What Qualifies as COGS for Cannabis Businesses Under 280E?

For a cannabis business subject to Section 280E, cost of goods sold under 280E is the only figure that reduces taxable income, because COGS is subtracted before gross income is calculated and therefore sits outside the statute’s ban on deductions and credits. Producers and cultivators can inventory direct materials, direct production labor, and a fairly apportioned share of indirect production costs under the pre-uniform-capitalization rules of Treasury Regulation 1.471-11. Retailers and dispensaries are held to a much narrower rule: invoice price, less trade discounts, plus the cost of getting the goods to the store.

Why COGS Is the Only Number That Matters Under 280E

Section 280E denies any deduction or credit for a business that traffics in Schedule I or II controlled substances.¹ Rent for retail space, budtender wages, advertising, insurance, and administrative payroll are all non-deductible at the federal level. A dispensary with $2 million in gross profit and $1.8 million in those operating costs still owes federal income tax on the full $2 million.

The Tax Court’s decision in CHAMP v. Commissioner confirmed the escape hatch: cost of goods sold is not a “deduction.” COGS is subtracted from gross receipts to reach gross income under Section 61(a)(3), and that subtraction happens before 280E applies. Every dollar legitimately classified as COGS directly lowers taxable income. Operators who fail to maximize COGS can see effective federal tax rates above 70%; operators who document inventory costs carefully bring that rate much closer to normal.

One boundary matters here. The Department of Justice has placed FDA-approved marijuana products and products regulated under a state medical marijuana license into Schedule III, and has begun a broader rescheduling process for all marijuana.² Treasury has said 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.”³ Medical operators whose products now sit in Schedule III should check with a tax professional about whether ordinary deductions are available to them. Adult-use businesses remain under 280E until the broader rescheduling is finalized, and the COGS analysis below still governs their federal return.

What Producers and Cultivators Can Include in COGS

Cannabis cultivators and manufacturers calculate inventory costs under Section 471 of the Internal Revenue Code and the Treasury Regulations that predate the uniform capitalization rules.⁴ Section 263A, which normally lets producers capitalize additional indirect costs into inventory, does not help cannabis businesses. The statute’s flush language provides that any cost that could not otherwise be taken into account in computing taxable income cannot be treated as inventoriable under 263A.⁵ Since 280E disallows those costs, they can’t be recycled into inventory through 263A. The IRS Chief Counsel has confirmed this reading.

That leaves producers with the “full absorption” method under Treasury Regulation 1.471-11, which still allows a meaningful set of costs:

Direct materials: seeds, clones, soil, growing medium, nutrients, water, and pesticides used in cultivation.
Direct labor: wages and benefits for employees who physically cultivate, harvest, trim, dry, cure, and process the plants.
Indirect production costs: rent, utilities, depreciation on grow equipment, quality control testing, and packaging materials, but only the portion attributable to the production facility.⁶

The line between production costs and disallowed operating expenses is where audits are won or lost. Wages for a cultivation manager who also handles marketing are only partially includable, and the production share has to be documented through contemporaneous time tracking, not estimated after the fact.

Allocating Indirect Production Costs

The full absorption regulations require indirect production costs to be “fairly apportioned” among items produced. They split into fixed costs (rent, property taxes on production buildings, depreciation) and variable costs (heat, power, lighting).⁶ Both categories can be inventoried, but only to the extent they relate to production rather than retail or administration.

Two allocation methods are specifically recognized. The manufacturing burden rate method lets you build overhead rates using acceptable accounting principles, and you can apply different rates to different cost categories, such as one rate for rent and another for utilities. The standard cost method works similarly but uses predetermined estimates that are adjusted periodically. Whichever you choose, the IRS gives “great weight” to the method you use in your financial reports, so your tax allocation and your internal books should agree.⁶

Practical capacity is the other concept to understand. If your grow facility could produce more than it actually does, you can allocate only the fixed costs tied to the capacity you actually use. Fixed costs attributable to idle capacity would otherwise be currently deductible, which under 280E means they simply don’t reduce federal taxable income. That’s a loss, but it prevents you from inflating COGS with costs tied to unused space, which is the kind of discrepancy that draws IRS attention.

What Resellers and Dispensaries Can Include in COGS

Retailers and dispensaries buying finished product from wholesalers operate under a much narrower rule. Treasury Regulation 1.471-3(b) defines inventory cost for purchased merchandise as the invoice price minus trade discounts, plus transportation and other necessary charges to take possession.⁷

The purchase price on the supplier invoice, less volume discounts or rebates, forms the base. Add freight, delivery, and any applicable duties. Everything else a dispensary spends money on, including budtender wages, security, point-of-sale systems, display fixtures, and store rent, falls outside COGS and is non-deductible under 280E.¹ This is why standalone retailers carry a heavier effective tax burden than vertically integrated operations that can fold cultivation costs into COGS.

Choosing an Inventory Valuation Method

How you value inventory on hand at year-end directly affects COGS. Four methods are available:

First-in, first-out (FIFO): assumes the oldest inventory is sold first. When wholesale prices are rising, FIFO produces a lower COGS because sold units carry older, cheaper prices.
Last-in, first-out (LIFO): assumes the newest inventory is sold first. In a rising-price environment, LIFO produces a higher COGS, which is generally more favorable under 280E.
Weighted average cost: spreads total costs across all units. This smooths price fluctuations and simplifies record-keeping.
Specific identification: tracks the actual cost of each individual item. The most precise and the most labor-intensive, usually practical only for high-value, low-volume products.

The IRS requires consistency. Switching methods requires filing Form 3115 and obtaining IRS consent. Between FIFO and LIFO alone, the choice can shift thousands of dollars between taxable and non-taxable income, so it deserves more thought than many operators give it.

Documentation the IRS Expects

The IRS expects records that trace every dollar from purchase or production through to sale. During an audit, the agency looks for receipts grouped by date with a note on business purpose, bills showing recipient and service type, canceled checks matched to those bills, loan agreements with full terms, and logs or diaries tracking business activity.⁸ No single document stands on its own; the agency wants the surrounding context.

For producers, that means time sheets or labor tracking for cultivation staff, invoices for seeds and growing supplies, utility bills with clear allocation between grow space and other areas, and equipment depreciation schedules. For resellers, supplier invoices and freight receipts form the core. Both should maintain beginning and ending inventory counts for each tax year, since COGS equals beginning inventory plus purchases and production costs minus ending inventory.

Retention: the IRS baseline is three years from filing or two years from payment, whichever is later, but that extends to six years if you fail to report more than 25% of gross income.⁹ Given the scrutiny cannabis returns attract, six years is the safer floor. Employment tax records require at least four.

Reporting COGS on the Return

Corporations and partnerships report COGS on Form 1125-A, which attaches to Form 1120 or Form 1065.¹⁰¹¹ The form asks for beginning inventory, total purchases, labor costs, other costs (indirect production overhead), and ending inventory. Beginning inventory plus costs minus ending inventory equals COGS for the year.

Sole proprietors don’t use Form 1125-A. They report COGS directly in the cost-of-goods-sold section of Schedule C (Form 1040). This is a common point of confusion for single-owner dispensaries and small cultivators.

State Relief From 280E

At least 22 states have decoupled from federal 280E treatment, allowing cannabis businesses to deduct ordinary expenses on their state returns even when those deductions are blocked federally. Some states enacted specific exemptions; others never adopted 280E in the first place. States that have decoupled include California, Colorado, Connecticut, Illinois, Maryland, Massachusetts, Michigan, Minnesota, Missouri, New Jersey, New York, Oregon, and Vermont, among others.

The mechanism works because most states start from federal taxable income or federal AGI. When 280E inflates federal taxable income, that inflated number flows through. Decoupling states add the disallowed deductions back at the state level, producing a state figure that reflects actual profitability. If your state has decoupled, your state tax bill can be significantly lower than the federal return suggests, but you have to file state returns that specifically claim those deductions.

Audit Risk and Accuracy Penalties

Cannabis returns draw elevated audit attention because COGS is the single largest variable and operators have every incentive to push costs into it. Common triggers include COGS figures that look high against industry benchmarks, inconsistent allocation between tax returns and financial statements, and thin inventory records.

When the IRS reclassifies expenses from COGS to disallowed deductions, the result is additional tax plus an accuracy-related penalty of 20% of the underpayment, rising to 40% for a gross valuation misstatement.¹² Interest runs on both the tax and the penalty from the original due date. For a business already paying effective tax rates far above normal, an audit adjustment with penalties can be existential.

The strongest defense is contemporaneous documentation, meaning records created when costs were incurred rather than reconstructed before an audit. Time-tracking for production labor, utility sub-metering for grow spaces, and inventory software that logs unit costs at purchase all create evidence that holds up. Operators who wait until tax season to sort expenses into categories are the ones who lose audit fights.

1
Office of the Law Revision Counsel. 26 U.S.C. 280E – Expenditures in Connection With the Illegal Sale of Drugs
2
U.S. Department of Justice. Justice Department Places FDA-Approved Marijuana Products and Products Containing Marijuana Regulated by State Medical Marijuana Licenses in Schedule III
3
U.S. Department of the Treasury. Treasury, IRS Announce Process for Tax Guidance Following DOJ Rescheduling Order
4
Office of the Law Revision Counsel. 26 U.S.C. 471 – General Rule for Inventories
5
Office of the Law Revision Counsel. 26 U.S.C. 263A – Capitalization and Inclusion in Inventory Costs of Certain Expenses
6
eCFR. 26 CFR 1.471-11 – Inventories of Manufacturers
7
eCFR. 26 CFR 1.471-3 – Inventories at Cost
8
Internal Revenue Service. Audits – Records Request
9
Internal Revenue Service. How Long Should I Keep Records
10
Internal Revenue Service. About Form 1125-A, Cost of Goods Sold
11
Internal Revenue Service. Form 1120 – U.S. Corporation Income Tax Return
12
Office of the Law Revision Counsel. 26 U.S.C. 6662 – Imposition of Accuracy-Related Penalty on Underpayments