Cannabis taxation runs on three stacked layers: federal income tax, state and local excise and sales taxes, and ordinary employment and cash-reporting rules that apply to every business. What changed in April 2026 was the federal layer for one part of the industry. The Department of Justice moved medical cannabis and FDA-approved cannabis products to Schedule III of the Controlled Substances Act, which lifted the Section 280E deduction ban for those operations. Recreational cannabis stayed on Schedule I, so recreational-only businesses still calculate federal tax on gross profit instead of net income. State excise taxes, local taxes, sales tax, payroll obligations, and cash-transaction reports apply across the board.
Federal Income Tax After the 2026 Rescheduling
On April 23, 2026, the Department of Justice and the DEA signed a final order moving FDA-approved cannabis products and state-regulated medical cannabis into Schedule III. The Treasury Department and the IRS announced they would issue guidance clarifying that rescheduling “generally removes section 280E as a bar to claiming deductions and credits for businesses that as a result of the Final Order no longer traffic in Schedule I or II controlled substances.”1U.S. Department of the Treasury. Treasury, IRS Announce Process for Tax Guidance Following DOJ Final Order on Medical Marijuana Rescheduling
The transition rule is generous. For Section 280E purposes, the IRS plans to treat the rescheduling as applying to the business’s full taxable year that includes the effective date of the order. A calendar-year medical cannabis business gets the benefit for all of 2026, not just the months after April.1U.S. Department of the Treasury. Treasury, IRS Announce Process for Tax Guidance Following DOJ Final Order on Medical Marijuana Rescheduling
The limitation matters. The order covers medical cannabis and FDA-approved products only. Recreational cannabis remains on Schedule I, so a purely recreational operation still cannot deduct rent, wages, advertising, insurance, or other operating expenses on its federal return. Businesses that sell into both markets will have to apportion expenses between qualifying and non-qualifying activities, and the Treasury has signaled that upcoming guidance will address how to make that split.
Section 280E and Why Cost of Goods Sold Still Governs Recreational Operators
Internal Revenue Code Section 280E denies any deduction or credit for amounts paid in carrying on a business that consists of trafficking in Schedule I or II controlled substances.2Office of the Law Revision Counsel. 26 USC 280E – Expenditures in Connection With the Illegal Sale of Drugs For a recreational cannabis retailer, that means federal taxable income is calculated on gross profit rather than net profit. A business with $1 million in revenue, $400,000 in cost of goods sold, and $500,000 in operating expenses owes federal tax on $600,000 rather than $100,000. Effective federal rates can exceed 70%.
The only offset available is cost of goods sold, which is an inventory accounting concept rather than a deduction. The IRS requires cannabis cultivators and manufacturers to use the full absorption method under Section 471, meaning both direct and indirect production costs get allocated to the goods produced during the year.3Internal Revenue Service. 2022 National Tax Forum – Cannabis Industry Tax Issues
For a cultivator, direct costs include seeds, soil, nutrients, water, and the wages of employees who tend the plants. Indirect production costs that can also be captured include:
- Utilities used in the growing facility
- Rent for production space, but not office or retail space
- Repairs and maintenance on growing equipment and production facilities
- Indirect labor such as production supervisors and quality control staff, plus associated payroll taxes and benefits
- Depreciation on production equipment, depending on how it appears in financial records
For retailers buying finished inventory, cost of goods sold is simpler: invoice price less trade discounts, plus shipping and handling to get the product into the store.3Internal Revenue Service. 2022 National Tax Forum – Cannabis Industry Tax Issues
Marketing, advertising, selling and distribution expenses, interest, and general administrative overhead not tied to production can never be inventoried. Audits often turn on whether a cannabis business inflated cost of goods sold by reclassifying operating expenses as production costs. Records that clearly separate production activities from selling and administration are the best defense.
Larger cultivators also face the Uniform Capitalization rules under Section 263A, which pull additional costs into inventory. A small business exemption applies when average annual gross receipts over the prior three years fall below the inflation-adjusted threshold, currently around $30 million.4Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses Most cultivators sit below that line; multi-state operators and vertically integrated companies may not.
State Excise, Local, and Sales Taxes
State and local governments add their own layers on top of ordinary sales tax. These generally fall into two categories: percentage-based excise taxes on the retail price, and weight-based or potency-based taxes on the product itself.
Retail Excise Taxes
Most legal states impose an excise tax as a percentage of the retail sale price. Rates run from around 6% on the low end to 37% at the top, which is Washington State’s rate. Colorado layers a 15% retail excise on top of a 15% wholesale excise. Illinois uses a tiered system based on THC concentration, ranging from 10% for lower-potency flower to 25% for products above 35% THC. A handful of states use per-ounce or per-milligram flat taxes instead of or in addition to a percentage.
Local Taxes
Many states let cities and counties impose their own cannabis taxes, typically 1% to 5%, with some jurisdictions higher. Other states prohibit local cannabis taxes outright. In a city charging its own 3% gross receipts tax on top of a 15% state excise and standard sales tax, the combined rate can climb past 30% above the base product price.
Standard Sales Tax
Most states also apply ordinary sales tax to cannabis, the same as any other consumer product. Adding excise, local, and sales taxes together, consumers in some markets pay a combined rate below 20%, while high-tax markets can see totals above 40% of the shelf price.
Payroll Taxes
Payroll taxes are one area where cannabis employers are treated exactly like any other employer. Section 280E restricts income tax deductions but has no effect on the obligation to withhold and remit Social Security, Medicare, and federal income tax from paychecks. Cannabis employers file Form 941 quarterly, reporting wages, tips, withholding, and both the employer and employee shares of payroll taxes.5Internal Revenue Service. Instructions for Form 941
For 2026, the Social Security tax rate is 6.2% each for employer and employee, applied to wages up to $184,500.6Social Security Administration. Contribution and Benefit Base Medicare is 1.45% each with no wage cap, plus an additional 0.9% on employee wages above $200,000. Federal tax deposits must be made by electronic funds transfer, which is a problem for cash-heavy businesses that struggle with banking access. Missing a deposit creates personal liability for anyone responsible for the funds, typically owners, officers, and sometimes bookkeepers with check-signing authority.
Cash Handling and Form 8300 Reports
Even after the 2026 rescheduling, FinCEN guidance requires financial institutions to file Suspicious Activity Reports on marijuana-related business accounts, conduct extensive due diligence, and categorize each filing by level of concern.7Financial Crimes Enforcement Network. BSA Expectations Regarding Marijuana-Related Businesses Many banks decline the compliance burden, so cannabis businesses handle far more cash than any other legal retail industry.
That cash flow triggers a separate reporting duty. Any business that receives more than $10,000 in cash from a single transaction, or a series of related transactions within 24 hours, must file IRS Form 8300 within 15 days. The form is also required when the business knows a customer is structuring payments to stay under the threshold.8Internal Revenue Service. IRS Form 8300 Reference Guide A busy dispensary may file several 8300s a week.
Penalties are severe. Negligent failure to file carries $310 per return, capped near $3.8 million per year. Intentional disregard jumps to the greater of $31,520 or the cash involved, up to $126,000 per transaction. Willful failure is a felony, with fines up to $25,000 for individuals and $100,000 for corporations, plus up to five years in prison. Structuring transactions to avoid the filing carries the same criminal penalties.8Internal Revenue Service. IRS Form 8300 Reference Guide
Businesses must also send a written notice to each person named on a Form 8300 by January 31 of the following year, and keep every filed form with supporting documentation for at least five years.
Penalties and Personal Liability
Cannabis returns draw unusually close audit attention, and the penalties when the IRS disagrees can be steep.
The accuracy-related penalty under Section 6662 applies when there is a substantial understatement of income tax, meaning the understatement exceeds the greater of 10% of the correct tax or $5,000. The penalty is 20% of the underpaid amount.9Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments The IRS has specifically signaled it intends to pursue this penalty against cannabis taxpayers who aggressively deduct expenses disallowed under 280E.
The fraud penalty under Section 6663 is 75% of any underpayment attributable to fraud.10Office of the Law Revision Counsel. 26 USC 6663 – Imposition of Fraud Penalty The IRS bears the burden of proving fraud, so this is less common, but it applies when a taxpayer intentionally misrepresents income or fabricates deductions.
State-level personal exposure runs through collected taxes. When a dispensary rings up excise and sales tax on a sale, that money belongs to the government from the moment it is collected. Most states hold owners, officers, and managers personally liable for collected taxes that are not remitted, piercing the corporate form. The federal equivalent is the Trust Fund Recovery Penalty, which lets the IRS assess 100% of withheld payroll taxes against any “responsible person” who willfully fails to turn them over. Falling behind on tax remittances is one of the fastest ways to lose both a business and personal assets in this industry.
Filing, Payment, and Record-Keeping
State excise and sales tax returns are filed through online portals, with deadlines that vary by jurisdiction. Higher-volume businesses typically file monthly; smaller operations may file quarterly. Late filing penalties often start at 5% of unpaid tax and escalate with each additional month.
Payment is the practical problem. Because many cannabis businesses lack reliable banking, electronic payment is not always possible. Some operators schedule appointments at a state tax office to deliver cash in person, and a few states have arranged secure armored transport for those transfers. The federal system requires electronic funds transfer for payroll deposits and strongly prefers it for income taxes, which puts unbanked businesses in a bind.
Records tie everything together. State seed-to-sale tracking data feeds excise calculations, and point-of-sale gross receipts must reconcile with cash logs, any bank deposits, and the figures on tax returns. Every dollar of revenue and every ounce of product should be traceable from cultivation through final sale. Discrepancies between tracking system data and tax returns are among the most common audit triggers, and businesses that fall behind on documentation rarely catch up before the next deadline.