Payroll and Labor Cost Classification Under 280E

Payroll is usually one of the largest line items on a cannabis business's income statement and one of the most misunderstood when it comes to Section 280E. Unlike most ordinary business expenses, which are simply non-deductible for cannabis businesses, labor costs sit in a gray zone: some wages can be captured within Cost of Goods Sold, while others cannot be deducted at all. Where a given employee's wages fall depends almost entirely on what that employee actually does.

Getting this classification wrong is one of the more common and more costly mistakes cannabis operators make.

Why Job Function, Not Job Title, Determines Deductibility

The IRS doesn't look at what an employee is called. It looks at what they actually do, day to day. A "production associate" whose time is split between trimming product and helping at the retail counter isn't automatically eligible to have their full wage captured in COGS just because their title suggests a production role.

This means cannabis businesses generally need to track labor at a level of detail most other industries don't bother with: not just total payroll, but time allocated by function, and ideally by product or activity.

Labor That Generally Supports COGS Treatment

For cultivators and producers, labor directly tied to growing, processing, curing, trimming, and packaging product is generally the strongest candidate for inclusion in COGS. This typically includes:

• Cultivation staff directly tending plants

• Trimmers and processors handling raw product

• Quality control staff testing product as part of the production process

• Production supervisors whose time is spent directly overseeing these functions

  
  

Labor That Generally Does Not Qualify

Wages tied to activities outside direct production are typically treated as ordinary business expenses, and therefore non-deductible under 280E. This commonly includes:

• Budtenders and retail sales staff

• Marketing and business development roles

• Administrative and back-office staff

• Executive compensation, unless a clear, documented portion of time is spent directly on production activities

• Delivery drivers, in many cases, depending on state-specific interpretations

  
  

The Split-Role Problem

The hardest cases involve employees who split time across both deductible and non-deductible functions, a general manager who oversees both cultivation and retail, or an owner-operator involved in everything from trimming to sales. In these situations, businesses generally need to allocate wages based on a reasonable, documented method: time tracking, activity logs, or another defensible metric.

What doesn't work is an estimate applied after the fact with no supporting documentation. If an examiner asks how a 50/50 allocation was determined and the answer is "that felt about right," the allocation likely won't hold up.

Building a Defensible Payroll Classification System

1. Track time by function, not just by employee. Time tracking software that captures activity type not just clock-in and clock-out makes allocation dramatically easier to substantiate later.

2. Document your allocation methodology in writing. If wages are split between COGS-eligible and non-eligible activities, the method for doing so should be written down and applied consistently, not improvised each pay period.

3. Reassess when roles change. An employee who moves from a production role to a retail role or takes on new responsibilities needs their classification updated at that point, not retroactively at tax time.

4. Align payroll classification with your broader cost accounting methodology. Labor allocation shouldn't exist in isolation from how you're classifying other COGS-eligible costs. The two need to tell a consistent story.

5. Avoid blanket classifications across a whole team. Classifying an entire department as "production" without regard to individual job function is a common shortcut that rarely survives scrutiny.

Why This Matters More Than It Might Seem

Payroll misclassification doesn't just risk a disallowed deduction here or there because labor is often one of the largest expense categories, a single systemic misclassification can meaningfully overstate COGS across an entire tax year. That's exactly the kind of issue that turns a routine audit into a much larger examination.

Done correctly, payroll classification is one of the more powerful levers cannabis businesses have to legitimately maximize their COGS position. Done carelessly, it's one of the fastest ways to invite scrutiny.

Redbud Advisors helps cannabis businesses build payroll classification systems that are both accurate and audit-ready. Schedule a call to review how your current labor costs are being classified.