduling on Bankruptcy

This article was co-authored with Joel E. Cohen, Stout.

Despite the excitement of many over rescheduling cannabis from Schedule I to Schedule III, the move does not make cannabis “legal” unless it is produced, sold, and used within the tightly regulated parameters of the Controlled Substances Act (CSA). Many medical and adult-use cannabis stores and products that currently exist in approximately four-fifths of the United States are not in compliance with the CSA. These businesses violate federal law now, and they will still be violating federal law if and when cannabis is rescheduled; rescheduling does not make the conduct federally legal.

However, cannabis rescheduling may have a significant impact on the federal taxes that cannabis and cannabis-related businesses currently are required to pay. While Internal Revenue Code section 280E might prohibit a cannabis-related business from taking deductions and credits for most business expenses incurred in carrying on the trade or business of trafficking Schedule I and II controlled substances, 280E typically does not apply to the trafficking of Schedule III substances. Therefore, if rescheduling occurs and cannabis is no longer a schedule I or II substance, cannabis-related businesses could be able to deduct traditional business expenses.

We cannot say that rescheduling will cause similar—nor immediate—changes with respect to bankruptcy. This is because there is no bright-line rule like there is in the federal tax code, whereby cannabis-related businesses (or individuals involved in them) will likely have different legal treatment following rescheduling.

Instead, in the bankruptcy context, a debtor’s proposed plan should not violate the “good faith” requirements of 11 U.S.C §§ 1129(a)(3) and 1325(a)(3) and (a)(7). A debtor must not also run afoul of the doctrine of “unclean hands.” Both rules are equitable concepts which involve the balancing of interests and harms, rather than the application of a bright-line rule. Because these are equitable analyses, different courts could cause different results for parties similarly situated based on the circumstances of a particular case, the values held by the judge deciding their matter, and more.

Equitable concepts such as “good faith” and “unclean hands” provide flexibility in the judiciary’s analyses and, thus, in the outcome of each case. Historically speaking, with respect to bankruptcy courts governed by the U.S. Bankruptcy Code, the federal illegality of cannabis has long have presented a roadblock for cannabis companies seeking bankruptcy protection. However, starting years before the DEA’s rescheduling news was announced, some courts have already started to demonstrate a more nuanced and perhaps more open-minded stance with respect to both state-legal cannabis businesses and individuals who derive income from such business activity. This evolution suggests a departure from blanket refusals, providing hope for cannabis businesses and individuals who derive income from those businesses seeking bankruptcy protection.

Indeed, prior to the rescheduling news, there had already been a trend of bankruptcy courts approaching cannabis-related bankruptcy issues with more nuance and open-mindedness. In the last year, two important cases demonstrating a moving-away from a complete prohibition when it comes to bankruptcy for both businesses and individuals who derive, or at some time in the past derived, income from a federally illegal cannabis business.

In re Blumsack

In In re Blumsack...