Tax Accounting for Cannabis Businesses: Navigate 280E, Maximize Deductions, and Stay Audit-Ready
The cannabis industry is booming, but success does not happen without considerable sacrifice. Proper tax accounting practices are essential to ensure you maximize allowable deductions under IRC 280E and have audit-ready books.
Easily one of the biggest challenges for cannabis operators in the United States, IRC 280E restricts what you can deduct on your federal income tax return. As cannabis is still considered a Class I (illegal) substance in the eyes of the federal government, businesses cannot deduct standard business expenses, like rent, payroll, and marketing. While some states have decoupled from 280E, the federal rule will remain in place until the FDA reschedules cannabis.
Cannabis companies were poised for this to happen in 2025, as significant progress was being made in that direction; however, the current government has other priorities, and it appears we’re in a holding pattern until something changes.
But enough talking about things we can’t change! Let’s dive into how we can make the most of the situation and ensure you’re leveraging every opportunity to reduce your taxable income, understand what you can and can’t deduct, and ensure every aspect of your accounting is audit-ready.
IRC 280E Deductions: What You Can (and Can’t) Deduct
Under 280E, cannabis businesses can only deduct expenses related to the cost of goods sold (COGS).
Such expenses include costs related to:
Cultivation
Harvesting
Trimming
Lab testing
Packaging
Inventory
Storage
Utility costs related to storage
Transportation and shipping
Cultivators and labs tend to do better in this area as they can also deduct equipment, land or real estate, utilities, and security, so long as they are directly related to inventory. Anything that can be capitalized into COGS is fair game, including tools, machinery, and payroll directly associated with producing the product.
Dispensaries, on the other hand, do not fare so well. Retail cannabis operations can only deduct inventory expenses and packaging (if they are involved in that aspect).
What you can’t deduct is a much longer list. Office equipment, point-of-sale systems, software, security cameras (except in cultivation and storage areas), legal fees, accounting fees, waste removal, administrative costs, utilities, and marketing are part of the cost of doing business. As such, these expenses inflate taxable income, so care must be taken to minimize these costs to reduce the tax burden.
Determining COGS Expenses
Knowing what you can deduct is one thing. However, some expenses can be split between COGS and regular business expenses. For example, you can deduct a portion of your electricity bill if some of it is dedicated to COGS, which means cultivation buildings and storage. The calculation can’t be arbitrary. You must apply a consistent formula to determine these costs and document it thoroughly for backup, as the auditor may want to see your rationale.
Regulations under IRC Section 471(c) provide a framework for calculating COGS for various business models. In a rare and recent win for the industry, 471(c) is now permanent, meaning cannabis businesses have a legal way to reduce taxable income by capitalizing expenses into COGS.
Not that 280E doesn’t still apply (it does), but now, there are options, and they are all above board.
Still, many operators make mistakes in calculating COGS, either by blending deductible and non-deductible expenses or failing to maintain proper documentation and inventory systems.
Similarly, different business models require various methodologies to ensure accuracy. Regardless of the methods you choose, proper documentation is essential. Working with a qualified cannabis accountant, CFO, or controller can provide the appropriate allocation.
Maximizing COGS Deductions
Making the most of your COGS can mean substantial tax savings for cannabis businesses. However, it requires strategic tax planning to make it work.
Inventory valuation must be optimized to maximize COGS. This means that you must adequately document what portion of an expense is attributable to inventory and COGS. Precision, as always, is crucial.
Vertically integrated companies might also consider a multi-entity structure. For example, if the business intends to own its property, it might consider creating a real estate entity that leases property to the cannabis business; therefore, all business expenses can be deducted as they are not directly related to the cannabis operation.
Speak with a cannabis CPA to explore your options, but in the meantime, maintain accurate documentation for all financial decisions, as they may become of interest in an audit.
Technology is a massive help, especially when systems are integrated with state-mandated seed-to-sale platforms. Cannabis-specific software anticipates the unique needs of the industry, providing COGS calculation tools and automated tracking and analytics to ensure you’re seizing every opportunity.
Audit Ready Tips for Cannabis Businesses
Audits are a fact of life in the cannabis industry. No matter what state you operate in, you will face audits from regulators, the state, and the IRS. Why, you say? It’s simple. Strange as it may seem, given its status in most states, cannabis is an illegal substance. This limits banking options, leading to higher-than-average cash transactions and increased scrutiny.
Additionally, the limitations on what businesses can and cannot deduct create a complex tax environment. It’s not simple or straightforward by any stretch, and there are plenty of grey areas where over-deducting or under-reporting can happen.
Lastly, the IRS generates a substantial amount of revenue from the cannabis industry, so it pays them to audit regularly, and they usually come out ahead.
All that being said, with the right attitude and focus, you can beat them at their own game. Here are a few tips to ensure your books are always audit-ready:
Utilize cannabis-specific software to its fullest advantage.
Document all transactions meticulously and retain records for a minimum of ten years.
Establish stringent accounting methods by using a GAAP-compliant methodology to ensure transparency and standardization.
Comply with local, state, and federal tax laws. File and pay your taxes on time without exception.
Stay informed about developments in cannabis compliance. A cannabis CPA is your best source!
Proactively document all accounting practices and tax methodologies. If the auditor wants to see these details, you’ll be ready!
Review your documentation regularly and adjust as needed.
Need Help with This? Growise Has Your Back!
Set up a call with the cannabis tax experts at Growise today, and let’s get your books in order!