The 280E Framework for Cultivators
IRC Section 280E prohibits cannabis businesses from deducting ordinary and necessary business expenses. However, it does not prohibit the calculation of cost of goods sold (COGS), which is treated as a reduction to gross receipts rather than a deduction. For cultivators, this means the only costs that offset revenue on your federal tax return are those properly classified as COGS.
The IRS has directed cannabis businesses to calculate COGS under the pre-2018 inventory accounting rules, specifically IRC Section 471 (inventory valuation) and IRC Section 263A (uniform capitalization). Section 263A is particularly important because it requires producers to capitalize certain indirect costs into inventory. These are costs that a non-cannabis business might deduct as overhead but that a cannabis cultivator can include in COGS.
Understanding which costs qualify as COGS, and which do not, is worth six figures annually for most cultivation operations.
Direct Costs: The Foundation of COGS
Direct costs are always includable in COGS. These are costs that can be traced directly to the production of inventory.
Direct Materials
Every tangible input that goes into growing cannabis is a direct material cost. This includes seeds and clones (or genetics licensing fees for proprietary strains), growing media (soil, coco coir, rockwool, perlite), nutrients and fertilizers (base nutrients, cal-mag, bloom boosters, teas), water and irrigation inputs (pH adjusters, water filtration supplies), integrated pest management inputs (beneficial insects, neem oil, sulfur, biological controls), and plant support materials (trellising, stakes, clips, tomato cages).
Track every purchase order and invoice for these materials. Assign material costs to specific batches or rooms where possible. If materials are used across multiple batches, allocate based on a reasonable method such as square footage or plant count.
Direct Labor
Direct labor includes the wages, payroll taxes, and benefits for employees whose work is directly tied to production. For cultivators, this typically includes growers and cultivation technicians responsible for planting, feeding, training, and monitoring plants. It also includes harvest crew members who cut, hang, and rack plants, trim staff (whether hand-trimming or operating machine trimmers), and drying and curing technicians who manage the post-harvest environment.
The key question for each employee is: does this person's work directly produce inventory? If yes, their compensation is direct labor and belongs in COGS. If their work is administrative, managerial, or sales-related, it does not qualify as direct labor.
For employees who split their time between production and non-production activities, you must allocate their compensation based on the percentage of time spent on each. This requires time studies or time-tracking records.
Indirect Costs Under Section 263A
This is where the real tax savings opportunity lives. Section 263A requires producers (including cannabis cultivators) to capitalize certain indirect costs into inventory. These costs are not directly traceable to a specific plant or batch, but they support the production process and must be included in COGS under the UNICAP rules.
Facility Costs
Rent, depreciation, property taxes, and insurance for your cultivation facility are partially allocable to COGS. The allocable portion is the percentage of facility space dedicated to production activities.
Production space includes grow rooms (veg and flower), drying rooms, cure rooms, trim rooms, and any other space where inventory is being produced, processed, or stored as part of the production process. Non-production space includes offices, break rooms, reception areas, and retail space if applicable.
Measure your facility and calculate the production percentage. A cultivation facility that is 10,000 square feet total with 8,000 square feet of production space allocates 80% of facility costs to COGS. This calculation should be documented with a floor plan that clearly delineates production and non-production areas.
Utilities
Electricity is typically the largest utility cost for indoor cultivation. Grow lights, HVAC, dehumidifiers, and irrigation pumps all consume significant power. The portion of utility costs attributable to production is allocable to COGS.
The best approach is sub-metering. Install electrical sub-meters on the panels that serve grow rooms, HVAC systems for production areas, and other production-specific equipment. This gives you actual consumption data by production area.
If sub-metering is not feasible, use a reasonable allocation method. One approach is to calculate the wattage of all production equipment, multiply by hours of operation, and compare that to your total facility consumption. This gives you a production percentage to apply to your total utility bill.
Water costs can be allocated similarly based on irrigation system metering or estimated consumption by production areas.
Equipment Depreciation
Grow lights, HVAC systems, irrigation equipment, trimming machines, drying racks, and other production equipment are depreciated over their useful lives. The depreciation expense for production equipment is allocable to COGS.
Maintain a fixed asset register that clearly identifies each piece of equipment, its location (production vs. non-production area), its depreciable life, and its annual depreciation expense. Equipment used exclusively in production areas allocates 100% of its depreciation to COGS. Equipment shared between production and non-production areas should be allocated based on usage.
Indirect Labor
Certain employees whose work supports production, but who are not directly producing inventory, can have their compensation partially allocated to COGS. This includes production managers and supervisors who oversee grow operations, quality control staff who perform in-process inspections (not post-sale customer service), maintenance personnel who service production equipment and facilities, and compliance staff whose work directly supports production tracking (METRC data entry, harvest documentation).
These allocations must be supported by time studies or detailed job descriptions that document the percentage of time each person spends on production-supporting activities.
Repairs and Maintenance
Repairs and maintenance on production equipment and production areas are allocable to COGS. This includes HVAC servicing for grow rooms, grow light replacements and ballast repairs, irrigation system maintenance, and pest remediation costs for production areas.
Repairs to non-production areas (office painting, parking lot maintenance) are not allocable.
Documentation Methodology
The IRS does not prescribe a specific documentation format for COGS allocation. However, the documentation must be sufficient to support every number on your return. At minimum, maintain the following.
The Cost Study
A formal Section 263A cost study is a written document that identifies every cost category in your operation, classifies each as direct, indirect-allocable, or non-allocable, describes the allocation methodology for each indirect cost, and calculates the resulting COGS figure.
This study should be prepared or reviewed by a CPA with cannabis and 263A experience. It should be updated annually or whenever your operations change materially (new facility, new equipment, significant staffing changes).
Supporting Records
Behind the cost study, maintain detailed records including payroll reports with job classifications and time allocation data, facility floor plans with square footage calculations, utility bills and sub-metering data, fixed asset registers with depreciation schedules, purchase orders and invoices for all direct materials, METRC batch records tying material inputs to specific harvests, and time studies or employee timesheets supporting labor allocations.
Consistency
Apply your allocation methodology consistently from year to year. The IRS is suspicious of methods that change frequently, especially when changes consistently increase COGS. If you need to change your methodology (because of an operational change or an error in your prior approach), document the reason for the change and the impact on COGS.
IRS Audit Triggers
Cannabis businesses face elevated audit risk. Understanding what triggers IRS scrutiny helps you prepare.
Disproportionately High COGS
If your COGS as a percentage of revenue is significantly higher than industry averages, the IRS may challenge your classification. While there is no published 'safe' percentage, COGS ratios above 70% of gross revenue will likely draw attention. This does not mean you should artificially reduce your COGS. It means you should be prepared to defend every dollar.
Inconsistent Methods
Changing your allocation methodology year to year, especially in ways that increase COGS, is a red flag. If your facility costs were allocated at 60% to production last year and 85% this year, the IRS will want to understand why.
No Formal Cost Study
Filing a return with a large COGS deduction but no supporting cost study is an invitation to an audit adjustment. The IRS examiner will apply their own allocation methodology, and it will not be favorable to you.
Large Round Number Adjustments
Year-end journal entries that increase COGS by large, round numbers (e.g., $500,000) without detailed supporting calculations look like estimates rather than properly calculated allocations. Every adjustment should tie to specific calculations with specific supporting data.
Costs That Do Not Qualify
Certain costs are clearly not allocable to COGS under any methodology. These include executive compensation for non-production management (CEO, CFO, sales director), marketing and advertising, legal and professional fees not related to production, office supplies and general administrative costs, travel and entertainment, and retail operations costs (if you also operate a dispensary).
Under 280E, these costs are permanently disallowed. They cannot reduce your federal taxable income. This is painful, but attempting to classify them as COGS creates audit risk that far exceeds the potential tax savings.
The Financial Impact
Consider a cultivation operation with $4 million in gross revenue. Under a basic approach that includes only direct materials ($600,000) and direct labor ($400,000), COGS totals $1 million. Taxable income is $3 million.
Under a properly executed Section 263A cost study, the same operation adds allocable facility costs ($320,000), allocable utilities ($240,000), equipment depreciation ($80,000), and allocable indirect labor ($160,000). COGS increases to $1.8 million. Taxable income drops to $2.2 million.
At a 37% federal rate, that $800,000 increase in defensible COGS saves $296,000 in federal tax. Over five years, that is nearly $1.5 million in cash tax savings from a single facility.
The cost of a proper Section 263A study and the systems to support it is a fraction of this savings. For any cultivation operation generating meaningful revenue, this is not optional work.