Understanding IRC Section 280E: A Guide for Cannabis Businesses

What is IRC Section 280E?

IRC Section 280E is a federal tax provision enacted in 1982 that prohibits businesses "trafficking in controlled substances" from deducting ordinary and necessary business expenses. Because cannabis remains a Schedule I substance under the Controlled Substances Act, all state-licensed cannabis businesses — dispensaries, cultivators, manufacturers, and distributors — fall under 280E.

This means that while a typical business can deduct rent, utilities, marketing, salaries, and other operating expenses, a cannabis business cannot. The only deduction available under 280E is Cost of Goods Sold (COGS).

Why 280E Matters for Your Bottom Line

Without 280E optimization, cannabis businesses routinely overpay their federal taxes by tens of thousands of dollars per year. A dispensary generating $2 million in revenue might have an effective tax rate of 70% or more if expenses aren't properly classified. Proper COGS allocation can reduce this dramatically.

The difference between getting 280E right and getting it wrong is often the difference between profitability and operating at a loss.

What Qualifies as COGS Under 280E?

Under IRS guidance and Revenue Procedure 2010-13, cannabis businesses can deduct costs directly related to producing or acquiring inventory:

• Direct Materials — Seeds, clones, soil, nutrients, growing media, packaging materials for finished products
• Direct Labor — Wages for cultivation staff, trimmers, extraction technicians, and production workers
• Indirect Production Costs — Facility rent (production areas only), utilities for grow rooms, depreciation on production equipment, quality testing

What Cannot Be Deducted?

The following expenses are disallowed under 280E and cannot be deducted from taxable income:

• Advertising, marketing, and promotional expenses
• Administrative salaries (owners, managers, office staff not in production)
• Professional fees (legal, accounting, consulting)
• Office rent and supplies (non-production areas)
• Insurance premiums
• Bank fees and interest
• Travel and entertainment

Inventory Costing Methods

IRS Revenue Procedure 2010-13 allows cannabis businesses to use standard inventory costing methods to calculate COGS:

• FIFO (First In, First Out) — Oldest inventory costs are matched to revenue first. Best when input costs are rising.
• LIFO (Last In, First Out) — Newest inventory costs are matched first. Can increase COGS deductions when prices rise.
• Weighted Average — Averages all inventory costs over the period. Simplest to maintain and defend in an audit.

Choosing the right method depends on your business type, inventory turnover rate, and pricing trends. Consistency is key — the IRS expects you to use the same method each year.

The Separate Trade or Business Strategy

Some cannabis operators structure their business with a separate entity that handles non-plant-touching activities (consulting, management, real estate). This "separate trade or business" can potentially deduct expenses that the cannabis entity cannot. However, this strategy requires careful legal structuring and genuine economic substance to withstand IRS scrutiny.

Common 280E Audit Triggers

The IRS actively audits cannabis businesses. Common triggers include:

• Unusually high COGS relative to revenue
• Inconsistent expense classification between periods
• Lack of documentation supporting COGS allocations
• Cash-heavy operations without proper transaction records
• Discrepancies between state reports (METRC) and tax filings

Maintaining detailed, audit-ready records is the best defense. Every expense allocation should be documented and defensible.