For a cannabis business subject to IRC §280E, one question shapes the federal return more than almost any other: which costs belong in cost of goods sold. Costs that properly belong in inventory still reduce taxable income. Costs that do not may produce no federal benefit at all.
Here is what the inventory rules allow, why two common workarounds fall short, and the bookkeeping that supports the numbers.
Why cost of goods sold survives §280E
IRC §280E denies any deduction or credit for amounts paid or incurred in a trade or business that consists of trafficking in Schedule I or II controlled substances. Cost of goods sold is not a deduction. It is subtracted from gross receipts to arrive at gross income. The Senate report on §280E said the provision does not affect that adjustment, and the IRS has acknowledged the point (CCA 201504011).
The catch: cost of goods sold follows IRC §471 and its regulations, not preference, and what qualifies depends mostly on whether you buy finished product to resell or produce it yourself.
A timing note: in April 2026, marijuana subject to a state medical license moved to Schedule III, with Treasury and IRS guidance on §280E still to come. Adult-use cannabis remains in Schedule I, so these rules still apply to it. See Section 280E After the 2026 Partial Rescheduling.
Resellers: dispensaries that buy finished product
A reseller’s inventory cost is the invoice price, less trade or other discounts, plus transportation or other necessary charges incurred in acquiring possession of the goods (Treas. Reg. §1.471-3(b)). Chief Counsel advice released in 2021 applied that limit to a reseller (CCA 202114019). For a dispensary, that generally leaves out retail wages, store rent, security, marketing, and other overhead.
In Patients Mutual Assistance Collective Corp. v. Commissioner, 151 T.C. No. 11 (2018), the Tax Court held that the dispensary was a reseller. The court said producer status turns on ownership during production, and that reinspecting, packaging, and labeling purchased product did not make the dispensary a producer.
Producers: cultivators and manufacturers
Producers include more: raw materials and supplies, direct labor, and indirect production costs incident to and necessary for production, including an appropriate portion of management expenses, but not selling costs or a return on capital (Treas. Reg. §1.471-3(c)). The IRS reads this together with the full-absorption rules of Treas. Reg. §1.471-11 (CCA 201504011). In general terms:
- Direct costs. Materials that become part of the product, and labor for work such as cultivation, harvest, trimming, and extraction.
- Included indirect production costs. When incident to and necessary for production: repairs, maintenance, utilities, rent, indirect labor and production supervision, indirect materials and supplies, tools and equipment not capitalized, and quality control and inspection (Treas. Reg. §1.471-11(c)(2)(i)).
- Costs that generally follow your financial statements. Examples include depreciation on production assets, factory administrative expenses, insurance on production equipment, and rework, scrap, and spoilage (Treas. Reg. §1.471-11(c)(2)(iii)).
- Costs generally outside inventory. Marketing, advertising, selling, distribution, interest, research, and general and administrative costs of the business as a whole (Treas. Reg. §1.471-11(c)(2)(ii); CCA 201504011).
Vertically integrated operators may hold both kinds of inventory, so production costs and resale purchases are best tracked separately.
Why §263A cannot widen the net
Many producers and larger resellers capitalize additional costs under the uniform capitalization rules of IRC §263A. For a §280E business, that route is closed: a cost that could not be taken into account in computing taxable income, but for §263A, is not treated as a §263A cost (IRC §263A(a)(2)).
In Patients Mutual, the Tax Court relied on that language: because §280E bars the deductions, §263A cannot be used to capitalize them. The Ninth Circuit affirmed (No. 19-73078, Apr. 22, 2021). The dispensary did not challenge the §263A ruling on appeal, but the court restated the principle: if a cost is not deductible, it cannot be capitalized under §263A. The IRS had taken the same view years earlier (CCA 201504011).
What about the small business inventory methods?
For tax years beginning after 2017, a business that meets the gross receipts test of IRC §448(c) and is not a tax shelter may set aside the §471(a) inventory rules. It may treat inventory as non-incidental materials and supplies, or follow its applicable financial statement or, if it has none, its books and records (IRC §471(c)). For tax years beginning in 2026, the test is generally met with average annual gross receipts of $32 million or less over the three prior tax years (Rev. Proc. 2025-32).
Some argued this lets a §280E business put more costs into inventory through its books. Final regulations issued in January 2021 point the other way: under each of these methods, inventory cost excludes costs that are not deductible or otherwise recoverable, and nothing in §471(c) permits recovery of a cost another Code provision bars (Treas. Reg. §1.471-1(b)(4) through (b)(7)). The regulations do not name §280E, but their text is broad enough to reach it. Relying on §471(c) to recover costs §280E disallows runs against the regulations and calls for careful review before filing.
California runs its own computation
Under California’s personal income tax law, §280E does not apply to commercial cannabis activity by a licensee for taxable years beginning on or after January 1, 2020, and before January 1, 2030 (California Revenue and Taxation Code §17209). According to the Franchise Tax Board, licensed cannabis businesses may deduct cost of goods sold and ordinary and necessary business expenses, while unlicensed businesses may deduct only cost of goods sold.
For licensees, a cost left out of federal inventory may still be deductible in California, so the same cost detail needs to serve both returns.
Bookkeeping habits that support cost of goods sold
The strongest inventory position is the one your records can prove. Habits that help:
- Count and reconcile. Take physical counts on a regular schedule and reconcile them to the state track-and-trace system and the general ledger.
- Set up cost centers. Separate cultivation, manufacturing, retail, and administration in the chart of accounts, so production costs are identified when recorded, not reclassified at year end.
- Track shared labor. Keep time records for employees who split their day between production and other work.
- Document facility allocations. When one building houses production and retail, allocate rent and utilities on a reasonable, written basis, such as square footage.
- Record losses when they happen. Enter waste, destruction, and failed tests promptly, tied to regulatory records, so ending inventory stays accurate.
- Write down your method and apply it consistently. Changing an accounting method generally requires IRS consent (IRC §446(e)).
How TreeStar can help
TreeStar works with cannabis businesses on bookkeeping, inventory and cost accounting, and tax preparation and planning, with both the federal and California returns in mind. If you would like a second look at how your costs flow into inventory, we are glad to review it with you.
This article is general information, not advice for your situation. Rules change; confirm current law before acting.
