Section 280E of the Internal Revenue Code is a federal tax rule that bars any business trafficking in Schedule I or Schedule II controlled substances from claiming ordinary business deductions or credits on its federal return. The only offset against revenue is cost of goods sold. Because rent, payroll, marketing, and most other operating costs remain fully taxable, a state-licensed cannabis business can face an effective federal tax rate well above the 21% corporate rate, sometimes exceeding 70% of actual net profit. The provision has been on the books since 1982 and applies in full even in states where cannabis is legal.1Office of the Law Revision Counsel. 26 USC 280E – Expenditures in Connection With the Illegal Sale of Drugs
What the Statute Blocks
The text of 280E is short. No deduction or credit is allowed for any amount paid or incurred in carrying on a trade or business that consists of trafficking in Schedule I or Schedule II controlled substances, where that trafficking is prohibited by federal law or the law of any state in which the business operates.1Office of the Law Revision Counsel. 26 USC 280E – Expenditures in Connection With the Illegal Sale of Drugs
Two features matter. First, the rule blocks both deductions and credits, so items like the research and development credit are also off the table. Second, it does not care whether state law permits the activity. Marijuana remains a Schedule I substance under federal law, so a fully licensed state operator falls squarely within 280E.
Which Businesses Are Covered
Section 280E applies to any trade or business, or any activity within a trade or business, that consists of trafficking in Schedule I or Schedule II substances.1Office of the Law Revision Counsel. 26 USC 280E – Expenditures in Connection With the Illegal Sale of Drugs “Trafficking” is read broadly. It covers retail sale, distribution, cultivation, and manufacturing, not just illegal street-level activity. A dispensary selling to patients with a physician’s recommendation is trafficking for these purposes. The restriction applies the same way to sole proprietorships, partnerships, LLCs, and corporations.
Expenses You Cannot Deduct
Ordinary businesses deduct their ordinary and necessary expenses under Section 162(a).2Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses A 280E business cannot. The blocked items include:
- Rent and utilities for retail space
- Wages paid to sales, administrative, and management staff, unless the labor ties directly to production and lands in cost of goods sold
- Marketing and advertising
- Legal, accounting, consulting, and compliance fees
- Property, liability, and workers’ compensation insurance
- Employer-paid health premiums, retirement contributions, and other employee benefits
All of it must be paid from after-tax revenue. Most of a cannabis operator’s spending stays exposed to federal tax even though the money has already gone out the door.
What You Can Subtract: Cost of Goods Sold
The one meaningful offset is cost of goods sold. Courts have long treated COGS as a return of capital rather than a business deduction, which puts it outside 280E’s reach. Taxing gross receipts without allowing recovery of product cost would run into Sixteenth Amendment problems. What counts as COGS depends on whether the business is a reseller or a producer.
Resellers
A dispensary or distributor buying finished product from a supplier can include the purchase price of inventory, freight in, and other charges directly tied to acquiring the goods. These items are governed by Treasury Regulation 1.471-3(b). The range of includable costs is narrower than what a producer can capture.
Producers and Manufacturers
Growers, cultivators, and manufacturers can include a wider set of costs. Under the full absorption method in Treasury Regulation 1.471-11, producers include all direct production costs plus certain indirect production costs in inventory:3eCFR. 26 CFR 1.471-11 – Inventories of Manufacturers
- Heat, power, and light used in the production facility
- Maintenance and repairs on production equipment and growing facilities
- Indirect labor, including production supervisors, plus related payroll taxes, overtime, and benefits
- Indirect materials and supplies consumed in production
- Quality control and inspection
- Tools and equipment not capitalized as fixed assets
Factory-related property taxes, production insurance, and factory administrative expenses can also be included if the taxpayer’s treatment matches its GAAP financial statements.3eCFR. 26 CFR 1.471-11 – Inventories of Manufacturers Building out COGS carefully is one of the few real levers a 280E business has.
The Section 471(c) Small Business Exception
The Tax Cuts and Jobs Act of 2017 added Section 471(c), which lets qualifying small businesses account for inventory based on their financial statements or books and records rather than the full absorption method.4Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories To qualify, average annual gross receipts must generally be $30 million or less over the prior three years under the Section 448(c) test. Some practitioners argue this allows cannabis businesses to move costs into COGS that would otherwise be blocked by 280E. The IRS has not issued definitive guidance, so the position carries real risk.
How the Math Works
The federal corporate rate is 21%. An ordinary business pays that on net income after all deductions. A 280E business pays on gross profit, revenue minus COGS only.
Take a dispensary with $1,000,000 in revenue, $400,000 in COGS, and $500,000 in operating costs. An ordinary business would report $100,000 in taxable income and owe $21,000. The 280E business reports $600,000 (revenue minus COGS) and owes $126,000, more than its actual $100,000 net profit. Effective rates on real earnings above 70% are common in the industry, and in tight-margin cases the number tops 100%.
Running a Separate Non-Trafficking Business
One approach that has held up in court is operating a genuine non-trafficking business alongside the controlled-substance activity. In Californians Helping to Alleviate Medical Problems (CHAMP) v. Commissioner, the Tax Court held that 280E does not prevent deducting expenses tied to a trade or business separate from the trafficking activity. CHAMP provided caregiving services, including support groups, food distribution, counseling, and educational classes, alongside medical marijuana. The court found the caregiving side stood on its own and allowed the associated deductions.
Whether two activities are actually separate is a facts-and-circumstances question that turns on how economically intertwined they are. When the separation holds, expenses have to be allocated between the two operations, typically by headcount, square footage, or a similar objective measure. Expenses allocated to the non-trafficking side are deductible normally. Expenses allocated to the trafficking side remain blocked.
Audit Risk and Penalties
Cannabis businesses draw much heavier IRS scrutiny than comparably sized businesses in other industries. The gap between what an operator might try to deduct and what 280E actually permits tends to be large, which makes these audits productive for the agency.
An underpayment that traces to improperly deducted expenses can pick up an accuracy-related penalty of 20% under Section 6662, or 40% for a gross valuation misstatement, on top of the tax owed.5Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments With the dollar amounts involved, careful recordkeeping around COGS calculations and any separated business lines is essential.
State Tax Treatment Is Not the Same
State rules do not automatically follow federal. At least 22 states have decoupled from 280E, letting state-licensed cannabis businesses deduct normal operating expenses on their state returns even though those same expenses remain nondeductible federally. A cannabis operator in a decoupled state can face a reasonable state tax bill alongside an outsized federal one. The details, including which expenses qualify and any state-specific COGS rules, vary, so check the rules in your state.
Rescheduling and Whether 280E Might Go Away
Section 280E only reaches substances on Schedule I or Schedule II. If marijuana moves to Schedule III, cannabis businesses would drop out of 280E and could deduct operating expenses like any other legal business, and previously blocked credits such as the R&D credit would become available.
The rescheduling process is not finished. HHS recommended a Schedule III move in 2023. In May 2024, the Department of Justice issued a proposed rule to implement it, drawing nearly 43,000 public comments.6The White House. Increasing Medical Marijuana and Cannabidiol Research An administrative law judge hearing scheduled for January 2025 was postponed pending an interlocutory appeal.7Moritz College of Law. Federal Marijuana Rescheduling – Process and Impact In December 2025, President Trump signed an executive order directing the Attorney General to complete the rulemaking as quickly as possible.
No final rule has issued, and no effective date is set. Until rescheduling takes effect, 280E applies in full. Claiming deductions on the assumption that the change is coming risks the accuracy-related penalties above.