Cannabis Business Tax Rules: How IRC 280E Eliminates Most Deductions and What Operators Can Do About It

By Yarik Yarosh, CPA ·September 5, 2026 ·7 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

IRC 280E is the most devastating tax provision affecting any legal industry in the United States. Under IRC 280E, no deduction or credit is allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substances Act). Because marijuana is still classified as Schedule I under federal law, every cannabis business, even those operating legally under state law, is subject to this rule. The only relief is that COGS isn’t technically a “deduction” under the Internal Revenue Code; it’s a calculation of gross income. Under IRC 61 and the related regulations, gross income from a trade or business is gross receipts minus cost of goods sold. Because COGS reduces gross receipts before the deduction calculation begins, cannabis businesses can still claim COGS. This distinction has been confirmed by the Tax Court in cases like Californians Helping to Alleviate Medical Problems (CHAMP) v. Commissioner and Olive v. Commissioner. The result is that cannabis businesses must maximize COGS by capitalizing every possible cost into inventory (using the UNICAP rules under IRC 263A, including indirect costs that most businesses would prefer to expense currently) and by structuring their operations to separate cannabis-touching activities from non-cannabis activities that are not subject to 280E.

✓Key takeaway

IRC 280E impact on cannabis businesses:

Item	Normal Business	Cannabis Business (IRC 280E)
Revenue	Deduct from gross income	Same
Cost of Goods Sold (COGS)	Deductible (reduces gross income)	Deductible (only deduction available)
Operating expenses (rent, wages, utilities)	Deductible	NOT deductible
Business interest	Deductible	NOT deductible
Depreciation	Deductible	NOT deductible (unless capitalized into COGS via UNICAP)
Tax credits (R&D, WOTC, etc.)	Available	NOT available
Effective tax rate	Based on net profit	Based on gross profit (can exceed 100% of actual profit)

What qualifies as COGS for cannabis businesses:

Direct Costs (always in COGS)	Indirect Costs (capitalizable under UNICAP/IRC 263A)
Raw materials (seeds, clones, growing medium)	Rent on cultivation/production facility
Direct labor (cultivators, trimmers, processors)	Utilities for cultivation/production
Packaging materials	Depreciation on production equipment
Extraction chemicals and supplies	Quality control and testing
	Indirect labor (supervisors in production)
	Insurance on inventory
	Purchasing and receiving costs

How does IRC 280E affect cannabis business taxes?

Hypothetical example

Round numbers. A cannabis cultivation and retail operation has the following financials:

Income statement:

Item	Amount
Gross revenue (retail sales)	$5,000,000
Cost of goods sold	($2,000,000)
Gross profit	$3,000,000
Operating expenses:
Retail employee wages	($600,000)
Retail rent	($300,000)
Marketing and advertising	($100,000)
Insurance	($80,000)
Utilities (retail)	($40,000)
Professional fees (legal, accounting)	($50,000)
Other operating expenses	($130,000)
Total operating expenses	($1,300,000)
Actual net profit	$1,700,000

Tax calculation (normal business vs. cannabis):

Item	Normal Business	Cannabis (IRC 280E)
Gross revenue	$5,000,000	$5,000,000
COGS	($2,000,000)	($2,000,000)
Operating expenses	($1,300,000)	$0 (not deductible)
Taxable income	$1,700,000	$3,000,000
Federal tax (21% C-Corp)	$357,000	$630,000
Effective rate on actual profit	21%	37%

For a pass-through entity (S-Corp/LLC) at the 37% individual rate:

Item	Normal Business	Cannabis (IRC 280E)
Taxable income	$1,700,000	$3,000,000
Federal tax (37%)	$629,000	$1,110,000
Effective rate on actual profit	37%	65%

If the business earns a thinner margin:

Scenario	Revenue	COGS	Operating Expenses	Actual Profit	Taxable (280E)	Tax (37%)	Effective Rate
High margin	$5,000,000	$2,000,000	$1,300,000	$1,700,000	$3,000,000	$1,110,000	65%
Medium margin	$5,000,000	$2,500,000	$1,800,000	$700,000	$2,500,000	$925,000	132%
Low margin	$5,000,000	$3,000,000	$1,800,000	$200,000	$2,000,000	$740,000	370%

At medium and low margins, the tax exceeds the actual profit, meaning the business cannot survive long-term under IRC 280E.

COGS maximization strategies:

Strategy 1: Capitalize indirect costs into inventory (UNICAP) Under IRC 263A, a cultivator/producer must capitalize certain indirect costs into inventory. For a cannabis business, this is beneficial because it moves costs from “operating expenses” (not deductible under 280E) to “COGS” (deductible).

Cost	Normal Treatment	Cannabis Strategy
Cultivation facility rent	Operating expense	Capitalize into COGS (production facility)
Cultivation utilities (grow lights, HVAC)	Operating expense	Capitalize into COGS
Cultivation labor (trimmers, harvesters)	Operating expense	Capitalize into COGS (direct production labor)
Equipment depreciation (extraction equipment)	Operating expense	Capitalize into COGS
Quality testing	Operating expense	Capitalize into COGS
Security (production facility)	Operating expense	Capitalize into COGS (arguable)

Potential COGS increase from UNICAP capitalization:

Item	Amount Moved to COGS
Cultivation facility costs	$200,000
Utilities (production)	$80,000
Production labor (reclassified)	$150,000
Equipment depreciation	$50,000
Additional COGS	$480,000
Tax savings (37% x $480,000)	$177,600

Strategy 2: Separate cannabis and non-cannabis operations If the business can separate its operations into a cannabis-touching entity and a non-cannabis entity, the non-cannabis entity isn’t subject to 280E.

Entity	Activities	Subject to 280E?
Cannabis LLC	Cultivation, processing, wholesale	Yes
Management Co. LLC	Real estate, management services, consulting	No (if it doesn’t directly traffic in controlled substances)

The management company charges the cannabis LLC for:

Service	Fee	Deductible by Management Co.?
Facility rent (arm’s length)	$300,000	Yes (and expenses against this income are deductible)
Management services	$200,000	Yes
IP licensing (brand, processes)	$100,000	Yes

This requires genuine economic substance, arm’s length pricing, and separate books and records. The IRS has challenged arrangements that are purely tax-motivated.

Entity structure considerations:

Entity	Tax on Cannabis Income	Advantage
C-Corp	21% on gross profit (no operating expense deductions)	Lower rate than individual; can retain earnings
S-Corp/LLC (pass-through)	Up to 37% on gross profit	No double taxation, but higher rate
C-Corp with salary	21% corporate rate + payroll tax on salary	Salary is COGS if the employee works in production

Most cannabis tax advisors recommend C-Corp structure because the 21% flat rate is lower than the 37% individual rate, and the C-Corp can accumulate earnings for reinvestment (although the accumulated earnings tax under IRC 531 may apply if accumulations exceed $250,000 without a reasonable business need).

Legislative outlook:

Development	Status
Rescheduling to Schedule III	DEA proposed rule (2024); if finalized, would remove IRC 280E for cannabis businesses
SAFE Banking Act	Would allow cannabis businesses to access banking; doesn’t address 280E
Full descheduling	Would completely remove 280E; would require congressional action
State-level relief	States with legal cannabis generally allow operating expense deductions on state returns

Illustrative numbers only, not a real client and not advice for your facts.

Related guides:

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Cite this page

Yarik Yarosh, CPA. "Cannabis Business Tax Rules: How IRC 280E Eliminates Most Deductions and What Operators Can Do About It." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-tax-planning-cannabis-marijuana-irc-280e

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