At a Glance
Section 280E can create effective tax rates exceeding 70% for cannabis businesses, fundamentally altering the economics of an otherwise profitable industry. Originally enacted in 1982 after Edmondson v. Commissioner allowed a cocaine trafficker to deduct business expenses, the statute now applies to every state-legal cannabis operation.
IRS audit data has historically shown significantly higher yields from cannabis examinations compared to mainstream businesses. This disparity reflects the reality that every ordinary business expense becomes a permanent addition to taxable income for cannabis operators.
For producers under Section 1.471-11, the inventory rules let you capitalize the costs of making product, not running the business. Plant-room rent, production wages, grow-room utilities, and other indirect manufacturing overhead can be allocated into COGS on a reasonable basis. Corporate office rent, sales salaries, marketing, and similar selling or administrative costs stay outside COGS.
For resellers under Section 1.471-3(b), COGS generally covers only what it took to acquire the merchandise: the invoice price plus pre-title freight, handling, and any required testing before title passes. After title passes, store rent, budtender wages, security, marketing, insurance, and other operating costs are selling or administrative and remain disallowed under Section 280E. Clear contract language about when title passes and consistent documentation help keep these lines clean.
Illustrative Example: The 280E Impact
Two identical retail businesses operating in Denver demonstrate the federal tax disparity:
Mountain Gear (Outdoor Equipment)
Mountain Cannabis (Dispensary)
The cannabis operator pays $945,000 more in federal tax annually on identical economics.
This structural disadvantage affects every state-legal cannabis business. When combined with state conformity and limited access to capital, the tax burden can exceed the actual economic profit of the business. Understanding how inventory accounting under Section 471 can provide relief becomes essential for managing this extraordinary burden.
With ordinary deductions blocked, inventory accounting under Section 471 becomes the primary mechanism for reducing taxable income. Cost of goods sold remains deductible because federal income tax measures income, not receipts, providing the sole federal tax relief for cannabis operators.
Section 471 creates two distinct frameworks for cannabis businesses. The classification between producer and reseller can significantly affect tax liability and overall business viability. Each framework offers different opportunities for capturing costs, making the initial classification decision critical for long-term tax efficiency.
Resellers operate under Section 1.471-3(b), which limits inventory costs to amounts “necessary to acquire possession.” This includes:
That last category deserves attention. State-mandated testing performed before title transfer can qualify. Secure transport required by regulation before taking possession counts. Compliance costs incurred after you already own the product don’t. Costs incurred after title passes are generally not includible in COGS.
The optimization opportunity is limited but important. Structure vendor agreements so compliance costs occur before title transfers. Negotiate delivery terms that keep ownership with suppliers longer. Every dollar that becomes acquisition cost instead of operating expense directly reduces the tax burden. While resellers face these constraints, producers operating under Section 1.471-11 enjoy substantially broader opportunities for cost inclusion.
Cultivators and manufacturers must use full absorption costing under Section 1.471-11, but navigating its categories requires precision. The regulation creates distinct buckets with different treatment, and misunderstanding these distinctions can trigger costly adjustments.
Direct production costs under 1.471-11(b)(2) include direct material costs and direct labor costs:
Required indirect costs under 1.471-11(c)(2)(i) must be capitalized when “incident to and necessary for production”:
Costs under 1.471-11(c)(2)(iii) are inventoriable only to the extent capitalized for financial accounting purposes. These include:
The critical limitation: these costs can only be included in tax COGS if you also capitalize them for book purposes. Cannabis businesses that expense these items for financial reporting effectively block them from tax COGS. Tax inclusion is permitted only to the extent the cost is also capitalized for financial reporting.
The 1.471-11(c)(2)(ii) categories create confusion for cannabis operators. Unlike the required costs above, this section lists costs explicitly “not required to be included” in inventory:
While flush language suggests these indirect production costs may be included if treated consistently for book and tax purposes, cannabis businesses face unique barriers. Lord v. Commissioner held that accelerated depreciation (Section 179 and bonus depreciation) cannot be included in cannabis COGS. The IRS has consistently rejected attempts to include marketing or advertising costs, even when allocable to production.
Even if a cannabis operator wanted to add these (c)(2)(ii) costs to inventory, method changes require IRS consent (Form 3115), and approvals for cannabis inventory methods are effectively unavailable.
The practical reality for cannabis producers: capture all clearly allowable costs under (c)(2)(i), evaluate whether capitalizing (c)(2)(iii) costs for book purposes makes sense given the tax benefit, and avoid aggressive positions on (c)(2)(ii) costs. The IRS has shown limited tolerance for (c)(2)(ii) interpretations in cannabis cases, and the cost of reversal often exceeds any temporary benefit. Keep cost allocations reasonable and maintain consistency between book and tax where advantageous.
Inventory costing methods affect when capitalized costs hit the tax return. Standard costing, burden rates, or specific identification all work, but they determine how much of production costs get deducted when product sells versus sitting in ending inventory. For cannabis businesses carrying significant inventory, this timing difference can swing taxable income by hundreds of thousands. Whatever method chosen must reflect actual operations and be applied consistently. Changing methods to chase favorable outcomes invites unwanted attention.
The economic impact of classification extends beyond technical distinctions. A cultivation facility capturing indirect production costs might achieve COGS of 50% of revenue, while a dispensary limited to acquisition costs might reach only 30%. This difference substantially affects profitability in an industry already facing extraordinary tax burdens.
Illustrative Example: Classification Impact
Consider two cannabis operations, each with $10 million in annual revenue:
GrowCo (Cultivation Facility – Producer Treatment)
DispenseCo (Retail Dispensary – Reseller Treatment)
The reseller pays $168,000 more in annual federal tax despite identical revenue
The lesson is clear: classification sets the base. Execution determines the result.
Vertical integration offers cannabis operators a path to capture producer treatment benefits while controlling their supply chain. When related entities handle multiple stages of production and distribution, the structure creates opportunities to maximize COGS through internal transfer pricing.
The key lies in proper segmentation and documentation. Cultivation and manufacturing operations function as producers, capturing direct and indirect production costs under 1.471-11. When product transfers to distribution or retail operations, that transfer price becomes the next entity’s acquisition cost. Each transfer point requires arm’s length pricing (what unrelated parties would pay) documented with comparable market transactions.
For example, a vertically integrated operator with $10 million in total revenue might structure as follows: cultivation sells flower to the manufacturing arm at $1,500 per pound (wholesale market rate), manufacturing processes into oil and sells to distribution at standard wholesale pricing, and distribution sells to third-party retailers or the company’s own dispensaries. Each producer entity (cultivation and manufacturing) captures its full 1.471-11 costs, while distribution operates under the more limited 1.471-3(b) rules.
This structure can be particularly powerful when manufacturing adds significant value. A cultivation facility might achieve COGS of 40% of revenue, but the extraction facility processing that flower into concentrates might reach 60% or higher due to labor-intensive processing and specialized equipment costs.
Success requires genuine operational separation between business segments, contemporaneous documentation of transfer pricing methodology, and consistency with state regulations on vertical integration. The cumulative tax savings from multiple producer segments can justify integration even when market dynamics might otherwise favor specialization.
Maintaining separate trades or businesses provides another potential avenue for tax relief. This approach emerged from Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP), where a nonprofit’s caregiving services were found to be distinct from its cannabis operations.
The Tax Court held that Section 280E doesn’t automatically apply to all activities within an organization. CHAMP successfully deducted expenses attributable to its caregiving services, which operated independently from cannabis sales. However, subsequent cases have established strict requirements for qualifying as separate businesses.
Olive v. Commissioner held that activities generating no revenue cannot constitute a trade or business. Harborside found that de minimis non-cannabis sales lacked substance for separation. These precedents establish that genuine economic substance and operational independence are essential for any separation strategy to succeed.
The 2018 Farm Bill created one concrete opportunity for cannabis operators: industrial hemp. Hemp with less than 0.3% delta-9 THC falls outside the Controlled Substances Act and therefore outside Section 280E. This regulatory distinction opens the door to normal tax treatment for qualifying operations.
An operator could potentially segregate hemp operations from THC cannabis activities. The hemp business would enjoy normal tax treatment, including full deduction of ordinary business expenses, while the cannabis operations remain subject to 280E.
Success requires operational segregation, regulatory compliance with all hemp requirements, and genuine economic substance. Operators must confirm that hemp operations meet all federal and state definitions (≤0.3% delta-9 THC, licensing, testing) and that cannabinoid derivatives are compliant in each state. Operators successfully maintaining both hemp and cannabis businesses report meaningful tax savings on hemp-related operating expenses.
The separate trade or business approach remains available, but the requirements for establishing genuine separation are substantial. Operational independence matters. The degree of separation between businesses, including factors like shared employees, common management, and financial relationships, affects the strength of the position. Each situation requires careful analysis of specific facts and circumstances.
The gap between understanding 280E principles and implementing effective strategies often determines whether operators face sustainable tax rates or crushing burdens. Success requires aligning tax positions with actual operations while maintaining the flexibility to adapt as regulations and interpretations evolve.
The producer-reseller distinction isn’t always binary. Extraction operations that transform flower into concentrates likely qualify as manufacturing, but the degree of transformation matters. Infusing purchased distillate into edibles might qualify; packaging purchased flower into pre-rolls might not. These edge cases require careful analysis of actual operations against judicial precedent.
Multi-state operators face particular complexity when operations differ by state. Cultivation in one state and reselling in another creates transfer pricing questions that affect both federal tax burden and state apportionment. The interplay between federal classification and state sourcing rules can create unexpected results.
For producers, the choice of allocation method can swing tax liability by hundreds of thousands annually. While Section 1.471-11 permits various reasonable methods, the definition of “reasonable” requires both economic logic and consistent application.
Consider a cultivation facility allocating utility costs. Simple square footage might suggest 60% allocation to grow rooms. Actual metering showing 85% consumption by cultivation operations supports higher allocation. But switching between methods based on favorable outcomes invites scrutiny. The key is selecting methods that reflect actual usage and maintaining them consistently.
Federal 280E creates the primary challenge, but state treatment determines whether federal strategies deliver meaningful relief.
Decoupling states include California and New York. These states allow normal deductions for state purposes, reducing combined effective rates but requiring maintaining separate calculations. Federal COGS positions might not optimize state deductions, creating competing incentives with different optimal strategies.
Conformity states follow federal treatment, making federal COGS maximization critical. Every dollar excluded from federal COGS increases state tax proportionally, multiplying the impact of classification decisions. Partial-conformity rules in other states require targeted adjustments that can change the combined result.
Multi-state operators face additional complexity with transfer pricing across jurisdictional boundaries. Cultivation in conformity states and retail in decoupling states creates both tax planning challenges and operational considerations that affect competitiveness.
Certain municipalities also impose gross-receipts taxes regardless of profitability, which sit outside 280E.
Sapowith Tax Advisory helps cannabis operators develop sustainable tax strategies within 280E’s constraints. We combine technical mastery of Section 471 with practical experience across cultivation, manufacturing, distribution, retail, and vertically integrated operations.
Our approach recognizes that effective tax positions must align with actual operations and withstand examination. From single-state dispensaries to multi-state operations, we provide planning and implementation support calibrated to each client’s specific circumstances.
Contact us to develop a comprehensive strategy aligned with your operational model, growth objectives, and risk parameters. In cannabis taxation, the difference between sophisticated planning and aggressive positioning often determines long-term viability.
This article is for general information only; it is not tax, legal, or accounting advice. Reading it does not create a client relationship with Sapowith Tax Advisory. Consult your own qualified advisers before acting on any information contained here. Sapowith Tax Advisory disclaims all liability for actions taken, or not taken, based on this content.