Understanding COGS Under 280E: What Actually Qualifies

Ask any cannabis operator what matters most on their tax return, and the answer is almost always the same: Cost of Goods Sold. Under IRC Section 280E, COGS is the only meaningful offset to gross income that cannabis businesses are allowed to claim. Every other ordinary business expense, rent, marketing, most wages, administrative costs is off the table for federal tax purposes.

That makes COGS the single most important calculation in a cannabis tax return, and also one of the most misunderstood. Getting it right isn't just about minimizing tax liability. It's about building a number that can survive an IRS examination.

Why COGS Exists as the Exception to 280E

280E denies deductions for expenses connected to trafficking a Schedule I controlled substance. But it doesn't touch COGS, because COGS isn't technically a deduction, it's a reduction to gross receipts used to arrive at gross income in the first place. That distinction, rooted in longstanding tax law that predates 280E, is why cannabis businesses can still recover product costs even though they can't deduct nearly anything else.

The IRS applies different COGS rules depending on whether a business is a producer/cultivator or a reseller/retailer, which is where a lot of the complexity and a lot of audit risk comes from.

What Generally Qualifies as COGS for Cultivators and Producers

Businesses that grow or manufacture cannabis products have more room to capitalize costs into COGS, including things like:

• Seeds, clones, and other direct cultivation inputs

• Growing supplies directly tied to production, such as nutrients and soil

• Utilities directly attributable to cultivation or production space

• Labor directly involved in growing, trimming, curing, and processing

• Packaging materials that are part of the finished product

The key word throughout is direct. Costs have to be tied specifically to production activity, not the business in general.

What Generally Qualifies as COGS for Retailers

Retail-only operations, like dispensaries that don't cultivate or process, have a much narrower path to COGS. Historically, resellers were largely limited to the invoice cost of the product itself, plus certain transportation and warehousing costs necessary to get inventory into a saleable condition. Marketing, most labor, rent, and general overhead typically fall outside what a pure retailer can capitalize into COGS.

This is one of the most consequential differences in the industry: a vertically integrated business that also cultivates has meaningfully more flexibility in its COGS calculation than a retail-only dispensary sourcing product from third parties. It's a major reason cost accounting methodology needs to be built around what your business actually does, not a generic template.

What Does Not Qualify

Costs that generally fall outside COGS and remain non-deductible under 280E include:

• Marketing and advertising

• Most administrative and executive salaries

• Rent for retail or office space not tied to production

• Security costs for retail locations

• General liability insurance and professional fees not tied to production

Attempting to reclassify these as COGS sometimes called "COGS creep" is one of the more common reasons cannabis returns draw IRS attention.

Building a Defensible Cost Accounting Methodology

The IRS doesn't just look at your final COGS number. It looks at how you got there. A defensible methodology generally includes:

1. A documented, consistent approach. Whether you use standard costing, actual costing, or another accepted method, apply it the same way every period. Switching methods to optimize a particular year's outcome is a red flag.

2. Clear allocation of shared costs. If a facility handles both cultivation and retail, costs need to be allocated between the two based on a reasonable, documented method; square footage, time spent, or another defensible metric not guesswork.

3. Contemporaneous documentation. Costs should be tracked and allocated as they happen, not reconstructed at tax time. Real-time tracking is both more accurate and far easier to defend under examination.

4. Alignment with inventory records. Your COGS calculation needs to tie directly back to your inventory reconciliation. If the two don't match, neither one is defensible on its own.

The Cost of Getting COGS Wrong

Overstate COGS, and you're inviting an audit that could result in disallowed deductions, back taxes, penalties, and interest. Understate it out of caution, and you're simply paying more tax than you need to. Neither outcome serves the business. The goal is a number that's both maximized within the rules and fully substantiated if questioned.

Because the line between what qualifies and what doesn't is genuinely industry-specific and because it depends heavily on whether you cultivate, process, retail, or some combination, this is one area where general small business accounting experience isn't enough. It takes an accountant who works in cannabis specifically.

Redbud Advisors builds 280E-compliant cost accounting methodologies tailored to what your cannabis business actually does. Schedule a call to have your current COGS calculation reviewed.