Introduction

As cannabis legalization expands across the United States, many business owners are shocked to discover that federal tax law treats their industry very differently from nearly every other legitimate business. The culprit is Internal Revenue Code § 280E, a provision that can result in effective tax rates exceeding 70%.

This article breaks down the rule, quotes the governing law, and explains how it works in practice.

The Law: IRC § 280E

The operative statute is short—but devastating:

“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… consists of trafficking in controlled substances… prohibited by Federal law.”
— 26 U.S.C. § 280E

Because marijuana remains a Schedule I controlled substance under federal law, cannabis businesses fall squarely within this rule—even if they are fully legal under state law.

What § 280E Actually Does

Unlike normal businesses, cannabis operators:

• ❌ Cannot deduct ordinary and necessary business expenses under Internal Revenue Code § 162
• ❌ Cannot claim most tax credits
• ❌ Cannot deduct rent, wages, marketing, or utilities

However, they can still recover Cost of Goods Sold (COGS).

The Critical Exception: Cost of Goods Sold (COGS)

Even under § 280E, businesses may reduce gross receipts by COGS, because this is not considered a “deduction”—it is an adjustment to gross income.

The framework comes from:

“The term ‘gross income’ means total sales… less the cost of goods sold…”
— Internal Revenue Code § 61 (interpreted through case law and accounting principles)

For cannabis businesses, this distinction is everything.

Example

A dispensary earns:

• Revenue: $1,000,000
• COGS: $400,000
• Operating expenses: $400,000

Normal business taxable income:

• $1,000,000 – $400,000 – $400,000 = $200,000

Cannabis business under § 280E:

• $1,000,000 – $400,000 = $600,000 taxable income

That’s a massive difference—and why tax planning is critical.

IRS Guidance: Inventory Rules Matter

Cannabis businesses often attempt to maximize COGS to offset § 280E.

However, the IRS limits how inventory is calculated:

“Taxpayers must compute taxable income using the method of accounting regularly used… but clearly reflecting income.”
— Internal Revenue Code § 446

And under inventory rules:

“Inventories shall be taken… as conforming as nearly as may be to the best accounting practice…”
— Internal Revenue Code § 471

The IRS has taken the position that cannabis businesses cannot use aggressive inventory capitalization techniques that are otherwise available to non-§ 280E taxpayers.

Key Case Law: CHAMP and Olive

Two major cases define how § 280E is applied:

1. CHAMP v. Commissioner

Allowed partial deductions where a business had separate non-trafficking activities (e.g., caregiving services).

2. Olive v. Commissioner

Denied deductions where the entire business was considered trafficking.

The takeaway:

• If your business has distinct lines of activity, some deductions may survive § 280E
• If not, you’re likely stuck with full disallowance

Common Planning Strategies (and Risks)

Cannabis businesses often attempt:

1. Entity Separation

Creating separate entities for:

• Retail operations (subject to § 280E)
• Management or services (potentially deductible)

⚠️ Risk: The IRS may collapse entities under substance-over-form principles.

2. Maximizing COGS

Allocating more expenses into inventory

⚠️ Risk: Over-aggressive capitalization can trigger audit adjustments

3. Vertical Integration

Growing + manufacturing + selling

✔️ Benefit: More expenses may qualify as COGS
⚠️ Risk: Still heavily scrutinized

Why This Matters Now

This is not a niche issue anymore:

• Cannabis is legal in many states
• Billions in annual revenue are affected
• Federal reform (rescheduling or legalization) could dramatically change the landscape

Until then, § 280E remains one of the harshest provisions in the entire tax code.

Practical Takeaways

• Cannabis businesses are taxed closer to gross income than net profit
• COGS is the only meaningful shield
• Structuring matters—but must be done carefully
• Audit risk is extremely high in this space

Conclusion

IRC § 280E creates a unique and often punishing tax environment where legal businesses can face extraordinarily high effective tax rates. While planning opportunities exist, they must be executed with precision to withstand IRS scrutiny.

If federal law changes, § 280E could disappear overnight—but until then, it remains a critical issue for any cannabis-related business or investor.

At Dino Tax Co, we help clients navigate tax matters ranging from unfiled returns to IRS letters and levies and everything in between with clarity and confidence. If you’d like guidance on your situation, schedule a consultation today. Call or text (713) 397-4678 or email davie@dinotaxco.com. We’re here to help you take the next step.