What 280E Actually Says
IRC Section 280E is a single sentence: '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 (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.'
The impact of that sentence on cannabis retailers is enormous. A typical retail business deducts rent, payroll, marketing, insurance, utilities, and dozens of other operating expenses from its gross income before calculating taxable income. A dispensary cannot deduct any of those expenses if they are classified as ordinary business deductions.
The one exception is cost of goods sold. COGS is not technically a 'deduction' under the tax code; it is a reduction of gross receipts to arrive at gross income. The IRS has acknowledged this distinction, and it is the foundation of every 280E tax strategy for dispensaries.
The COGS Allocation Framework
What Clearly Qualifies as COGS
The starting point is straightforward. The direct cost of cannabis products purchased for resale is unambiguously COGS. If you buy an ounce of flower from a distributor for $100 and sell it for $250, the $100 is COGS. This includes the product cost, excise tax paid on acquisition (in states where the distributor passes this through), and inbound freight or delivery charges.
For dispensaries that also process or package products (such as pre-roll operations or in-house edible production), the direct materials and direct labor involved in that production are also clearly COGS.
Where It Gets Complicated: Indirect Costs
The real tax savings come from allocating indirect costs into inventory under IRC Section 471. This section governs how businesses value their inventory and allows certain indirect costs to be capitalized as part of inventory cost rather than expensed as period costs.
Under the full absorption method described in Treas. Reg. 1.471-11, the following indirect costs may be allocable to inventory:
Rent for inventory storage and handling areas. If your dispensary has a vault, stockroom, or receiving area dedicated to inventory, the rent attributable to that square footage can be included in COGS. You must calculate this as a proportion of your total leased space. A 2,000 square foot dispensary with a 400 square foot vault and stockroom can allocate 20% of its rent to COGS.
Utilities for inventory areas. The same proportional allocation applies to utilities. The electricity, HVAC, and security systems protecting your inventory storage areas are allocable.
Labor directly tied to inventory handling. This is the largest and most scrutinized category. Budtenders who receive, count, label, stock shelves, and manage inventory are performing inventory-related functions. The portion of their time spent on these activities (as opposed to customer-facing sales activities) can be allocated to COGS.
This is where documentation becomes critical. The IRS will not accept a blanket statement that '50% of budtender time is inventory handling.' You need time studies, job descriptions, and activity logs that demonstrate the allocation.
Quality control and compliance testing. The cost of testing products for potency, purity, and regulatory compliance is an inventory cost because the product cannot be sold without passing these tests.
Security for inventory areas. Security costs attributable to protecting inventory (cameras, alarm systems, armed guards for the vault) are allocable to the extent they relate to inventory protection rather than general business security.
What Does Not Qualify
Certain costs are clearly not allocable to COGS, regardless of how creative your accountant tries to be:
Marketing and advertising, general and administrative salaries (owners, managers, HR, accounting), customer-facing sales labor (the portion of budtender time spent helping customers choose products), point-of-sale system costs, general insurance (unless specifically for inventory), and any expense that does not have a direct or indirect connection to acquiring, storing, or handling inventory.
The CHAMP Decision and Dual-Business Strategy
In CHAMP v. Commissioner (2012), the Tax Court ruled that a medical cannabis dispensary that also provided caregiving services could deduct expenses attributable to the caregiving (non-trafficking) portion of its business. This case established the principle that cannabis businesses with legitimate non-trafficking activities can segregate those activities and deduct associated expenses normally.
For dispensaries, the practical application is limited but worth exploring. If your dispensary operates a legitimate, separately identifiable non-cannabis activity (such as a wellness consulting service, educational programming, or the sale of non-cannabis products like accessories and apparel), the expenses directly attributable to that non-trafficking activity may be deductible.
The key requirements are that the non-trafficking activity must be a separate and distinct trade or business, not merely ancillary to cannabis sales. It must have its own revenue, its own cost structure, and its own business purpose independent of cannabis trafficking. The IRS scrutinizes these arrangements heavily, and a poorly structured dual-business strategy will not survive an audit.
Building Your Allocation Methodology
Step 1: Map Your Physical Space
Create a floor plan that clearly identifies every area of your dispensary by function. Categories should include sales floor, inventory storage (vault, stockroom), receiving area, processing/packaging area, administrative offices, break rooms, and common areas. Measure each area precisely. This floor plan becomes the basis for your rent and utility allocations.
Step 2: Conduct Time Studies
For each employee role, document the percentage of time spent on inventory-related activities versus non-inventory activities. This should not be a one-time exercise. Conduct time studies quarterly and maintain the results in your records.
For budtenders, typical inventory-related activities include receiving deliveries, counting inventory, labeling products, stocking display cases, conducting inventory audits, and processing returns into METRC. Non-inventory activities include greeting customers, explaining product features, processing sales transactions, and providing consumption guidance.
A well-documented time study might show that budtenders spend 30% to 40% of their time on inventory-related activities. That percentage of their total compensation (wages, benefits, payroll taxes) becomes allocable to COGS.
Step 3: Calculate Your Allocation Percentages
Using your space measurements and time studies, calculate the percentage of each indirect cost category allocable to COGS. Be conservative. An overly aggressive allocation that does not survive audit scrutiny is worse than a moderate allocation that the IRS accepts.
Step 4: Apply Consistently
Whatever methodology you adopt, apply it consistently from period to period. Changing your allocation methodology mid-year, or between years, raises red flags with the IRS and suggests that you are manipulating the allocation to achieve a desired tax outcome rather than following a principled accounting methodology.
Documentation That Survives an IRS Audit
The IRS has audited hundreds of cannabis businesses since legalization began, and 280E is their primary focus area. The auditors are not looking at your top-line revenue; they are looking at your COGS calculation and challenging every allocation.
Maintain contemporaneous records. Records created at the time the cost was incurred are exponentially more credible than records reconstructed after the fact. Time sheets, floor plans, utility bills with annotated allocations, and purchase orders should all be maintained in real time.
Keep your METRC records reconciled. Your track-and-trace data should match your inventory records, which should match your COGS calculation. Any discrepancy between METRC and your financial records will be interpreted unfavorably.
Preserve your methodology documentation. Write a memo explaining your COGS allocation methodology, the basis for each allocation percentage, and the supporting documentation. Update this memo annually. When an auditor asks how you calculated COGS, you want to hand them a clear, professional document rather than scrambling to reconstruct your logic.
Engage a 280E-experienced tax advisor. General tax preparers who are not experienced with 280E will either be too aggressive (leading to audit adjustments and penalties) or too conservative (leaving significant tax savings on the table). The cost of specialized advice is a fraction of the tax impact.
The Financial Impact: A Worked Example
Consider a dispensary with $3,000,000 in annual revenue, $1,200,000 in direct product costs, and $1,400,000 in operating expenses (rent, payroll, utilities, insurance, marketing, etc.).
Without 280E optimization: The dispensary reports $1,200,000 in COGS and $1,800,000 in gross income. None of the $1,400,000 in operating expenses are deductible. Taxable income is $1,800,000. At a combined federal and state rate of 40%, the tax bill is $720,000.
With proper COGS allocation: After allocating eligible indirect costs (portions of rent, utilities, inventory-handling labor, security), COGS increases to $1,550,000. Gross income drops to $1,450,000. Taxable income is $1,450,000. The tax bill drops to $580,000.
That is a $140,000 annual tax savings from nothing more than proper cost allocation. Over five years, that is $700,000 in cash preserved in the business. And this example uses conservative allocation percentages. Dispensaries with larger inventory areas, more employees dedicated to inventory functions, or in-house processing operations can see even greater savings.
Preparing for Changes in the Law
The potential rescheduling of cannabis from Schedule I to Schedule III would effectively eliminate 280E for the cannabis industry, since Section 280E applies only to Schedule I and II substances. If and when that happens, dispensaries will need to transition their accounting from a 280E framework to a standard retail framework.
Until rescheduling is enacted into law, dispensaries should continue to operate under the current 280E rules. Do not anticipate a change that has not yet happened. Instead, maintain clean financial records under both frameworks so that you can transition smoothly if and when the law changes, without missing a beat or leaving money on the table in the interim.