Tax Planning for Cannabis Businesses: IRC 280E, COGS Deductions, and Entity Structure Under Federal-State Conflict
Cannabis taxation is the most extreme example of the disconnect between state and federal law creating a punitive tax outcome. Under IRC 280E, “No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.” As long as marijuana is a Schedule I substance under federal law, every state-legal cannabis business is subject to this provision. The only costs that can offset revenue are those that are properly included in cost of goods sold (COGS) under IRC 471 and the regulations thereunder, because COGS is a component of gross income computation, not a “deduction” within the meaning of IRC 280E. This distinction (confirmed by the Tax Court in Californians Helping to Alleviate Med. Problems, Inc. v. Commissioner, 128 T.C. 173 (2007)) is the sole planning lever available to cannabis businesses: maximizing the costs that are properly allocable to COGS reduces the taxable income that IRC 280E would otherwise inflate.
IRC 280E impact:
| Item | Normal Business | Cannabis Business (IRC 280E) |
|---|---|---|
| Revenue | $2,000,000 | $2,000,000 |
| COGS | ($1,200,000) | ($1,200,000) (allowed: gross income computation) |
| Gross profit | $800,000 | $800,000 |
| Operating expenses | ($600,000) deductible | ($600,000) NOT deductible |
| Taxable income | $200,000 | $800,000 |
| Tax (37%) | $74,000 | $296,000 |
| Effective rate on economic income | 37% | 148% |
What’s and isn’t deductible under IRC 280E:
| Item | Deductible? | Why |
|---|---|---|
| Cost of goods sold (product cost) | Yes | Not a “deduction”; part of gross income calculation |
| Direct materials (cannabis flower, concentrates for resale) | Yes (COGS) | |
| Direct labor (cultivation, processing, packaging) | Yes (COGS) | Allocable to production |
| Rent (production facility, warehouse) | Partially (COGS allocation) | Production-related portion only |
| Utilities (grow facility) | Partially (COGS allocation) | Production-related portion |
| Depreciation (production equipment) | Partially (COGS allocation) | Equipment used in production |
| Rent (dispensary/retail) | No | Operating expense, not COGS |
| Dispensary employee wages (budtenders, cashiers) | No | Not production labor |
| Marketing and advertising | No | Operating expense |
| Insurance | No | Operating expense |
| Professional fees (legal, accounting) | No | Operating expense |
| Office supplies | No | Operating expense |
| Vehicle expenses | No | Operating expense |
| Interest expense | No | Operating expense |
| State/local taxes | No | Not deductible under 280E |
How do cannabis businesses minimize the IRC 280E burden?
Start with a Diagnostic: a CPA licensed in the US and Canada reads your file and answers in writing, three to four business days after you finish the questions. $250 for cross-border, $195 for a second opinion on a filed return, and it comes straight off the bill if we do the work after. Or book a free 15-minute fit call first.
One or two plain-English guides a week on US-Canada tax. No spam, unsubscribe anytime.
Done. The next guide will land in your inbox.
Yarik Yarosh, CPA. "Tax Planning for Cannabis Businesses: IRC 280E, COGS Deductions, and Entity Structure Under Federal-State Conflict." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-tax-planning-cannabis-marijuana-irc-280e-limitations
This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.