What Is the 280E Tax Code and How Does It Affect Businesses?

Tax laws can significantly influence business operations, particularly in industries facing unique restrictions. One such regulation, Section 280E of the Internal Revenue Code, limits tax deductions for certain businesses, creating financial challenges that impact profitability and sustainability.

Understanding this tax code is crucial for business owners to avoid unexpected liabilities and remain compliant with federal regulations.

Businesses Subject to 280E

Section 280E applies to businesses handling controlled substances classified as Schedule I or II under the Controlled Substances Act. This primarily affects the cannabis industry, as marijuana remains a Schedule I substance under federal law, despite legalization in many states for medical or recreational use. Since federal law supersedes state law, cannabis businesses must comply with 280E regardless of state legality.

The rule applies to dispensaries, cultivators, and manufacturers of cannabis-derived products. Even businesses indirectly involved—such as landlords leasing to dispensaries or service providers catering exclusively to the industry—may be affected. The IRS has broadly interpreted “trafficking,” leading to tax liabilities for businesses that might not have initially considered themselves subject to 280E.

Restrictions on Deductions

Businesses affected by 280E cannot deduct most standard operating expenses, including rent, wages, marketing, insurance, and professional services. This results in a significantly higher tax burden compared to other industries.

For example, a traditional retail business with $1 million in revenue and $700,000 in operating expenses is taxed on $300,000 of profit. A cannabis dispensary with identical revenue and expenses, however, is taxed on the full $1 million, as most operating costs are non-deductible. This often leads to effective tax rates exceeding 60%, depending on state and local taxes.

Legal challenges have attempted to expand allowable deductions, but courts have consistently upheld 280E’s restrictions. In Alterman v. Commissioner and Harborside v. Commissioner, businesses sought broader deductions, but rulings confirmed that only expenses directly tied to the cost of goods sold (COGS) are exempt. As a result, many cannabis businesses explore restructuring or separating non-cannabis-related activities to reduce tax exposure.

Treatment of Cost of Goods Sold (COGS)

While 280E disallows most deductions, businesses can deduct COGS, making it a key tax planning factor. COGS includes direct costs of acquiring or producing inventory, such as raw materials, wholesale purchases, and certain production-related expenses. For cultivators and manufacturers, this can also include labor directly involved in production, utilities for grow facilities, and equipment depreciation.

Properly categorizing expenses as COGS rather than operating costs is one of the few ways cannabis businesses can lower taxable income. The IRS relies on general accounting principles and tax regulations, such as Section 471 of the Internal Revenue Code, to determine what qualifies. Under these rules, production-related costs can be capitalized into inventory and deducted when goods are sold. However, indirect costs, such as administrative salaries or general office expenses, cannot be included in COGS.

To maximize deductions, many businesses use inventory costing methods like full absorption costing, which allows more production-related costs to be included in inventory valuation. However, the IRS closely examines these allocations, and improper classification can result in audits, back taxes, and penalties.

Reporting and Disclosure Implications

Businesses subject to 280E must carefully document expenses and comply with federal and state tax regulations. The IRS requires affected businesses to file standard corporate tax forms, such as Form 1120 for corporations or Schedule C for sole proprietors, with heightened scrutiny on expense classifications. Since only COGS is deductible, financial statements must accurately separate inventory-related costs from non-deductible expenses. Errors or misclassifications can trigger audits, which are increasingly common in the cannabis industry.

Inventory accounting under Section 471 and the Uniform Capitalization Rules (UNICAP) under Section 263A adds complexity. While Section 263A typically allows businesses to capitalize a broader range of costs into inventory, cannabis businesses are explicitly barred from using its benefits due to IRS guidance. This means they must rely solely on Section 471, limiting the expenses that can be deferred and deducted over time. Proper application of these rules is essential to maintaining compliance and avoiding penalties.

Consequences of Noncompliance

Failing to comply with 280E can lead to significant financial and legal consequences. The IRS actively audits cannabis businesses, often resulting in substantial tax assessments, penalties, and interest charges. Given the already high tax rates imposed by 280E, noncompliance can further strain finances and, in extreme cases, force businesses to close due to unmanageable tax liabilities.

One immediate consequence is the imposition of back taxes and penalties. If a business improperly deducts disallowed expenses, the IRS can reassess its tax liability and demand repayment, often with interest. Additional penalties for negligence or substantial understatement of tax can add another 20% to the total owed under Section 6662 of the Internal Revenue Code. In cases of willful tax evasion, criminal charges may follow, leading to even more severe financial and legal repercussions.