Cannabis Tax Law: 280E, COGS, and Audit Risk

Cannabis tax law is governed at the federal level by Section 280E of the Internal Revenue Code, which denies state-legal cannabis businesses nearly every ordinary business deduction and forces them to pay federal income tax on gross profit rather than net income. The U.S. Senate Finance Committee has estimated that the resulting effective income tax rate can reach as high as 80%.¹ Cost of Goods Sold is the only lawful offset, and calculating it correctly is the single most consequential tax decision a cannabis operator makes. On top of that federal burden, state excise taxes, local levies, cash-reporting obligations, and elevated audit exposure define the rest of the compliance landscape.

What Section 280E Does

The statute is one 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.² Because marijuana remains a Schedule I substance under federal law, every state-legal cannabis business falls within the prohibition regardless of how its home state classifies the activity.

Congress added 280E in 1982 after a convicted drug dealer successfully claimed business deductions on his tax return.² It was aimed at illegal operators. Nobody anticipated a regulated, multi-billion-dollar industry would later be trapped under it.

The scope of what gets disallowed is broad. Rent, utilities, advertising, insurance, professional fees, non-production salaries, employee benefits, and even the costs of complying with state cannabis regulations are all operating expenses. Under 280E, none of them reduce federal taxable income. A normal business paying $2.5 million in operating costs subtracts all of that from revenue before calculating tax. A cannabis business gets no such relief.

Why Cost of Goods Sold Is the Only Offset

Section 280E blocks deductions and credits. Cost of Goods Sold is neither. COGS is an adjustment to gross receipts that determines gross income, and that classification is what keeps it available to cannabis operators.

The U.S. Tax Court confirmed this in Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, citing legislative history stating that “the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill.”³ Congress preserved COGS because taxing gross receipts without allowing for the cost of acquiring or producing the product would likely violate the Sixteenth Amendment.

The practical consequence: every dollar that can defensibly be classified as a cost of producing or acquiring inventory reduces the 280E tax base dollar for dollar. Every dollar that falls into operating expenses effectively disappears from a tax perspective.

The Math

Consider a dispensary with $5 million in gross receipts and $2 million in COGS, leaving $3 million in gross profit. The business also incurs $2.5 million in operating expenses like payroll, rent, and marketing. A normal business would subtract those operating expenses, pay tax on the remaining $500,000, and owe roughly $105,000 at the 21% corporate rate. Under 280E, the dispensary pays tax on the full $3 million of gross profit. At 21%, the federal bill jumps to $630,000. On paper the business lost $500,000, yet it owes the IRS more than its entire net income.

The distortion gets worse at scale, and worse at thin margins. Operators in their early years can owe more in federal income tax than they earn in profit.

COGS for Cultivators and Producers

Cultivators and manufacturers have the most room to build a defensible COGS figure because they produce inventory rather than resell it. The IRS requires these businesses to use inventory accounting methods under IRC Section 471, and the older full-absorption regulations allow certain indirect production costs into inventory value. The IRS has taken the position that Section 263A’s uniform capitalization rules do not apply to cannabis businesses, so cultivators generally rely on the narrower pre-1986 inventory rules. That still allows meaningful overhead absorption.

Direct costs go into COGS with little controversy. Seeds, clones, growing media, nutrients, and other raw materials are direct material costs. Wages paid to employees who physically cultivate, harvest, trim, or process cannabis are direct labor costs.

Indirect production costs are where the real value lies. A cultivator can generally include a reasonable share of:

Facility costs tied to production, such as the portion 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 for supervisors, to the extent their time is spent overseeing production.
Lab testing required to prepare 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.

Allocating Shared Costs

The audit battleground for cultivators is how costs get split between production and non-production activities. When a building houses both a grow facility and an administrative office, you need a defensible method for allocating rent, utilities, and similar costs. Common approaches allocate by square footage, direct labor hours, or machine hours, depending on which best reflects how the cost relates to production. The method matters less than applying it consistently and documenting it thoroughly.

Marketing, human resources administration, accounting fees unrelated to inventory valuation, and front-office salaries cannot be loaded into COGS no matter how they are recategorized. Trying to do so is a fast path to an audit adjustment.

COGS for Retailers and Dispensaries

Retailers face a harsher reality. A dispensary buying finished product from a distributor is not producing anything, so its COGS is essentially limited to the purchase price paid to the supplier, plus inbound freight and any other costs directly necessary to get product onto the shelf.

Budtender wages, security costs, point-of-sale systems, store rent, advertising, and compliance staff are all selling and administrative expenses. None qualify as COGS for a reseller. That makes retail the most exposed segment of the industry, because the gap between gross profit and net income is composed almost entirely of non-deductible costs. Vertically integrated companies that both grow and sell have a structural advantage, because the cultivation side generates far more COGS capacity.

Inventory Method Selection

Every cannabis business that carries inventory must choose and consistently apply an inventory accounting method. First-In, First-Out and specific identification are the most common in the industry. The choice affects both COGS timing and the value of ending inventory. Smaller operators may qualify for a simplified approach: 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 following the full absorption rules.⁴ Larger multi-state operators will exceed that threshold and must use the full inventory framework. Changing methods requires filing IRS Form 3115.⁵

Separating Cannabis and Non-Cannabis Activities

A cannabis business that earns income from genuinely separate activities can deduct the expenses of those non-cannabis operations normally. If a cultivator sells branded merchandise through a separate retail channel, or a dispensary owner provides consulting services unrelated to cannabis sales, the income and expenses of those activities can be segregated and treated like any other business.

The key word is “genuinely.” 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 non-cannabis activity needs its own customers, its own revenue stream, and its own books.

Shared expenses between the two sides, including dual-use office space, shared employees, and common equipment, must be allocated using a reasonable and documented methodology. Where the non-cannabis activity is small relative to the cannabis operation or fundamentally dependent on it, the IRS may treat the whole enterprise as a single trafficking business and disallow the ancillary deductions.

State and Local Cannabis Taxes

Federal income tax is only part of the burden. State and local governments impose their own cannabis-specific taxes, and these vary widely. States generally use one or more of three structures:

Weight-based taxes, meaning a flat dollar amount per ounce of flower or per gram of concentrate, typically assessed at the cultivator or wholesale level.
Potency-based taxes tied to milligrams of THC, which result in concentrates and edibles being taxed at higher effective rates than raw flower.
Ad valorem taxes, a percentage of the wholesale or retail price, with rates across states generally ranging from around 6% to 37%.

Many states layer multiple structures. Illinois imposes a 7% wholesale cultivation tax plus retail excise taxes ranging from 10% to 25% depending on THC concentration, on top of a 6.35% general sales tax. Washington applies a flat 37% retail excise tax plus standard state and local sales taxes. Combined state and local burdens frequently push above 20% of retail revenue before federal income tax enters the picture. Local municipalities in many states add another 2% to 4%.

Are State Cannabis Taxes Deductible Federally?

Under normal circumstances, state taxes are deductible business expenses. But 280E blocks deductions for amounts paid in carrying on a cannabis business, which creates uncertainty. Cultivation excise taxes imposed at the production level have the strongest argument for inclusion in COGS, since they are a cost of producing or acquiring 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 where deductibility depends on how the tax is characterized and how aggressively the IRS applies 280E.

States That Decouple From 280E

At least 22 states have decoupled their state income tax codes from Section 280E, allowing cannabis businesses to deduct normal business expenses on their state returns even though those expenses remain non-deductible federally. In some states the legislature created a specific exemption; in others the state tax code never tracked 280E in the first place. The practical effect is the same. A cannabis business in a decoupled state pays state income tax on its actual net income rather than its inflated gross profit.

Compliance and Audit Risk

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 an operator has, so every dollar claimed will be scrutinized. Any expense reclassified from COGS to operating expense becomes entirely non-deductible.

Building an audit-proof record starts at invoicing. Every expense should be classified immediately into one of three buckets: deductible COGS, non-deductible 280E operating expense, or deductible non-cannabis expense if you have a genuinely separate business line. Your chart of accounts should be structured around this three-way split from day one. Retrofitting after an audit notice arrives is far harder and far less credible.

Production businesses face especially demanding documentation requirements. You need detailed time logs showing how production employees spend their hours, utility usage reports broken out by production versus non-production areas, depreciation schedules tied to specific production assets, and allocation calculations showing how shared costs were split. Without a clear paper trail connecting each COGS dollar to the production process, the IRS will reclassify it.

Inventory tracking must reconcile across three systems: internal accounting software, the state-mandated seed-to-sale tracking system, and physical inventory counts. Discrepancies between these records 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 inventory units to their production costs and sale dates is essential.

Cash Reporting Under Form 8300

Limited access to banking means many cannabis businesses handle large volumes of cash. Any business that receives more than $10,000 in cash in a single transaction or in related transactions must file IRS Form 8300 within 15 days of the transaction, provide a written statement to each person named on the form by January 31 of the following year, and keep copies of filed forms for five years.⁶

Since January 2024, businesses required to e-file other information returns such as Forms 1099 or W-2 must also e-file Form 8300 through FinCEN.⁶ Late or missed filings carry penalties that are adjusted annually for inflation. For a high-volume dispensary, a handful of missed deadlines can compound into significant liability.

Making Tax Payments Without a Bank

Federal estimated tax payments are generally due quarterly.⁷ Employment tax deposits follow either a monthly or semi-weekly schedule depending on the size of payroll.⁸ When a cannabis business owes hundreds of thousands or millions of dollars and operates largely in cash, meeting those deadlines requires planning around cashier’s checks, money orders, or in some cases physically delivering cash to an IRS office.

Where Rescheduling Stands

Section 280E only applies to substances listed in Schedule I or II of the Controlled Substances Act.² If marijuana is reclassified to Schedule III, the statute would no longer reach cannabis businesses, and operators could deduct ordinary business expenses on their federal returns like any other legal industry.

The process has been moving slowly. In August 2023 the Department of Health and Human Services recommended moving marijuana to Schedule III. In May 2024 the DEA proposed a rule to do so. An administrative hearing scheduled for January 2025 was postponed while an appeal by an involved party is resolved. On December 18, 2025, President Trump issued an executive order instructing the Attorney General to expedite and complete the rescheduling process. As of early 2026, no final rule has been published and marijuana remains a Schedule I substance.

Even if rescheduling is finalized, the IRS has stated in Tax Court filings that the change would not be retroactive. Cannabis businesses that overpaid taxes in prior years under 280E should not expect refunds. Relief would apply only going forward from the effective date of rescheduling. Rescheduling would also not make cannabis fully legal under federal law. Schedule III substances are still controlled and regulated. The change would primarily affect tax treatment, facilitate medical research, and potentially ease some banking restrictions. It would not eliminate federal oversight of the industry or resolve every conflict between state and federal cannabis law.

1
U.S. Senate Finance Committee. Marijuana Revenue and Regulation Act Summary
2
Office of the Law Revision Counsel. 26 USC 280E – Expenditures in Connection With the Illegal Sale of Drugs
3
Bradford Tax Institute. CHAMP v. Commissioner, 128 T.C. 173
4
Internal Revenue Service. Revenue Procedure 2025-32
5
Internal Revenue Service. Instructions for Form 3115
6
Internal Revenue Service. Form 8300 and Reporting Cash Payments of Over $10,000
7
Internal Revenue Service. Estimated Taxes
8
Internal Revenue Service. Depositing and Reporting Employment Taxes