Section 280E of the Internal Revenue Code (§ 280E) poses significant challenges for cannabis businesses by prohibiting them from deducting ordinary and necessary business expenses due to the federal illegality of marijuana. In simple terms, this means cannabis businesses can only deduct cost of goods sold (COGS). (Some states, including New Jersey, have decoupled from the IRS and allow the deduction of all ordinary and necessary business expenses for state income tax filings.)
Impact of IRC § 280E
Filing a federal tax return in accordance with § 280E can result in significant tax burdens, as demonstrated in the charts below. It can result in negative cash flow for otherwise profitable businesses. Hardest hit by § 280E are dispensaries.
According to Brotherly Bud (https://brotherlybudnj.com) dispensary co-owner Matthew Sirois, “As a small, family-owned dispensary, the burden of 280E is crushing. While we operate legally under New Jersey’s state laws, we’re treated like criminals under federal tax rules. We can’t deduct ordinary business expenses like rent, utilities, or employee wages—costs that every other small business takes for granted. This makes it nearly impossible to reinvest in our business, support our staff, and compete in the market. We’re paying tax rates that are excessively high and for a family-run operation, that’s not sustainable. It is deeply disheartening to work so hard to follow the rules and still be penalized simply because federal law hasn’t caught up with state progress.”
IMPACT ON § 280E FOR CORPORATIONS
IMPACT OF § 280E FOR PASSTHROUGH ENTITIES
Until cannabis is rescheduled to Schedule III or below, or descheduled, operators have a few options when filing their returns:
- Apply § 280E using the normal inventory rules.
- Apply § 280E using the special § 471(c) inventory rules for small businesses. This may require filing Form 8275-R to appropriately disclose the position.
- Do not apply § 280E, relying on your tax attorney’s opinion that the disallowance rule is not applicable to you under various legal theories. This would require filing Form 8275 to appropriately disclose the position.
IRC § 471: a Potential Strategy
What is included in COGS is relatively simple for retailers, but more complex for cultivators and manufacturers. We recommend they consult a cannabis industry-savvy tax advisor.
IRC § 471(a) and the regulations thereunder set forth specific rules regarding inventory. Cultivators are generally required to use the full absorption method, while dispensaries use landed cost. Because the full absorption method permits the capitalization of various indirect costs into inventory, cultivators have that as a tax advantage over dispensaries in most cases.
Internal Revenue Code § 471(c), introduced by the Tax Cuts and Jobs Act of 2017, has emerged as a potential strategy for small cannabis businesses (those with less than $27 million in revenue) to mitigate the impact of § 280E. Businesses of that size are not required to use the normal inventory rules. Instead, they can report inventories in accordance with the method they use in their books and records, which might not comply with the normal rules under § 471(a). In short, costs otherwise disallowed under § 280E may be treated as inventory then recovered through COGS.
Brotherly Bud’s Sirois believes this method will at least allow for more flexible inventory methods, including allocating indirect costs (like certain rent or utilities) to COGS. “We are forced to get creative as normal inventory rules would result in a devastating tax bill,” he said.
Treasury Regulations indicate that § 471(c) cannot be used to circumvent § 280E, but these regulations have been viewed as dubious by much of the tax community. Additionally, the Treasury’s deference in court has been cast in doubt after the recent Supreme Court decision in Loper Bright Enterprises v. Raimondo. In any case, any time a taxpayer takes a position contrary to the regulations they must file a Form 8275-R to mitigate the risk of accuracy-related penalties.
In 2024, some prominent operators took the position, with the support of their attorneys’ opinion letters, that they have “reasonable basis” to believe § 280E is not applicable to their specific operation. Reasonable basis is key to protecting the taxpayer from potential penalties for underpayment of taxes or accuracy-related penalties related to negligence, disregard of rules or regulations, substantial understatement of income tax, or a substantial valuation misstatement Those companies filed amended tax returns without the application of 280E and received significant refunds. There is no guarantee the companies will be able to keep these refunds. And if they have to pay the IRS back because the IRS doesn’t accept their tax position under audit, they will also have to pay interest on the refund.
Taking the position that § 280E is not applicable requires filing Form 8275. Obtaining an opinion letter does NOT guarantee the Internal Revenue Service will accept the taxpayer’s treatment of the expense. The benefit of obtaining the letter is the penalty protection. As well, the attorney letters may not be an ideal option for everyone as they can be expensive. It may be worth determining the savings from taking the position and comparing it against the cost.
Stacey D. Udell, CPA/ABV/CFF
HBK CPAs and Consultants https://hbkcpa.com/
Cherry Hill, New Jersey 08002
sudell@hbkvg.com
(1)Treas. Reg. § 1.471-11.
(2)Treas. Reg. § 1.471-3(b).
(3)Treas. Reg. § 1.471-1(b)(6) “ . . . However, an inventory cost does not include a cost that is neither deductible nor otherwise recoverable but for paragraph (b)(5) of this section, in whole or in part, under a provision of the Internal Revenue Code . . . “
(4)603 U.S. 369 (2024).
