Section 280E of the Internal Revenue Code is the cannabis tax law that forces every state-legal marijuana business to pay federal income tax on gross profit rather than net income, because marijuana remains a Schedule I controlled substance. The statute disallows every ordinary business deduction and credit for a company “trafficking” in Schedule I or II substances, leaving Cost of Goods Sold as the only figure that reduces the federal tax base. The U.S. Senate Finance Committee has estimated that effective income tax rates on cannabis operators can reach 80%.1U.S. Senate Finance Committee. Marijuana Revenue and Regulation Act Summary Everything else in cannabis tax planning flows from that one fact.
What Section 280E Actually Says
The statute is a single sentence: no deduction or credit is allowed for any amount paid or incurred in carrying on a trade or business that consists of trafficking in controlled substances listed in Schedule I or II of the Controlled Substances Act.2Office of the Law Revision Counsel. 26 USC 280E – Expenditures in Connection With the Illegal Sale of Drugs Congress added it in 1982 after a convicted drug dealer successfully deducted business expenses on his tax return. It was aimed at illegal operators. It caught the legal cannabis industry decades later by accident of drafting.
The reach is broad. Rent, utilities, advertising, insurance, professional fees, non-production salaries, employee benefits, and costs incurred specifically to comply with state cannabis regulations are all treated as operating expenses, and 280E disallows every one of them at the federal level. A conventional business subtracts those costs from revenue before calculating tax. A cannabis business gets no such subtraction.
Why Cost of Goods Sold Is the Only Way Out
Section 280E blocks deductions and credits. Cost of Goods Sold is neither. COGS is an adjustment to gross receipts that produces gross income, and that technical distinction is what keeps it available.
The U.S. Tax Court confirmed this in Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP), citing the legislative history of 280E directly: “To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill.”3Bradford Tax Institute. CHAMP v. Commissioner, 128 T.C. 173 Congress preserved COGS because taxing gross receipts without allowing for the cost of the product would likely violate the Sixteenth Amendment. The IRS has conceded the point.
Every dollar defensibly classified as a cost of producing or acquiring inventory reduces the 280E tax base. Every dollar sitting in operating expenses is, from a federal tax perspective, lost.
What the Math Looks Like
Consider a dispensary with $5 million in gross receipts, $2 million in Cost of Goods Sold, and $2.5 million in operating expenses like payroll, rent, and marketing. Gross profit is $3 million. A conventional business subtracts the $2.5 million in operating costs and pays 21% on $500,000, roughly $105,000 in federal income tax. Under 280E, the dispensary pays 21% on the full $3 million of gross profit, or $630,000. On paper the business lost $500,000 for the year. It still owes the IRS more than its entire net income.
At thin margins or in early years, the tax bill can exceed actual profit. That pressure is what pushes cannabis operators to keep prices high and, in practice, keeps some of the illicit market alive.
Building COGS as a Cultivator or Producer
Producers have the most room to work with because they turn raw inputs into finished inventory. The IRS requires inventory accounting under IRC Section 471, which allows a form of absorption costing that pulls certain indirect production costs into inventory value.
Direct costs go in without controversy. Seeds, clones, growing media, nutrients, and other raw materials are direct material costs. Wages for employees who cultivate, harvest, trim, or process cannabis are direct labor costs. Both flow straight into inventory.
The larger opportunity is in indirect production costs. Under absorption costing, a cultivator can include a reasonable share of:
- Rent, utilities, and property taxes attributable to grow rooms, processing areas, and curing facilities.
- Depreciation on lights, HVAC systems, extraction equipment, and other production assets.
- Wages and benefits of managers overseeing growing or processing, to the extent their time is spent on production.
- Lab testing required to prepare the product for sale, such as potency and contaminant testing.
- Packaging materials that become part of the finished product, including containers, labels, and child-resistant packaging.
The IRS has taken the position that the Section 263A uniform capitalization rules do not apply to cannabis businesses, on the reasoning that applying 263A would effectively create deductions in violation of 280E. Cannabis producers accordingly use the older IRC 471 inventory rules and the full-absorption method described in the pre-1986 Treasury regulations. That framework is narrower than 263A, but it still allows meaningful overhead absorption.
Splitting Shared Costs
Allocation is where audits get fought. When a building houses both a grow and an administrative office, the split of rent and utilities needs a defensible method. Square footage, direct labor hours, and machine hours are all common. The choice matters less than picking one that reasonably reflects how the cost relates to production, applying it consistently, and documenting it.
Marketing, human resources, front-office salaries, and general accounting fees are non-production operating expenses. They cannot be loaded into COGS under any allocation method. Attempting to reclassify them is one of the fastest ways to trigger an adjustment.
COGS for Retailers and Dispensaries
Retailers get a much worse deal. A dispensary buying finished product from a distributor isn’t producing anything, so its COGS is essentially the purchase price paid to the supplier, plus inbound freight and any other cost directly necessary to get the product on the shelf.
Budtender wages, security, point-of-sale systems, store rent, advertising, and compliance staff are selling and administrative expenses. None qualify as COGS for a reseller. That is why the retail segment is the most exposed to 280E: almost the entire gap between gross profit and net income sits in non-deductible costs.
The IRS has consistently pushed back on retail operators who try to reclassify selling expenses as inventory costs. Since the purchase price dominates a retailer’s COGS, there is very little overhead capacity compared to a cultivator running a complex production operation. Vertically integrated companies that both grow and sell have a structural advantage, because the cultivation side generates far more COGS.
Inventory Method Selection
Any cannabis business carrying inventory must pick and consistently apply an inventory accounting method. First-In, First-Out and specific identification are the most common. The choice affects COGS timing and ending inventory value. Switching methods requires IRS Form 3115 (Application for Change in Accounting Method), which goes through either automatic or non-automatic approval depending on the change.4Internal Revenue Service. Instructions for Form 3115
Under IRC Section 471(c), businesses with average annual gross receipts of $32 million or less over the prior three years can account for inventory using their financial statements or books and records rather than the full absorption rules.5Internal Revenue Service. Revenue Procedure 2025-32 For a small cultivator or single-location dispensary, this simplifies compliance considerably. Multi-state operators generally exceed the threshold.
Separating Cannabis and Non-Cannabis Activities
A cannabis business that also earns income from a genuinely separate activity can deduct the expenses of that non-cannabis operation normally. Merchandise sold through a separate retail channel, or consulting services unrelated to cannabis sales, can be segregated and treated like any other business line.
“Genuinely” is the operative word. The IRS and Tax Court look at whether the non-cannabis activity has real economic substance independent of the trafficking operation. A management company that only manages one cannabis business, or a merchandise line that exists solely to absorb overhead, will not survive scrutiny. The separate activity needs its own customers, its own revenue stream, and its own books.
Shared costs between the two operations, including dual-use office space, shared employees, and common equipment, must be split using a reasonable and documented method. If the non-cannabis activity is small relative to the cannabis business or fundamentally dependent on it, the IRS can treat the whole enterprise as a single trafficking business and disallow all the deductions anyway.
State Taxes: Decoupling and Excise Layers
Federal income tax is only part of the burden. Most legal-cannabis states impose their own excise taxes on top of 280E, using one or more of three structures: weight-based taxes assessed at the cultivator or wholesale level, potency-based taxes tied to milligrams of THC, and ad valorem taxes charged as a percentage of wholesale or retail price, generally ranging from around 6% to 37%. Many states layer more than one. Local municipalities often add another 2% to 4%. Combined state and local burdens frequently exceed 20% of retail revenue before federal income tax enters the picture.
Whether state and local cannabis taxes are themselves deductible federally is unsettled. Cultivation excise taxes imposed at the production level have the strongest argument for inclusion in COGS as a cost of producing inventory. Retail excise taxes collected from consumers are arguably not the business’s own expense at all. Retail excise taxes imposed on the business itself sit in a gray area.
At least 22 states have decoupled their state income tax codes from Section 280E. Cannabis businesses in those states can deduct ordinary operating expenses on their state returns even though the same expenses remain non-deductible federally. In some states the legislature created a specific exemption; in others the state code never tracked 280E to begin with. Either way, operators there pay state income tax on actual net income rather than inflated gross profit.
Compliance and Audit Exposure
Cannabis businesses face a substantially higher probability of federal audit than mainstream businesses, and the stakes are large. The IRS knows COGS is the only lever, so every dollar claimed there will be tested. Any expense reclassified from COGS to operating expense becomes fully non-deductible, not just taxed differently.
Audit-defensible recordkeeping starts at invoicing. Every expense should be classified immediately into one of three categories: deductible COGS, non-deductible 280E operating expense, or deductible non-cannabis expense. The chart of accounts should be built around that three-way split from day one. Retrofitting records after an audit notice is far harder and far less credible.
Production businesses carry the heaviest documentation load. Time logs showing how production employees spend their hours, utility usage broken out by production versus non-production areas, depreciation schedules tied to specific production assets, and written allocation calculations for shared costs are all effectively required. Without a clear paper trail connecting each COGS dollar to the production process, the IRS will move those dollars into non-deductible operating expenses.
Inventory tracking has to reconcile across three systems: internal accounting software, the state-mandated seed-to-sale system, and physical counts. Discrepancies among those three are among the biggest audit triggers in the industry. COGS can only be claimed for units actually sold during the tax period, so matching specific units to their production costs and sale dates matters.
What Rescheduling Would Change
Section 280E only reaches substances in Schedule I or Schedule II.2Office of the Law Revision Counsel. 26 USC 280E – Expenditures in Connection With the Illegal Sale of Drugs If marijuana is moved to Schedule III, 280E stops applying to cannabis, and operators can deduct rent, payroll, marketing, insurance, and other ordinary expenses like any other legal industry.
The process has moved slowly. HHS recommended a move to Schedule III in August 2023. The DEA proposed a rule in May 2024. An administrative hearing set for January 2025 was postponed pending an appeal. On December 18, 2025, President Trump issued an executive order instructing the Attorney General to expedite and complete rescheduling. As of early 2026, no final rule has been published and marijuana remains Schedule I.
Two limits on the relief are worth noting. The IRS has stated in Tax Court filings that any rescheduling would not be retroactive, so operators who overpaid under 280E in prior years should not expect refunds. And rescheduling would not make cannabis federally legal. Schedule III substances are still controlled and regulated; the change would primarily affect tax treatment, facilitate medical research, and potentially ease some banking restrictions. Until a final rule takes effect, every cannabis business in the country has to run its tax strategy on the assumption that 280E still governs.