As the cannabis industry continues to expand across the United States, entrepreneurs face a unique and often daunting tax challenge. While dozens of states now allow medical or adult-use cannabis sales, the plant remains federally classified as a Schedule I controlled substance. This contradiction brings the Internal Revenue Service (IRS) and Section 280E of the tax code squarely into play, shaping how cannabis companies must operate financially.

Understanding Section 280E

Section 280E of the Internal Revenue Code was enacted in 1982 after a court case where a convicted cocaine trafficker attempted to claim business deductions for his illegal enterprise. To close this loophole, Congress barred deductions or credits for businesses trafficking in controlled substances listed under Schedule I or II of the Controlled Substances Act.

Because cannabis is still federally illegal, even fully licensed dispensaries and cultivators are considered “traffickers” under 280E. This means they cannot deduct most ordinary expenses—such as payroll, rent, insurance, or advertising—that every other business in America relies on to reduce taxable income.

The Tax Burden on Cannabis

For cannabis operators, the consequences of 280E are enormous. Businesses are required to pay federal income tax on gross income minus only their cost of goods sold (COGS). As a result, many companies face effective tax rates that can reach 60% or higher.

This disproportionately impacts smaller, independent operators who often lack the scale or resources to absorb such heavy tax burdens. In contrast, large multi-state operators (MSOs) sometimes have more flexibility to manage costs, though they still remain heavily impacted by the rule.

What Counts as COGS?

The one area of relief under 280E comes from deductions tied to the cost of goods sold. These are expenses directly associated with producing cannabis, including cultivation supplies, packaging, and sometimes a portion of facility costs.

However, the IRS carefully scrutinizes these deductions, and definitions of what qualifies can be narrow. Attempts to shift general business expenses into COGS can lead to audits, penalties, and long-running disputes. Many cannabis operators work closely with accountants who specialize in 280E compliance to strike the right balance between maximizing deductions and staying within the law.

IRS Enforcement and Audits

The IRS has identified cannabis businesses as high-risk for tax misreporting and often targets them for audits. This has forced operators to invest heavily in bookkeeping, compliance systems, and specialized tax professionals. Any missteps can result in significant fines, back taxes, or even criminal scrutiny given the plant’s continued federal status.

Push for Reform

The cannabis industry has long argued that Section 280E unfairly penalizes state-legal businesses that contribute to local economies and generate billions in tax revenue. Advocates for reform point out that these companies are effectively taxed like criminal enterprises, despite being regulated and licensed at the state level.

Federal legislation such as the MORE Act and banking reform bills have brought attention to this issue, though none have yet delivered relief. Recent moves by the Biden administration to reclassify cannabis as a Schedule III substance could be a game-changer. If cannabis is rescheduled, Section 280E would no longer apply, allowing businesses to claim normal deductions and freeing up much-needed capital for growth.

Navigating the Present

Until that change arrives, cannabis operators must remain cautious and strategic. Many focus on vertical integration to maximize what qualifies as COGS, while others turn to partnerships, advanced accounting practices, or financial restructuring to mitigate the effects of 280E.

Looking Ahead

Section 280E remains one of the most significant obstacles to profitability for cannabis businesses. Its origins in the war on drugs make it ill-suited for today’s evolving legal landscape. While reform is not guaranteed, momentum is building toward easing the tax burden. In the meantime, operators must remain vigilant, compliant, and innovative in order to survive under one of the harshest tax codes in the business world.