Cannabis COGS Calculation: What Costs Can You Actually Include?

Cannabis businesses still under 280E pay federal income tax on their gross income with exactly one offset: cost of goods sold. That is the consequence of IRC 280E, which denies every deduction and credit to any business that traffics in a Schedule I or Schedule II controlled substance. Since April 28, 2026, a Justice Department final rule has placed marijuana in an FDA-approved product or subject to a state medical marijuana license in Schedule III, and the rule says those state licensees will no longer be subject to 280E (while stating it makes no federal tax determination). All other marijuana, including adult-use (recreational) product, remains on Schedule I, so 280E still applies to those businesses. A broader proposal to move all marijuana to Schedule III is still pending at DEA (its hearing began June 29, 2026, and no final rule has been published), and no legalization bill has been enacted. This guide is written for businesses still under 280E. The only relief available is the COGS subtraction, because COGS is not a “deduction” under the tax code. It is an adjustment to gross receipts that determines gross income in the first place. The broader mechanics of 280E are covered in our 280E overview. This article is about the calculation itself: what goes into COGS, what stays out, and how to build the cost-accounting methodology that survives an audit.

Why is COGS the only offset under 280E?

Because the statute denies “any deduction or credit” to a business trafficking in a controlled substance, but COGS is neither a deduction nor a credit. COGS is the mechanism by which gross income is calculated under IRC 61. The IRS recognized this distinction in Chief Counsel Advice 201504011 and in its cannabis industry FAQs. In Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173 (2007), the government conceded that 280E does not bar COGS, even though 280E barred the deductions of the dispensary’s marijuana business. The CHAMP decision did not expand what counts as COGS. Because the government conceded the point, the case left the existing COGS rules in place, and 280E does not override them.

The practical result is that every dollar you can legitimately move from “operating expense” into “cost of goods sold” reduces your taxable income dollar-for-dollar, while every dollar that stays classified as an operating expense produces zero tax benefit. For a cannabis business in the 37% federal bracket, a $100,000 cost that qualifies as COGS saves $37,000 in federal tax. The same $100,000 classified as a selling or administrative expense saves nothing.

What costs go into COGS for a cannabis cultivator?

The IRS position is that cannabis businesses must use the inventory-costing rules under IRC 471 and its regulations as they existed when 280E was enacted in 1982, not the later IRC 263A rules. The TCJA added Section 471(c), which lets certain small businesses (average annual gross receipts of $32 million or less for 2026) use a simplified inventory method or treat inventory as non-incidental materials and supplies. IRS cannabis guidance (Chief Counsel Advice 201504011 and the cannabis industry FAQs) does not say how Section 471(c) works for a business under 280E, so using it carries risk. The traditional route for a cultivator is the full-absorption costing rules of Treas. Reg. 1.471-11, which capture production overhead such as rent and utilities into inventory (and therefore into COGS).

Under the full-absorption method, the following categories of cost are includable in COGS.

Direct materials. Seeds, clones, starter plants, soil, growing medium, nutrients, fertilizers, pesticides, and water used in cultivation. These are the raw-material inputs to the production process and are always part of COGS without dispute.

Direct labor. Wages, payroll taxes, and benefits for employees whose work is directly attributable to the cultivation, processing, trimming, curing, or packaging of the product. This includes growers, trimmers, extraction technicians, and packaging line workers. It does not include budtenders, delivery drivers, sales staff, or the general manager (unless the general manager spends a substantial, documented percentage of time on production activities, in which case that percentage is allocable).

Packaging and labeling materials. Containers, child-resistant packaging, labels, and compliance stickers that are part of the finished product as it enters inventory. These are direct materials consumed in the production process.

Quality-control testing. Testing costs incurred as part of the production process (potency testing, contaminant screening required before the product can be sold) are allocable to COGS as an indirect production cost under Treas. Reg. 1.471-11. Testing performed for marketing purposes or consumer education is not.

Facility costs allocated to production. This is where the calculation becomes both more valuable and more contentious. Under the full-absorption rules of Treas. Reg. 1.471-11, indirect costs that are incident to and necessary for production are capitalized into inventory (rent and utilities always; property taxes, insurance, and depreciation follow how the business’s financial statements treat them). For a cannabis cultivator, this includes the portion of facility rent, utilities (electricity for grow lights, HVAC, water systems), property taxes, insurance, and building depreciation that is attributable to the cultivation and processing areas of the facility.

The allocation must be reasonable and documented. A common method is square-footage allocation: if 60% of a facility’s square footage is dedicated to cultivation, processing, and packaging, then 60% of rent, utilities, property insurance, and building depreciation is allocable to COGS. The remaining 40% (retail floor, offices, break rooms, storage for non-production items) is a period cost, and under 280E, it produces no tax benefit.

Equipment depreciation. Depreciation on equipment used directly in production (grow lights, irrigation systems, trimming machines, extraction equipment, packaging machinery) is an indirect production cost under Treas. Reg. 1.471-11 and is includable in COGS when the business’s financial statements treat it as a production cost. Depreciation on office furniture, point-of-sale systems, or delivery vehicles is not.

What costs are excluded from COGS?

The line is clear in principle: costs that relate to selling, marketing, administration, or distribution are not production costs and do not belong in COGS. Under 280E, they are simply non-deductible. The major categories that cannot be included are:

• Selling expenses: budtender wages, sales commissions, point-of-sale costs, display materials, customer loyalty program costs
• Marketing and advertising: website, social media, print advertising, promotional events, branding, consulting fees for marketing strategy
• General and administrative: executive compensation (unless allocated to production), legal fees, accounting fees, office supplies, office rent (for space not used in production), software subscriptions unrelated to production
• Distribution and delivery: driver wages, vehicle costs, fuel, delivery app fees, transportation insurance
• Regulatory compliance costs not tied to production: licensing fees, legal costs for license applications or renewals, lobbyist fees, compliance consulting
• Interest expense: interest is on the list of costs Treas. Reg. 1.471-11 leaves out of inventory, and the IRS position is that a 280E business cannot use Section 263A to capitalize it

The temptation is to reclassify selling and administrative costs as production costs to expand COGS. This is exactly what the IRS looks for in a cannabis audit. A budtender is a retail employee, not a production worker, regardless of whether the dispensary’s internal titles describe the role as “product specialist” or “patient consultant.” A delivery driver’s wages are distribution costs, not production costs, even if the driver occasionally helps unload shipments at the warehouse. The allocation must reflect the actual function performed, not the label assigned to it. The audit risk and compliance article covers how the IRS scrutinizes these classifications in practice.

How do the Section 471 inventory rules interact with 280E?

IRC 471 requires a business that produces or resells merchandise to account for inventory. COGS is calculated as beginning inventory plus purchases (or production costs) minus ending inventory. For a cannabis business, this means every unit of product must be tracked from seed or clone through harvest, processing, and sale. The inventory valuation method (FIFO, weighted average, specific identification) determines which costs flow through to COGS in each period.

The TCJA’s Section 471(c) created an exception for small businesses, allowing them to treat inventory as non-incidental materials and supplies deductible when used or consumed. IRS cannabis guidance does not say whether a business under 280E can use this exception. Its published position (Chief Counsel Advice 201504011 and its cannabis industry FAQs) is that a 280E business calculates COGS under Section 471 and the associated Treasury Regulations, which treat COGS as part of the gross-income calculation rather than as a deduction. That makes the traditional Section 471 rules the safer footing.

The key operational requirement is perpetual inventory tracking. A cannabis cultivator or processor needs a system that records the cost of every input (seeds, soil, nutrients, labor hours, facility overhead) allocated to each batch or lot, tracks the inventory through each stage of production, and releases costs to COGS only when the finished product is sold. Seed-to-sale tracking systems required by most state regulators provide the production-side data, but they do not calculate costs. A parallel cost-accounting system, whether built in a general ledger, a specialized cannabis ERP, or a well-structured spreadsheet, must assign dollar amounts to each unit of inventory and reconcile to the seed-to-sale records.

How does the CHAMP case affect the COGS calculation?

The Tax Court’s 2007 decision in CHAMP (Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173) is the foundational case for cannabis COGS. In CHAMP, the government conceded that 280E does not stop a dispensary from subtracting its cost of goods sold from gross receipts, because COGS is part of the gross-income calculation, not a deduction.

CHAMP also addressed the dispensary’s caregiving activities (counseling, support groups) and allowed deductions for those services under a separate-trade-or-business theory. That part of the holding is narrower. For COGS purposes, the important takeaway is straightforward: the purchase price of cannabis inventory (for a reseller) and the production cost of cannabis inventory (for a cultivator, under the Section 471 rules) is subtractable from gross receipts regardless of 280E.

Later cases have been hard on weak records. In Olive v. Commissioner, 139 T.C. 19 (2012), aff’d, 792 F.3d 1146 (9th Cir. 2015), the Tax Court upheld a negligence penalty where a marijuana business failed to keep adequate books and records. The lesson is consistent: the full-absorption method allows substantial costs into COGS, but only with a documented, reasonable allocation methodology.

What does a proper cost-accounting system look like?

A defensible COGS calculation requires three layers: a cost-accumulation system, an allocation methodology, and reconciliation to external records.

The cost-accumulation system captures every cost incurred in the production process. Direct materials and direct labor are traced to specific batches or production periods. Indirect costs (facility rent, utilities, depreciation, insurance, production-area maintenance) are accumulated in cost pools and then allocated.

The allocation methodology distributes indirect costs to inventory using a reasonable, consistent basis. Square footage is the most common allocation base for facility costs. Machine hours or direct labor hours are appropriate for equipment-related costs. The methodology must be documented in a written cost-accounting policy that specifies the allocation base for each cost pool, the data source for the allocation base (floor plans for square footage, payroll records for labor hours, utility sub-meters for electricity), and the frequency of allocation (monthly or per-batch).

Reconciliation ties the cost-accounting records to external sources: the general ledger, bank statements, payroll reports, vendor invoices, and the state-mandated seed-to-sale tracking system. In an audit, the IRS will test the COGS figure by pulling source documents and tracing them through the cost system. If the facility rent allocated to COGS does not tie to the lease agreement and a floor plan showing which rooms are used for production, the allocation fails. If direct labor allocated to COGS does not tie to payroll records and time-tracking data showing which employees worked in production (and for how many hours), the labor allocation fails.

How does entity structure affect the COGS calculation?

The entity itself does not change what qualifies as COGS. The Section 471 inventory rules apply the same way to a sole proprietorship, an LLC, an S-corp, and a C-corp. But the entity structure affects how the non-deductible expenses hit the owner’s tax return, which changes the overall effective tax rate and therefore the relative importance of maximizing COGS. A C-corp pays entity-level tax on the income that survives the COGS offset, and the remaining after-tax earnings face a second layer of tax when distributed as dividends. An S-corp or partnership passes the income through to the owners, who pay individual rates but avoid the double layer.

The entity-structure analysis is covered in detail in the cannabis entity structure guide. For COGS purposes, the important point is that the cost-accounting methodology must be built at the entity level, documented in the entity’s books, and consistent from year to year. An entity that switches allocation methods without a justifiable reason (other than producing a larger COGS) invites scrutiny.

How do multistate operations handle COGS?

A cannabis business that cultivates in one state and sells in another, or operates multiple grow facilities, needs a cost-accounting system that tracks costs by facility and by product line. The allocation methodology must reflect the actual cost structure of each facility, not a blended average across the organization. A 20,000-square-foot indoor grow in Colorado with $300,000 in annual electricity costs has a different cost profile than a 5-acre outdoor farm in Oregon with $15,000 in electricity and $80,000 in seasonal labor. Blending the two into a single COGS pool obscures the true cost of production at each location and can produce allocations that the IRS challenges as unreasonable.

State-level tax treatment varies significantly as well. State treatment differs. California, for example, lets licensed cannabis businesses deduct ordinary business expenses for state tax purposes, and some states have their own cannabis-specific tax regimes. The multistate considerations guide covers the state-level landscape. At the federal level, the COGS calculation is the same regardless of which state the production occurs in, but the underlying cost data must be facility-specific.

What documentation does the IRS expect in an audit?

Because COGS is the one offset 280E leaves, it is the natural focus of an IRS exam of a cannabis business, and examiners can require a business to move onto a proper inventory method. The minimum documentation the IRS expects includes:

• A written cost-accounting policy specifying the inventory method (FIFO, weighted average), the cost pools, the allocation bases, and the frequency of allocation
• Floor plans or facility diagrams showing the square footage dedicated to production versus non-production activities
• Payroll records with time-tracking data distinguishing production employees from sales and administrative staff
• Utility records (ideally sub-metered for production areas, though sub-metering is not required if an alternative allocation is reasonable)
• Vendor invoices for direct materials, tied to batch or lot records in the seed-to-sale system
• Monthly or quarterly inventory reconciliations showing beginning inventory, production costs added, and ending inventory
• General ledger detail supporting each cost category included in COGS

The absence of any of these creates an opening for the IRS to reclassify costs out of COGS and into non-deductible operating expenses. The audit risk article covers the examination process and how to prepare for it.

What’s the single most common mistake in cannabis COGS?

Under-inclusion. Most cannabis businesses leave money in COGS by failing to allocate indirect production costs, not by over-allocating. The dispensary that calculates COGS as “what we paid our supplier for the product” and ignores facility costs attributable to on-site processing and packaging is paying more federal tax than the law requires (a pure reseller, by contrast, is limited to purchase price plus freight). The cultivator that tracks direct materials and direct labor but does not allocate facility rent, utilities, and depreciation to the grow operation is doing the same.

The second most common mistake is inconsistency. A business that allocates 70% of rent to COGS in a profitable year and 50% in a loss year (because the loss year does not need the extra COGS) creates a pattern the IRS can use to challenge the entire methodology. The allocation basis must be set by the physical facts (square footage, labor hours, equipment usage) and applied consistently.

The third mistake is conflating COGS maximization with expense reclassification. Moving a budtender into the “production” category on the org chart does not make their wages a production cost. The IRS looks at the work actually performed, not the title. If the employee spends 90% of their time on the retail floor interacting with customers, their wages are a selling expense, full stop.

Related guides:

• Cannabis Ancillary Business Tax Planning
• Cannabis Entity Structure Llc Scorp C Corp
• Cannabis Irs Audit Risk Compliance
• Cannabis Payroll Employment Tax 280E
• Cannabis Real Estate Leasing Tax Treatment

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.