What does federal legalization mean for California’s cannabis industry?

Federal legalization will require cannabis to be rescheduled, descheduled or placed in a new classification altogether along with future adoption of new ordinances and processes.

Normalizing federal cannabis laws

Last month, President Biden directed the Department of Justice (DOJ) and the Department of Health and Human Services (HHS) to expeditiously review how cannabis is scheduled under federal law. Currently it is classified as a Schedule I drug under the Controlled Substances Act (CSA), which is reserved for dangerous narcotics such as heroin and LSD that have no accepted medical application and a high potential for abuse.

This is a momentous step towards “normalizing” federal cannabis laws and could promote greater consistency between federal law and the 39 states (California included) that have already moved to legalize cannabis for personal use or for a licensed and regulated commercial cannabis industry. However, those eager to participate in a nation-wide cannabis industry and sell product across state lines need to be prepared for a long, arduous process with an uncertain outcome.

In our current political environment, parties may benefit more from using such a values-based issue against one another rather than to accomplish legislative goals, making alignment near impossible to achieve. Even if all federal parties agree, this move would be unlikely to bear meaningful fruit for many years to come.

Past attempts at rescheduling

While the President can direct agencies like the Drug Enforcement Administration (DEA) and the Food and Drug Administration (FDA) to undertake a review, he does not have authority to legalize or reschedule a drug by executive order. The review process may also require the concurrence of additional agencies and can take several years to complete.

There have been numerous and persistent attempts to reschedule cannabis…

The National Organization for the Reform of Marijuana Laws (NORML) filed a petition in 1972 that went unanswered for 22 years before finally being rejected in 1994. The following year, NORML filed another petition that was rejected in 2001. Their third attempt in 2002 was again rejected in 2011.¹

In 2016, the DEA rejected two separate petitions filed five years previous, one filed by two governors and another by a health provider.²
In 2017, a bill was introduced in the House of Representatives to have cannabis rescheduled to Schedule III but died for lack of action.³

Even derivatives of a scheduled drug aimed at curing serious health issues must undergo the lengthy process…

In 2014, a pharmaceutical company entered into discussion with the FDA to reschedule a cannabis derivative called Epidiolex that was used in the treatment of epileptic seizures. The drug was finally moved to schedule V in 2018 and eventually delisted from the CSA completely in 2020.⁴
In 2018, the DEA received a petition to deschedule a drug named [18F] FP-CIT, a chemical compound derived from cocaine, to help diagnose Parkinson’s Disease. The agency conducted a review and issued a proposal to remove the compound from Schedule II of the CSA on November 4th, 2021. To date, the agency has not taken final action.⁵

Rescheduling or Descheduling

Rescheduling cannabis to a different tier under the CSA would carry very different ramifications than descheduling it completely. Being listed on Schedule I means the substance is federally illegal under any circumstances and, thus, unregulated. Moving cannabis to Schedule II is effectively a worst-case scenario, where it would be regulated by the FDA and would likely require the development of pharmaceutical-grade products that may or may not be available only by prescription. It would also still be subject to the restriction on tax deductions under Section 280E of the federal tax code.⁶Moving cannabis to Schedule III, IV or V would eliminate the restriction on tax deductions and would ease access to banking services, bringing significant benefits for cannabis businesses.

Keeping cannabis listed as a controlled substance would maintain the existing conflict between the federal designation and those states that have legalized cannabis for recreational use. However, descheduling cannabis completely would mean that it is not federally recognized or regulated as medicine, which could create conflict between the federal designation and the 20 states that currently allow cannabis only for medicinal use. Neither rescheduling nor descheduling is fully compatible with the dual medicinal/adult-use status of cannabis.

^{Source: National Conference of State Legislatures}

If the review by the DOJ and HHS results in a recommendation to reschedule or delist cannabis from the CSA, implementation of any changes would still require legislative action by Congress, which holds the power to regulate interstate (and international) commerce under Article 8 of the Constitution. The Congressional Research Service (CRS) recently released a memo outlining several issues and options for Congress to consider. Along with rescheduling, descheduling or maintaining the status quo, the memo also offers the possibility of creating an entirely new schedule or category for cannabis. This may be the “sweet spot” for allowing both medicinal and adult-use cannabis.

Though numerous bills have been introduced in recent years to prepare for possible federal legalization, most have languished in a deeply partisan and polarized Congress. Any legislation would still have to be enacted through the administrative rulemaking process which could add another year or more and could be subject to legal challenge and judicial review. Congress could still choose to hold hearings on the final rules or to impose funding restrictions that could hobble implementation.

Impacts on the industry

Every state that allows commercial cannabis has its own regulations that only allow cannabis produced by state-licensed businesses in accordance with that state’s program. Each state would have to separately enact new regulations to allow product grown or manufactured under other states’ programs and to be consistent with any new federal regulations. Businesses that have grown up under California’s regulatory paradigm may have to adapt to new testing, labeling, packaging and reporting requirements or other product limitations.

Allowing interstate cannabis commerce would not give California producers access to new unserved markets. Each state that allows legal cannabis already has licensed cultivators and manufacturers supplying that state’s market demand, and many already have their own issues with market oversaturation. California cannabis businesses would have to compete for valuable shelf space in stores across the country, just as they do here. The greater distances involved would put smaller cannabis businesses at a severe disadvantage compared with larger competitors that are already operating in multiple intrastate markets.

Given the lengthy timeline and difficulty of gaining a foothold in markets, businesses best able to position themselves now for a nationwide cannabis industry will be those with large amounts of available capital and the ability to withstand losses or lack of return for many years as they build operations in multiple states in preparation for national distribution and marketing. Access to a nationwide market will do little to help struggling small businesses.

Final thoughts

The recent announcement by the Biden administration is a positive step towards bringing consistency to cannabis regulation across the country. However, this is only a first step in a long process before cannabis businesses will be able to sell product across state lines. It’s unknown whether this process will result in cannabis being rescheduled or removed from the CSA completely, or whether it will be placed into a new classification of its own. Virtually any change to its status will bring benefits in regard to tax deductions and access to banking, but it is unlikely to provide new opportunities in any timeline that will help struggling cultivators in California.

California cities and counties can prepare for eventual federal legalization by taking steps to improve competitiveness and resilience for their local cannabis businesses. HdL can assist jurisdictions with reviewing tax rates, revising fees, ensuring compliance and future-proofing local ordinances to better accommodate the changes ahead.

_{Disclaimer: HdL Companies is neither for or against the legalization of cannabis. HdL understands that the sale of legalized cannabis acts as a form of revenue for the place of sale, and therefore it is categorized under tax types that HdL offers revenue management services for. Learn more about HdL’s Cannabis Compliance Services.}

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