Smoke Reports is a small San Francisco company working hard to improve the relationship between cannabis and human beings through education, outreach and technology.  Smoke Reports cares deeply about cannabis.  Our editorial board publishes whitepapers from time to time to express our opinion in the context of our commitment to making cannabis universally available as a safe consumer product.  

Our whitepapers are meant to engage a discussion among all members of the cannabis community – growers, manufacturers, dispensaries, retailers, patients and consumers, and in this case – legislators.  We encourage your comments and feedback.

Internal Revenue Code §280E Explained
and Legislative Recommendations

An editorial whitepaper from

The following is a general discussion of the legislative history and effects of certain federal tax code provisions. It is not intended to be tax or legal advice and should not be relied upon as such. For such advice, please contact a legal or accounting professional.


Tax court rulings prompted Congress to enact Internal Revenue Code §280E as a tool in the “war on drugs” to create a tax burden and reduce the profit incentive for businesses trafficking in illegal substances.

For the cannabis business, Internal Revenue Code § 280E disallows the “ordinary and necessary” business expense tax deduction allowed to other enterprises. The effect is to impose a higher effective tax rate on businesses selling cannabis legally. The tax code allows deductions for “cost of goods sold”, reducing the burden to businesses producing product, but taxpayers and businesses – primarily at the retail level – are still heavily burdened with federal income taxes by §280E.

Despite the legalization of cannabis in various state jurisdictions, recent appellate court rulings have upheld the application of §280E. Until Congress changes the law or the federal agencies reclassify cannabis from Schedule I, federal income tax remains a burden for the cannabis industry.

The editorial board at advocates the repeal of §280E as it applies to the cannabis industry. As many states follow the federal tax code and until such time as federal tax laws are amended, we recommend that state cannabis reform laws specifically address this issue and exempt the application of §280E at the state tax level.

“Cannabis deserves a better conversation.” –

“Current income tax law is a burden to the cannabis industry and must be changed.” –


Smoke Reports is a small San Francisco company working hard to improve the relationship between cannabis and human beings through education, outreach and technology. This editorial whitepaper’s purpose is to put forth a discussion topic related to that relationship – the structure around which we are building a cannabis industry and more specifically, the income taxation of cannabis enterprises.

The editorial board at observes much justifiable consternation regarding Internal Revenue Code §280E and its affect on the cannabis business owner. We also observe very little accurate information being offered which sheds light on the problem, and we even observe the circulation of inaccurate information. To that end, we wish to thoroughly and accurately describe the problem and recommend legislative solutions. believes that cannabis deserves a better conversation. The purpose of this whitepaper is to instigate a discussion of and promote legislative reform of the taxation of the cannabis industry.


Clearly stated, and as is discussed in further detail below, Internal Revenue Code §280E is a burden to the cannabis industry. It imposes a disproportionate tax structure not borne by other enterprises. It imposes a substantial barrier to entry into the cannabis industry. It requires an additional administrative burden for proper compliance. §280E has the practical of preventing some types of cannabis businesses from ever being profitable.

Legislative and Legal History of §280E

In Edmondson v. Commissioner[1] the federal tax court ruled that a taxpayer involved in the illegal drug trade was entitled to business deductions in arriving at federal taxable income. The opinion stated, in part, that business deductions were allowable because such deductions “were made in connection with [the taxpayer’s] trade or business and were both ordinary and necessary.”[2] (See discussion below regarding the significance of the term “ordinary and necessary” in the income tax context.)

The tax court decision treated the illegal drug trade as any other business for income tax purposes. Gross income is measured, deductions are taken and income tax is imposed on taxable income. The 1981 decision was handed down during the Reagan presidential administration and at the very beginning of America’s “war on drugs”. The decision did not sit well with the conservative American politics of the time.

Congress quickly reacted to the Edmondson decision. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)[3], a tax bill introduced specifically to close certain tax loopholes and raise taxes, contained a provision addressing the issues associated with income derived from the illegal drug trade. Congress made clear their intent in enacting these provisions, stating:

“There is a sharply defined public policy against drug dealing. To allow drug dealers the benefit of business expense deductions at the same time that the U.S. and its citizens are losing billions of dollars per year to such persons is not compelled by the fact that such deductions are allowed to other, legal, enterprises. Such deductions must be disallowed on public policy grounds.”[4]

Based on this justification, Congress included in TEFRA Internal Revenue Code §280E as an additional provision to the tax code:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.[5]

For reference, Schedule I of the Controlled Substances Act[6] states:

(b)Placement on schedules; findings required
[ . . . ] The findings required for each of the schedules are as follows:

(1) Schedule I.—
(A) The drug or other substance has a high potential for abuse.
(B) The drug or other substance has no currently accepted medical use in treatment in the United States.
(C) There is a lack of accepted safety for use of the drug or other substance under medical supervision.

(c) Initial schedules of controlled substances
[ . . . ]Schedule I
[Selected listing]
(a)(1) Opium
(c)(1)3,4-methylenedioxymethamphetamine [ecstasy]
(c)(9)Lysergic acid diethylamide [LSD]
(c)(10)Marijuana [cannabis]

Since the Controlled Substances Act clearly establishes cannabis as a Schedule I controlled substance, the provisions of §280E apply to the cannabis industry. Therefore, cannabis businesses cannot avail themselves of a deduction for “ordinary and necessary” business expenses incurred in the taxpayer’s trade or business in arriving at taxable income.

As recently as this year, §280E survived an appellate court challenge by an enterprise engaged in the legal sale of cannabis in California. On July 9, 2015, in Olive v. Commissioner[7] the Ninth Circuit Court of Appeals upheld a Tax Court ruling[8] upholding the applicability of §280E.

Council for the Vapor Room Herbal Center argued that its activities were legal under California law and therefore not subject to the provisions of §280E. The court soundly and definitively (again) rejected this line of reasoning:

“A taxpayer may not deduct any amount for a trade or business where the ‘‘trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances which is prohibited by Federal law[sic].’’ Sec. 280E. We have previously held, and the parties agree, that medical marijuana is a controlled substance under section 280E. [ . . . ] We therefore reject petitioner’s contention that section 280E does not apply because the Vapor Room was a legitimate operation under California law.”[9]

For businesses “trafficking in controlled substances”, Internal Revenue Code §280E disallows ordinary and necessary business deductions in determining taxable income. As more fully illustrated below, cannabis businesses conducting what may now be state-legal business activities are consequently subjected to a burdensome tax rate.

Taxable Income and §280E, Generally

Federal and (in most states) state income taxes are levied as a percentage of taxable income. The simple formula is “Taxable Income” multiplied by a tax rate percentage to equal tax due.

“Taxable Income” is computed by measuring Gross Income and subtracting allowable deductions:

Screen Shot 2015-10-29 at 4.04.38 PM

For businesses selling cannabis, §280E disallows business deductions in arriving at taxable income. These otherwise “allowable deductions” specifically denied by §280E are defined in Internal Revenue Code §162:

“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business . . .”[10]

In simple terms, these are expenses associated with items such as payroll, rent, utilities, advertising and business taxes. The term “ordinary and necessary business expenses” is a common and well-defined concept used in determining taxable income. Because §162 deductions are not allowed in computing taxable income for the sale cannabis, cannabis businesses are taxed on the equivalent of gross income.

“Gross income” is defined under Internal Revenue Code §61 as follows:

“Except as otherwise provided in this subtitle, gross income means all income from whatever source derived . . .”[11]

Although sale of cannabis is considered an illegal activity by the federal government, the legislative and legal histories are clear – all income, whether derived from legal or illegal activity, is considered taxable income.

As clear as the intent of the all-inclusive definition of §61 appears to be, certain deductions from “income from whatever source derived” may be taken to arrive at “Gross Income”. Technically, cost of goods sold (COGS) is considered an adjustment to Gross Income under the tax code. Consequently, costs associated with the purchase or production of inventory items held for sale – Cost of Goods Sold – may be deducted from income received in determining “gross income”. IRC Regulation §1.61-3 states:

In a manufacturing, merchandising, or mining business, “gross income” means the total sales, less the cost of goods sold . . .[12]

Similarly Regulation §1.162-1(a) states:

The cost of goods purchased for resale, with proper adjustment for opening and closing inventories, is deducted from gross sales in computing gross income.[13]

Including a deduction for COGS, the formula for computing income taxes is as follows:

Screen Shot 2015-10-29 at 4.05.36 PM

Regulation §1.162-1(a) provides for a COGS deduction “with proper adjustment for opening and closing inventories”. Beyond the scope of this whitepaper is a discussion describing a provision for proper accounting for inventory costs. The inventory capitalization rules found in Internal Revenue Code §263A allow for, and in some cases require, all costs associated with the production of inventory be included in COGS.

These costs can include things like production salaries, warehouse or farm-field rent and utilities – expenses otherwise associated with “ordinary and necessary” business deductions allowed by §162 and disallowed in §280E. The rules are complex and demand proper legal and accounting advice for implementation. A fully formed and well-researched technical discussion of this and other taxation issues affecting the cannabis industry can be found here.

An important final note: This is a discussion of federal tax law. Most states including California rely on the initial determination federal taxable income as a basis for determining state taxable income. Consequently, the provisions of §280E “flow down” to the calculation of state taxable income unless a specific adjustment is allowed under state law.

This may be true even in states where cannabis is legal. Therefore the consequences of §280E in the calculation of federal income taxes also affect the calculation of many state income taxes.

Effects of §280E on the Cannabis Business

Below is an illustrative example of the above conceptual discussion. These numbers are taken from the appellate court decision of Olive v. Commissioner and therefore represent the finances of a real cannabis business.

Screen Shot 2015-10-29 at 4.06.58 PM

Column A is the reported income statement for the Vapor Room for 2005, which also may represent a financial statement for any typical business. Shown is both a Net Profit and a Taxable Income of $32,242.

Column B illustrates the same financial statement differing only in that the Vapor Room is selling cannabis. §280E disallows the deduction of business expenses in arriving at Taxable Income, hence many of the items deductible in Column A do not appear as a Business Deduction in Column B. Because the expenses in Column A are actually incurred by the Vapor Room, its actual Net Profit is $32,242 (Column A). However, when imposing the restrictions of §280E , Taxable Income (the amount upon which taxes are calculated) is $319,127 (Column B).

Federal corporate income tax is calculated as follows:

Screen Shot 2015-10-29 at 4.08.19 PM


Of obvious note is the significant difference in the amount of tax due between Column A and Column B. Were this a business selling something besides cannabis, $4,836 is due in taxes in Column A. Because this business sells cannabis, $107,960 is due in taxes (Column B). Both columns reflect the same financial situation with drastically different tax consequences.

The less obvious difference between Column A and Column B is the tax rate. Federal income taxes (and many state income taxes) are assessed using a graduated tax rate – a rate that increases as taxable income increases. A corporation pays a 15% tax rate on $10,000 of taxable income, but pays a 39% marginal tax rate on taxable income in excess of $100,000. As Taxable Income goes up, so does the tax rate. Consequently, the cannabis business is hit by a secondary tax penalty – a higher tax rate applied to taxable income.

If we compare the after-tax net income of Column A and Column B, we see the following:

Screen Shot 2015-10-29 at 4.09.03 PM

As both columns represent the same business Net Profit calculations differing only in the type of business, both have the same Net Profit of $32,242. The business selling something besides cannabis in Column A has an After-Tax Net Income of $27,406. The business selling cannabis in Column B has an After-Tax Net Loss of $75,718.

An analysis when comparing Column A and Column B reveals the benefit to classifying expenditures as Cost of Goods Sold over classifying them as “ordinary and necessary business expenses” – thereby making the expenses tax deductible. The business and accounting term for this distinction is “above the line” deductions and “below the line” deductions – the “line” referring to the one found just below “Cost of Goods Sold”. For this, please refer to the discussion above and contact a legal or accounting professional.

§280E imposes a significant tax burden on the cannabis business owner. In this real-life example, an additional $103,123 in taxes are imposed compared to the same business selling something other than cannabis. Also, this clearly demonstrates that an otherwise profitable enterprise is no longer economically viable merely because of the provisions of the Internal Revenue Code. But the effects do not stop here. There are additional burdens created for the cannabis industry by §280E.

First, a cannabis business owner cannot possibly navigate the world of income taxation on their own. Where there is the possibility of any other business enterprise calculating profits and paying taxes on their own accord, no such possibility exists for the cannabis business owner.

Should a non-cannabis business owner not properly classify inventory costs of §263A, a deduction may simply be deferred or accelerated between tax periods. For a cannabis business, such misclassification eliminates the deductibility of expenses in their entirety. The tax consequence for such a miscalculation is expensive and severe. Therefore, costly professional help is required to accomplish a task which is not otherwise required for non-cannabis enterprises.

Second, simple business transactions must be structured in a way to alleviate income tax burdens. For instance, let’s say Grower X is selling inventory to Dispensary Y, and the state imposes a 10% transaction tax on the sale of cannabis. Grower X charges $5,000 for the inventory and must collect 10%, or $500, in state tax to forward to the state. Grower X has Total Sales of $5,000 plus $500, or $5,500. But the $500 in taxes which must be directly forwarded to the state is not associated with Cost of Goods Sold and is not deductible for tax purposes under §280E.

Therefore, even though it is a complete wash from an economic profit standpoint, Grower X is burdened with additional taxable income of $500 upon which income tax must be paid. If the marginal tax rate is 39%, Grower X must pay $195 in additional income tax as a result of the non-deductibility of collecting mandatory state transaction taxes.

Grower X has a solution, however. Rather than collecting and paying the tax, Grower X tells Dispensary Y the cost of the product is $5,000 and that Dispensary Y must pay the 10% state transaction tax directly. Grower X therefore will not have the increase in Total Sales as a result of the collection of $500 in transaction taxes, and will not bear the income tax burden associated with the additional revenue.

A simple solution? Yes. But look at what that does to the cannabis industry. Suddenly, even simple transactions like buying and selling inventory must be negotiated differently because they are affected by §280E. All similar transactions are affected by §280E, thereby creating constant burden for the industry in inventory transactions.

Third: a potential conflict exists between two parties negotiating a simple buy/sell contract. In our example, Grower X sells inventory to Dispensary Y adding the clause to the contract, “You pay the state transaction tax.” Dispensary Y pays $500 to the state as a transaction fee, but the question remains whether this expense is “above the line” or “below the line” for Dispensary Y. This question has a significant impact on the profitability of Dispensary Y – an expense associated with COGS is tax deductible but an “ordinary and necessary” business expense is not. Negotiation between Grower X and Dispensary Y is therefore not only about the cost of product, but also about bearing the potential income tax burden of the transaction.

Lastly, §280E creates significant tax differences between enterprises even within the cannabis industry. A typical grower or product manufacturer will primarily have expenses within the cost of producing product (“above the line”), whereas the typical reseller or retailer will primarily have business expenses “below the line”.

Referring to the general discussion above, cannabis growers and manufacturers may avail themselves of the provision of §263A to allocate otherwise “below the line” expenses to Cost of Goods Sold, thereby making additional expenses deductible for income tax purposes. Such is not the case for delivery, distribution and dispensary operations to such a significant extent. Delivery enterprises may only have “below the line” expenses. For others, Cost of Goods Sold is the cost of product; all other expenses are generally “below the line” and not tax deductible.

Internal Revenue Code §280E imposes significant burdens on the cannabis industry. It imposes a tax burden not otherwise imposed on other enterprises. It creates an administrative and technical burden requiring professionals to properly account for profit and calculate the proper imposition of income tax. It requires the industry to carefully negotiate each transaction to avoid tax burdens and sets negotiating parties in conflict over the issue. It even sets different tax structures for enterprises within the cannabis industry.


The editorial board at advocates for the revocation of Internal Revenue Code §280E as it applies to cannabis and cannabis products for the following reasons:

  1. As cannabis is legal in some states and a growing awareness of the medical benefit of cannabis is sweeping the country, the application of §280E to the sale of cannabis and cannabis products is no longer valid on public policy grounds – the explicit reason for the application of §280E.
  2. §280E creates a disproportionate tax burden on the cannabis industry as compared to other business enterprises.
  3. §280E creates a barrier to entry for entrepreneurs wanting to establish a cannabis business.
  4. The excessive taxation of §280E has every potential to make an otherwise profitable business unprofitable. As a public policy matter, our income tax code must not be the sole reason for keeping any business from becoming a viable economic activity.
  5. §280E creates an undue administrative burden for the cannabis business owner.
  6. §280E creates transactional disruption within the cannabis industry.

The editorial board at advocates the revocation of the applicability of §280E by the following means:

First, remove all forms of cannabis from Schedule I of the Controlled Substances Act. §280E explicitly states its applicability to Schedule I and Schedule II substances. A change in the status of cannabis quickly puts an end to this discussion and, aside from the other law-enforcement affects, is perhaps the single most necessary beneficial change to help foster a viable cannabis industry. Of special note – moving cannabis from Schedule I to Schedule II does not solve this problem as §280E applies to Schedule II substances as well.

Second, change one word of Internal Revenue Code §280E as follows:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or and the law of any State in which such trade or business is conducted.

Making such a change to provide that §280E applies only where “federal law and the law of any state” agree on a prohibition opens the door to §280E’s inapplicability to not just cannabis as it is legalized in the various states, but also to any other substance which a state may in its own judgment find a desire to declare legal. This simple modification to the Internal Revenue Code opens the door to state rights.

Our final recommendation appeals directly to the various state legislatures. As cannabis reform laws are considered, what must also be considered is the current application of IRC §280E to the state income tax system. For states that use the federal income tax code as a basis for computing state taxable income, the penalties of §280E found in the federal tax code are automatically incorporated into the calculation of state income tax.

States can at least provide some tax relief to the cannabis business by specifically enacting tax exemptions from the effects of IRC §280E. We recommend unequivocally that state-level cannabis reform include an exemption from the adverse tax consequences of IRC §280E.


The current income tax structure of cannabis is a burden to the industry on an economic level as well as a business operations level. With a growing trend toward the reform of cannabis laws at the state level, §280E no longer serves its public policy rationale. advocates the removal of cannabis from Schedule I. We advocate the amendment of IRC §280E. We urge state legislators to enact specific exemptions from §280E in their own state tax system.

Cannabis and hemp are legitimate agricultural products with valuable industrial, medical and social benefits. If we feel this way, all segments of cannabis in society should so reflect. Cannabis businesses should merely bear the same income tax burden as any other entrepreneurial activity.

Researched and written by [email protected]

Reference Access

[1] – T.C. Memo 1981-623
[2] – Id.
[3] – Pub.L. 97-248
[4] – Senate Finance Committee Report, S.Rept. 97-494 (Vol. 1) at 309
[5] – 26 USC §280E
[6] – 21 USC §812
[7] – Affirmed, CA9, No.13-70510, 7/9/12
[8] – 139 T.C. 2, (2012)
[9] – Id., Affirmed, CA9, at 38
[10] – 26 USC 162
[11] – 26 USC 61(a)
[12] – 26 CFR 1.61-3
[13] – 26 CFR 1.162-1(a)
[14] – This is the average rate.  The calculation is $22,500 plus 39% of taxable income in excess of $100,000.