White Paper · Cannabis Tax · §280E

How Section 280E Works: Cost of Goods Sold, Inventory Rules, and the Case Law

Adult-use cannabis businesses remain subject to §280E after April 28, 2026. This briefing explains what the statute disallows, why cost of goods sold survives it, what the Tax Court and Ninth Circuit held in Harborside and CHAMP, and how Illinois and Missouri treat 280E for state income tax.

By Lincoln Square Law · 8-minute read

Who still needs to understand §280E

The April 28, 2026 federal rule moved marijuana under a state medical license into Schedule III. It left adult-use marijuana in Schedule I. An adult-use dispensary, a cultivator or manufacturer serving the adult-use market, and the adult-use side of a mixed operator therefore still face section 280E. So do periods and activities that the April 28 rule does not reach. Our briefing on Schedule III and section 280E covers the rule itself. This one explains how section 280E works for anyone it still governs.

What the statute says

Section 280E provides that no deduction or credit is allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if the trade or business consists of trafficking in controlled substances within the meaning of Schedule I or II of the Controlled Substances Act, and the trafficking is prohibited by federal law or the law of any state in which the business is conducted (26 U.S.C. 280E). Congress added it in 1982 (Pub. L. 97-248, sec. 351(a)).

Each element matters. The statute applies to a trade or business, so the analysis starts with what the business is. It applies when the business “consists of” trafficking, which raises the question of whether a taxpayer has more than one business. It reaches only Schedule I and II substances, which is why the April 28 rule matters for medical activity. And it requires that the trafficking be prohibited by federal law or state law. State legalization does not satisfy that element, because federal law still prohibits Schedule I trafficking.

Why cost of goods sold survives

Section 280E disallows deductions and credits. Gross income for a business that sells goods is computed after subtracting the cost of goods sold, so cost of goods sold is not a deduction in the statutory sense. That is why a business subject to section 280E can still reduce gross receipts by the cost of the inventory it sells, while its other business expenses, such as rent for retail space, marketing, and administrative salaries, are disallowed.

The practical fight is over what belongs in inventory cost. In Patients Mutual Assistance Collective Corp. v. Commissioner, the Tax Court held that a dispensary that bought marijuana and resold it was a reseller, so its inventory cost was limited to the purchase price plus transportation and other necessary charges incurred in acquiring possession of the goods (Treas. Reg. 1.471-3(b)). It did not qualify for the producer rule in section 1.471-3(c), because it purchased rather than produced the products it sold (151 T.C. 176 (2018)).

Section 263A does not expand inventory cost for a §280E business

Section 263A, the uniform capitalization rules, ordinarily requires certain direct and indirect costs to be capitalized into inventory. Cannabis businesses argued that those rules let them move otherwise-disallowed costs into cost of goods sold. The Tax Court rejected that argument in Harborside, stating that the section 263A capitalization rules do not apply to drug traffickers, and reasoning that a cost that is not deductible cannot be capitalized under section 263A. The Ninth Circuit affirmed, holding that the taxpayer’s inventory costs were governed by section 1.471-3(b) (Patients Mutual Assistance Collective Corp. v. Commissioner, No. 19-73078 (9th Cir. Apr. 22, 2021)).

The result is that a section 280E business generally computes inventory cost under section 471 and its regulations, using the rule that fits its actual role: purchaser and reseller, or producer. A cultivator or manufacturer has a stronger basis for including production costs than a retailer does, but the classification follows what the taxpayer actually does with the product. The Ninth Circuit’s decision binds courts in that circuit. Tax Court decisions apply nationally, subject to the appellate rule in the taxpayer’s own circuit. Illinois and Missouri sit in the Seventh and Eighth Circuits.

When a second business can escape §280E, and when it cannot

In Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, the Tax Court held that section 280E did not preclude deductions attributable to the taxpayer’s counseling and other caregiving services, which the court treated as a separate trade or business from its medical marijuana activity (128 T.C. No. 14 (2007)). The opinion is often cited for the point that a genuinely separate business is outside section 280E.

Harborside shows the limit. The Tax Court rejected the argument that the dispensary’s other activities were separate businesses and held that Harborside had a single trade or business, the sale of marijuana (151 T.C. 176). The difference is factual. A separate business needs its own economic substance, its own revenue, and records that show it operated as a distinct activity. Labels and allocations created at tax time do not supply those facts.

Illinois and Missouri state income tax

Both states let cannabis businesses recover, for state purposes, deductions that section 280E disallows federally. Illinois’s Schedule M includes a subtraction for deductions disallowed under section 280E for cannabis establishments, cannabis cultivation centers, and medical cannabis dispensing organizations. It appears for tax years ending on or after December 31, 2023 (Ill. Dep’t of Revenue, Schedule M, line 35). Missouri’s 2025 partnership return instructions include a “Recreational Marijuana Business Deduction” for expenditures eligible as federal deductions but disallowed under section 280E (Mo. Dep’t of Revenue, Form MO-1065 instructions, rev. 12-2025). Each state’s subtraction has its own eligibility rules and documentation requirements, so confirm the current form, instructions, and statute for the specific entity type and year.

Records that support a §280E return

The records that matter are the ones that show how much product was bought or produced, at what cost, and what was sold. A retailer should keep purchase invoices, freight and receiving records, inventory counts, and the seed-to-sale data that ties purchases to sales. A producer should keep cultivation and production records, labor tied to production, yield and waste data, testing, and transfer records. Any business that claims a separate trade or business should keep separate books, contracts, staffing, pricing, and evidence that customers paid for that activity.

State seed-to-sale tracking and federal tax records should tell the same story. If inventory counts in the tracking system do not reconcile to the general ledger, the cost of goods sold figure is exposed on examination.

What to avoid

Avoid treating cost of goods sold as a place to park disallowed expenses. Avoid creating a “management company” or a second entity whose only purpose is to receive deductible expenses, unless it is a real business with real operations. Avoid assuming the April 28 rule covers activity that is not under a state medical license. And avoid filing state returns without the state subtraction, or claiming it without the documentation the form instructions require.

Developments that could change this analysis

Treasury and the IRS have listed guidance under section 280E as item 9 under “Other Priorities” in their 2026-2027 Priority Guidance Plan, which states that it sets no completion deadline. A final rule from DEA’s broader rescheduling proceeding would move adult-use marijuana out of Schedule I and change the analysis again. As of this writing, neither has been published.

Questions for your tax adviser and counsel

Is each entity a reseller or a producer for section 471 purposes, and do its records support that? Which activities, if any, are genuinely separate trades or businesses? Are we claiming the Illinois or Missouri subtraction with the required support? How do our seed-to-sale records reconcile to inventory on the return?