What Are the Best Practices for Strengthening Sales Tax Exemption Compliance Across an Organization?
Cannabis businesses operate within one of the most complex tax landscapes in the United States. While legalization at the state level continues to expand, the federal government still classifies cannabis as a Schedule I controlled substance. This means the Internal Revenue Service (IRS) enforces Section 280E of the Internal Revenue Code, restricting standard business deductions for any enterprise engaged in the “trafficking” of controlled substances. To remain compliant and financially stable, cannabis companies must understand how 280E applies to their operations and develop strategies to minimize its impact through proper accounting, documentation, and planning.
Section 280E was enacted in 1982 to prevent businesses involved in illegal drug trafficking from deducting ordinary business expenses. Under this rule, cannabis businesses cannot deduct typical operating costs such as rent, advertising, or salaries. However, they may deduct the Cost of Goods Sold (COGS), which includes expenses directly tied to production or acquisition of goods for resale.
This distinction is crucial because it determines how much taxable income remains after allowable deductions. A dispensary cannot write off sales staff wages or marketing expenses but may include cultivation labor, raw materials, and packaging costs within COGS if properly documented.
Achieving 280E tax compliance begins with a strong internal accounting structure and accurate documentation. Cannabis operators must differentiate between deductible and non-deductible expenses with precision. Every expense claimed under COGS should be directly traceable to inventory. Misclassification of expenses can trigger audits or penalties.
Proper cannabis accounting also requires adherence to IRS Section 471, which governs inventory accounting methods. Section 471-11 allows businesses to include certain indirect production costs in COGS if they maintain detailed inventory records. By leveraging these provisions, businesses can lawfully increase deductible expenses within the 280E tax code.
A strong accounting system is essential for effective tax accounting for cannabis business operations. Since most cannabis companies handle inventory, the IRS generally prefers accrual-based accounting under Section 471. This method aligns income and production costs accurately while supporting proper Cost of Goods Sold (COGS) calculations, the only allowable deduction under Section 280E. Using cannabis-specific software with integrated inventory and accounting functions enhances transparency, compliance reporting, and audit readiness.
Many operators also apply cost segregation by separating cultivation or production from retail activities to limit 280E exposure. This structure can increase allowable COGS deductions if properly documented and priced at arm’s length. However, poorly executed segregation may raise IRS concerns, so expert tax guidance is vital to maintain compliance and reduce overall tax risk.
While Section 280E restricts many deductions, it does not eliminate all opportunities for tax efficiency. Cannabis businesses can still claim deductions for direct production costs such as:
Expenses such as administrative salaries and marketing must be excluded from COGS. The key to maximizing legal 280E deductions lies in precise documentation and expert cost classification.
Technology platforms like Avalara support compliance by automating sales tax calculations, tracking excise taxes, and integrating financial data from multiple systems. Automation reduces manual errors and ensures consistency across reporting periods, which is vital during audits. Cannabis businesses operating in multiple states face varying local tax requirements, and automation tools simplify multi-jurisdiction compliance management.
Integrating accounting and inventory systems also creates real-time financial visibility. Automated data flows minimize human error, making it easier to reconcile COGS, verify income, and ensure timely filing.
Some states have eased the impact of Section 280E by allowing cannabis businesses to claim deductions at the state level. California and New York, for example, let licensed operators deduct ordinary business expenses on state returns, narrowing the gap between federal and state tax liabilities. Staying informed about these evolving rules is essential for optimizing compliance and managing financial obligations in cannabis business operations.
Cannabis companies pursuing innovation can explore state R&D incentives. While federal R&D tax credits are generally unavailable under 280E, certain state programs or hemp-related activities may qualify. Leveraging these credits helps offset costs that are otherwise nondeductible under the 280E tax code.
Given the heightened IRS scrutiny of the cannabis sector, meticulous recordkeeping is essential. Businesses should maintain detailed financial records for all transactions, payroll, inventory adjustments, and vendor invoices. Documentation should be organized by category such as production, administrative, and retail to demonstrate which costs qualify under COGS.
It is also wise to conduct periodic internal audits. A proactive approach helps identify compliance gaps before an IRS review. Employing professional tax advisors familiar with accounting for cannabis ensures all filings align with state and federal requirements.
The future of cannabis taxation remains uncertain as discussions continue around federal reform and possible descheduling. Until significant legislative changes occur, businesses must operate within the current framework and focus on compliance, transparent accounting, and strategic planning.
For cannabis operators, success depends on aligning operational efficiency with rigorous tax management. With informed planning, reliable systems, and professional guidance, cannabis businesses can remain compliant, reduce tax liabilities, and position themselves for long-term growth despite Section 280E challenges.
Back to Q&A
Never miss an update. Sign up to receive our monthly newsletter to unlock our experts' insights.
Subscribe Now