Federal Tax Rule (IRS Section 280E)
Section 280E of the U.S. tax code limits what cannabis businesses can deduct on their federal taxes. Because cannabis is illegal under federal law, most normal business expenses are not deductible.
Only Cost of Goods Sold (COGS) may reduce taxable income.
What This Covers
- What 280E is and why it applies
- What counts as deductible COGS
- What expenses are not deductible
- Required accounting structure
- Audit risks and enforcement
What 280E Is
280E is a federal tax rule that disallows deductions for businesses trafficking in federally illegal substances.
- Cannabis remains illegal under federal law
- Most operating expenses cannot be deducted
- Only COGS may reduce taxable income
State cannabis legality does not change federal tax treatment.
What You Can Deduct (COGS)
Only direct costs tied to acquiring and preparing inventory for sale.
- Wholesale cost of inventory
- Shipping or transportation of inventory to the store
- Certain storage costs directly tied to inventory
- Labor directly related to:
- Receiving product
- Stocking inventory
- Preparing product for sale
These expenses reduce taxable income because they qualify as COGS.
What You Cannot Deduct
Most operating expenses are not deductible under 280E.
- Rent
- Payroll for sales staff or managers
- Insurance
- Security
- Marketing and advertising
- Utilities
- Administrative expenses
- Software
- Professional services
These expenses must still be tracked and reported but do not reduce federal tax liability.
Accounting Structure
Proper accounting separation is required.
- Maintain separate accounts for:
- COGS expenses
- Non-deductible operating expenses
- Expense classification must be consistent and documented
Improper classification increases audit risk.
Audit Risks
Cannabis businesses face higher audit scrutiny.
- Common audit triggers include:
- Misclassifying operating expenses as COGS
- Missing or incomplete records
- Inventory tracking that does not reconcile
- Bookkeeping that conflicts with POS or seed-to-sale data
If audited, the IRS may:
- Reassess prior tax years
- Apply penalties
- Charge interest
Enforcement and Oversight
Identifies the enforcing authority.
- Enforcement agency: Internal Revenue Service (IRS)
What Operators Usually Miss
- State legality does not affect federal tax rules
- Payroll is rarely deductible
- Inventory accuracy directly affects tax exposure
When This Comes Up
- Setting up accounting systems
- Filing federal tax returns
- Responding to IRS inquiries
- Financial audits or due diligence
What Happens If You Ignore This
- Increased tax liability
- IRS audits
- Penalties and interest
- Cash flow disruption
Related Pages
Source Material
