The federal government prohibits cannabis, but many states allow it. How?
Few industries present as many tax compliance challenges as cannabis. If a client comes to you and says they are in the cannabis industry, what do you do as a tax professional?
More than half the states have legalized cannabis for medical use, recreational use, or both. Yet federal tax law has historically continued to treat marijuana as a Schedule I controlled substance under the Controlled Substances Act (CSA). This disconnect creates one of the most significant differences between state and federal tax law that tax professionals encounter.
For cannabis businesses, tax compliance extends well beyond preparing a federal return. Preparers must understand federal income tax rules, state conformity, inventory accounting, licensing requirements, employment taxes, and cash-reporting obligations.
“If cannabis is illegal under federal law, why do I have to report the income?”
The answer begins with IRC Section 61.
Section 61 defines gross income as “all income from whatever source derived,” unless another provision specifically excludes it.
The IRS reinforces this rule in Publication 525, stating that income from illegal activities (including drug sales) must be included in gross income.
That means cannabis income remains federally taxable even when the business operates legally under state law. Sole proprietors generally report business income on Schedule C (Form 1040), while partnerships, S corporations, and C corporations report income on their respective business returns.
Why IRC Section 280E Exists
Congress enacted IRC Section 280E after a court allowed an illegal drug trafficker to deduct ordinary business expenses.
Section 280E now provides that taxpayers trafficking in Schedule I or Schedule II controlled substances cannot deduct ordinary and necessary business expenses or claim related credits.
For cannabis businesses, this means expenses such as rent, administrative payroll, advertising, marketing, office expenses, utilities, insurance, professional fees are generally are not deductible for federal income tax purposes.
The result is a federal taxable income that may be substantially higher than book income.
Cost of Goods Sold Is Different
Fortunately, Section 280E does not prohibit a cannabis business from recovering its cost of goods sold.
COGS is treated as an adjustment to gross receipts rather than a business deduction.
Because of that distinction, inventory accounting becomes one of the most important aspects of preparing a cannabis return.
The IRS instructs cannabis businesses to calculate COGS under IRC Section 471 and the applicable Treasury Regulations. The IRS also directs taxpayers to Chief Counsel Advice 201504011 for additional guidance regarding inventory costs.
For many cannabis businesses, properly calculating inventory costs has a greater effect on taxable income than any other tax planning strategy.
The Ongoing Debate Over IRC Section 471(c)
The Tax Cuts and Jobs Act added IRC Section 471(c), allowing many small businesses meeting the gross receipts test to use simplified inventory accounting methods.
Some practitioners have argued that Section 471(c) permits additional costs to be included in inventory, effectively reducing the impact of Section 280E.
However, the issue remains unsettled.
In 2020, the Treasury Inspector General for Tax Administration (TIGTA) recommended that the IRS issue guidance explaining how Sections 280E and 471(c) interact. While the IRS agreed additional guidance would be beneficial, it has not issued definitive rules allowing cannabis businesses to use Section 471(c) to capitalize expenses otherwise prohibited by Section 280E.
Until further guidance is released, tax professionals should carefully evaluate any position relying on Section 471(c).
IRS Compliance Priorities
Cannabis businesses continue to receive increased IRS attention.
Beyond Section 280E, the IRS encourages cannabis businesses to:
- Report all taxable income.
- Pay employment taxes timely.
- Make required estimated tax payments.
- Maintain complete books and records.
- File Form 8300 when required for cash transactions exceeding $10,000.
- Maintain appropriate state licenses.
- Document inventory purchases and production costs.
Cash-intensive businesses face additional scrutiny, making strong documentation especially important.
Federal Law and State Law Often Differ
Federal taxation is only part of the picture.
Many states have chosen not to follow IRC Section 280E when calculating state taxable income.
Several states now allow licensed cannabis businesses to deduct ordinary and necessary business expenses even though those deductions remain disallowed federally. The DrakeCPE® course highlights examples including California (for licensed businesses), New York, Arizona, Illinois, and Colorado, each of which has adopted some form of relief from the federal Section 280E limitation.
Because conformity rules continue to change, tax professionals should verify each state’s current treatment before preparing returns.
States Also Tax Cannabis Differently
Income tax is only one consideration.
States commonly tax cannabis using one or more of three methods:
- Percentage-of-price taxes
- Weight-based taxes
- Potency-based taxes based on THC content
Many jurisdictions also impose retail sales taxes, excise taxes, cultivation taxes, or local taxes in addition to state income tax.
Cannabis Client Checklist
Before preparing a cannabis return, consider asking:
- Is the business licensed under state law?
- Which cannabis activities does the business perform?
- How is inventory tracked?
- How is COGS calculated?
- Does the state conform to IRC Section 280E?
- Is Form 8300 filing required?
- Are employment taxes current?
- Are estimated tax payments adequate?
- Does the business maintain documentation supporting inventory capitalization?
These questions often identify compliance issues before filing season.
Looking Ahead
Federal cannabis policy continues to evolve.
Treasury has announced plans to issue guidance following the Department of Justice’s rescheduling actions, including transition rules affecting the application of IRC Section 280E. Until those changes become effective, however, tax professionals should continue preparing returns under current law and applicable IRS guidance.
Monitoring IRS announcements, Treasury guidance, and state conformity changes will remain essential for practitioners serving cannabis businesses.
Key Takeaways
- Cannabis income is taxable under IRC Section 61, even if the activity is illegal under federal law.
- IRC Section 280E generally disallows ordinary business deductions for cannabis businesses.
- Proper calculation of COGS under IRC Section 471 remains critical.
- The interaction between Sections 280E and 471(c) remains unresolved.
- IRS enforcement extends beyond income tax to employment taxes, cash reporting, and recordkeeping.
- Many states have decoupled from Section 280E, making state returns significantly different from federal returns.
- Tax professionals should monitor federal guidance as cannabis tax law continues to evolve.
Sources
Primary Source
Internal Revenue Code § 61
Document Type: Internal Revenue Code
Section: 26 U.S.C. § 61
Link: https://www.law.cornell.edu/uscode/text/26/61
Internal Revenue Code § 280E
Document Type: Internal Revenue Code
Section: 26 U.S.C. § 280E
Link: https://www.law.cornell.edu/uscode/text/26/280E
Internal Revenue Code § 471
Document Type: Internal Revenue Code
Section: 26 U.S.C. § 471
Link: https://www.law.cornell.edu/uscode/text/26/471
IRS Publication 525, Taxable and Nontaxable Income
Document Type: IRS Publication 525
Link: https://www.irs.gov/publications/p525
IRS Cannabis Industry Frequently Asked Questions
Document Type: IRS FAQ
IRS Chief Counsel Advice 201504011
Document Type: Chief Counsel Advice
Number: CCA 201504011
Link: https://www.irs.gov/pub/irs-wd/201504011.pdf
U.S. Department of the Treasury
Document Type: Treasury Press Release
Title: Treasury, IRS Announce Process for Tax Guidance Following DOJ Final Order on Medical Marijuana Rescheduling
Practical Guidance
DrakeCPE – Cannabis and Taxes
This article incorporates practical guidance from Drake’s Cannabis and Taxes CPE course, including discussions of Section 280E, inventory accounting, IRS compliance priorities, state conformity, and cannabis-specific state tax considerations.
Supporting Context
State cannabis taxation continues to evolve. Before filing returns, verify current state conformity to IRC Section 280E, licensing requirements, and cannabis-specific excise or sales tax rules.
Disclaimer: This article is for informational purposes only and not legal or financial advice.
