Embedded Files
Free 60-Minute Risk List Session
Leverage Costs ▪ Accounting Principles
The Tax Man Cometh
The Tax Man Cometh
The cannabis industry continues to grow under the harshest tax codes in American business. Section 280E, reaffirmed by the IRS in 2024, blocks most deductions that traditional companies can claim. This forces operators to pay taxes on gross income instead of net profit. For prepared operators, this challenge can become an advantage. Precise accounting, intentional entity setup, and proactive recordkeeping separate those who survive from those who scale.
Answers 3 Important Questions
Answers 3 Important Questions
How do cannabis taxes differ from normal business taxation?
What role does GAAP play in protecting profits under 280E?
How can multi-entity structures minimize tax exposure?
What actions prepare a cannabis business for inevitable audits?
"Tax design, not tax rate, determines whether cannabis businesses can thrive."
— National Cannabis Industry Association (NCIA)
How Taxes Work Under 280E
How Taxes Work Under 280E
Most businesses follow a simple tax formula: Revenue – Expenses = Taxable Profit. Cannabis companies can't because the IRS enforces Section 280E. Denying claims for most standard deductions. Taxes are based on gross income, not profit, leading to effective rates of 60–80% compared to 21% for traditional corporations. This is why many cannabis businesses struggle to grow even with strong sales.
The Origins Of 280E
The Origins Of 280E
Section 280E was created in 1982 to stop drug traffickers from claiming business expenses. Decades later, it still applies to legal cannabis companies. Even with state-level legalization, federal law classifies cannabis as a Schedule I substance, leaving compliant businesses stuck in a tax system built for criminals.
Typical Business Taxes
Typical Business Taxes
Traditional industries can deduct “ordinary and necessary” expenses that lower taxable income and support reinvestment.
Rent, payroll, and marketing reduce taxable income.
Professional services, such as legal and accounting, are deductible.
Direct production costs (COGS) like labor, materials, and packaging.
Taxes apply only to net profit.
Example
Example
A coffee shop earning $1 million deducts $700,000 in operating expenses (staff, rent, utilities), leaving $300,000 in taxable profit. At a 21% corporate tax rate, the tax bill is roughly $63,000.
Cannabis Business Taxes
Cannabis Business Taxes
Under Section 280E, deductions are limited to Cost of Goods Sold (COGS). Everything else is disallowed.
Only direct production costs (labor, materials, packaging) qualify.
Rent, payroll, and advertising cannot lower taxable income.
Legal and accounting costs are usually disallowed.
Taxes apply to gross income, not net profit.
Example
Example
A cannabis dispensary also earning $1 million cannot deduct those same costs. Only $300,000 of production-related expenses qualify as COGS, leaving $700,000 in taxable income. At a 70% effective tax rate, the tax bill is roughly $490,000. Which is 8x higher.
"The difference between tax avoidance and tax evasion is the thickness of a prison wall."
— Denis Healey
The Cost Of Non-Compliance
The Cost Of Non-Compliance
The IRS is not lenient with cannabis operators. In 2023, 80% of audited dispensaries had compliance issues. Even small recordkeeping errors can result in heavy penalties or retroactive tax bills.
Common Penalties
Common Penalties
Accuracy penalties up to 40% of underpaid taxes.
Compounding interest on unpaid balances.
Suspension or loss of state licenses.
Seizure of business or personal assets.
Legal costs tied to audit defense.
Worst Case Scenario
Worst Case Scenario
Multi-year audits uncover misclassified expenses.
Retroactive denial of COGS deductions.
License revocation for “willful negligence”.
Personal liability exposure from commingled funds.
Best Practices
Best Practices
Maintain separate accounts for every entity and location.
Keep digital and paper backups for receipts and invoices.
Conduct quarterly internal audits.
Work with cannabis-specialized CPAs and attorneys.
"A tax problem is often a record-keeping problem in disguise."
— H&R Block
2 Types Of Taxable Cannabis Operations
2 Types Of Taxable Cannabis Operations
Every cannabis business fits into 1 of 2 categories. Knowing which you operate determines your exposure and eligible deductions. Smart operators separate these entities legally to reduce risk and preserve profit.
Plant-Touching Operations
Plant-Touching Operations
Handle the cannabis plant directly. Involves cultivation, processing, manufacturing, distribution, or retail.
Fully subject to Section 280E.
Only COGS-related expenses (labor, materials, packaging) are deductible.
Rent, payroll, and marketing can't reduce taxable income.
Inventory systems must align with accounting.
Non-Plant-Touching Operations
Non-Plant-Touching Operations
Support the industry without handling the plant, including real estate, consulting, marketing, or Intellectual Property (IP) management.
Eligible for normal business deductions.
Must maintain separate entities, accounts, and tax filings.
Intercompany agreements must reflect fair market value.
Clear documentation proves independence and compliance.
"In cannabis, not touching the plant is often the smartest business move."
— Forbes Cannabis Business
The COGS Opportunity
The COGS Opportunity
Under Section 280E, Cost of Goods Sold (COGS) is the only legitimate way to reduce taxable income. Every dollar you can tie directly to production reduces your tax liability.
COGS Deductions Worth Considering
COGS Deductions Worth Considering
Direct labor for cultivation, trimming, and packaging.
Raw materials, nutrients, and grow media.
Depreciation of manufacturing or grow equipment.
Utilities and rent specific to production areas.
"280E was written to stop drug dealers, not entrepreneurs."
— Marijuana Policy Project
Why GAAP Matters
Why GAAP Matters
Generally Accepted Accounting Principles (GAAP) provide the standardization and defensibility cannabis operators need. GAAP isn't just about bookkeeping; it's about building audit-proof financial governance.
Bridging The GAAP
Bridging The GAAP
By aligning with IRS Section 471, GAAP allows operators to classify eligible production costs under COGS while maintaining full compliance.
Keeps expense categorization consistent and defensible.
Aligns reports with IRS audit expectations.
Builds investor confidence and financial transparency.
Enables proactive documentation before audits occur.
"Only Cost Of Goods Sold (COGS) can offset cannabis income under federal tax law."
— IRS Chief Counsel
Structure Smart With Multi-Entity Strategies
Structure Smart With Multi-Entity Strategies
A multi-entity structure separates high-risk (plant-touching) from lower-risk (non-plant-touching) operations. Though it increases administrative work, the tax savings, liability protection, and scalability make it worth the effort.
Splitting Operations For Success
Splitting Operations For Success
This approach isolates risk, enables broader deductions, and creates a compliance shield between operations.
Entity A
Entity A
Handles cultivation, manufacturing, or retail.
Fully subject to Section 280E
Tracks COGS and inventory precisely
Maintains separate books and tax filings
Entity B
Entity B
Manages branding, leasing, consulting, or IP ownership.
Eligible for standard deductions (rent, payroll, marketing).
Invoices Entity A at fair market value.
Maintains independent accounting systems.
Both Entities
Both Entities
Maintain separate accounts and systems.
Document intercompany transactions transparently.
Work with legal and tax professionals for compliance oversight.
A Cautionary Cannabis Business Tale
A Cautionary Cannabis Business Tale
The Harborside Health Center (2021) case showed how poor documentation and blurred lines can devastate compliant businesses.
Commingled funds raised audit red flags.
Unclear relationships led to denied deductions.
Inconsistent pricing appeared as tax avoidance.
Poor documentation caused multi-million-dollar losses.
"Separate the plant-touching from the service side, or the IRS will separate your profits for you."
— MJBizDaily
Prepare For Inevitable Audits
Prepare For Inevitable Audits
The IRS has intensified cannabis audits since 2022. Proactive documentation and financial accuracy remain the strongest defenses.
3 Habits Of Successful Operators
3 Habits Of Successful Operators
Track every expense and reconcile monthly.
Conduct internal reviews to catch issues early.
Partner with specialized cannabis accountants and advisors.
Proactivity Protects Profits
Proactivity Protects Profits
Keep invoices and receipts organized.
Perform quarterly audits for accuracy.
Train staff on compliance and documentation.
Retain legal and financial experts for oversight.
Build Your Compliance Team
Build Your Compliance Team
CPA: Cannabis taxation and GAAP alignment.
Attorney: Entity formation and structure.
Consultant: Audit-preparation systems.
Bookkeeper: Daily transaction accuracy.
Looking Ahead
Looking Ahead
Rescheduling or reform may eventually remove Section 280E, but disciplined financial systems will always matter.
GAAP records prepare businesses for federal legalization.
Clean systems simplify funding and licensing.
Structured operators will scale faster.
"Compliance is cheaper than defense."
— U.S. Treasury Inspector General
Apply New Insights Now
Apply New Insights Now
Section 280E is among the toughest barriers in cannabis, but disciplined operators can turn it into a lasting competitive edge. Gather your leadership, finance, and compliance teams for a structured review session.
Identify Gaps In Your Tax Planning
Identify Gaps In Your Tax Planning
Strong documentation, GAAP-aligned systems, and smart entity structuring transform compliance from a cost into a safeguard for sustainable growth.
Activity Instructions
Activity Instructions
List every expense category your business records including rent, payroll, marketing, and materials.
Mark which qualify as COGS (direct production costs) and which must be excluded under 280E.
Identify 1 opportunity to restructure your business into separate plant-touching and non-plant-touching entities.
Schedule a CPA audit or review specializing in cannabis taxation to verify GAAP alignment.
Develop a compliance binder (digital or physical) with invoices, receipts, and internal audit notes to prepare for IRS scrutiny.
Bolster Your Tax Compliance
Bolster Your Tax Compliance
Tax code 280E isn't just a burden, it's a filter that rewards precision. Businesses that invest in documentation, structure, and foresight consistently outperform those that treat compliance as an afterthought. In a market where every percentage point matters, clarity is currency.
Reflection Questions
Reflection Questions
Which of your expenses would fail an IRS audit today and why?
How often do you reconcile COGS and general operating expenses for accuracy?
Are your entities and intercompany agreements structured to minimize tax exposure?
How confident are you that your accounting follows GAAP and Section 471 standards?
What savings or protections could a full compliance overhaul generate next year?
"Preparation turns penalties into profits."
— Nathan Rafter
Page updated
Report abuse