The short answer
Cannabis businesses subject to 280E can still subtract cost of goods sold because COGS reduces gross receipts rather than being a deduction, and what goes into it is governed by IRC 471. Resellers such as dispensaries generally include only the cost of the product plus the costs of acquiring it, like freight-in. Producers such as cultivators and manufacturers can include direct materials, direct labor and a broader set of indirect production costs under the full absorption rules. Courts have held that cannabis businesses cannot use Section 263A to capitalize additional costs and get around 280E.
Why is COGS so important for cannabis businesses?
Section 280E disallows deductions and credits for businesses trafficking in Schedule I or II substances. Adult-use cannabis is still Schedule I as of mid-October 2026, so for that activity, most operating expenses produce zero federal tax benefit.
Cost of goods sold is different. In the tax computation, COGS is subtracted from gross receipts to arrive at gross income. Deductions come after that. Because 280E only blocks deductions, it doesn't reach COGS. That has been accepted by the IRS and the Tax Court for years.
The practical result: for an adult-use operator, a dollar of cost that properly belongs in inventory reduces taxable income; the same dollar booked as an operating expense usually doesn't. That's the whole reason cannabis inventory costing gets so much attention. It's also why the IRS looks hard at it.
Medical activity moved to Schedule III effective April 28, 2026, so 280E generally no longer applies to it going forward. Accurate COGS still matters there for good books and margins, but the tax stakes are highest on the adult-use side. See What Is Section 280E? for the background.
What can resellers include versus producers?
The inventory regulations under Section 471 draw a sharp line between businesses that buy goods to resell and businesses that make them.
Resellers (most dispensaries that buy finished product). Under the 471 regulations, inventory cost for purchased goods is generally the invoice price, less trade or other discounts, plus transportation and other necessary charges incurred in acquiring possession of the goods. That's a narrow list.
Producers (cultivators, processors, manufacturers). Producers use the full absorption method, which includes direct material, direct labor and a range of indirect production costs incurred in the production process. That's a much wider list.
| Cost | Reseller (dispensary) | Producer (cultivator / manufacturer) |
|---|---|---|
| Product or raw material purchase price | Yes | Yes |
| Freight-in and delivery to acquire goods | Yes | Yes |
| Trade discounts and rebates | Reduce cost | Reduce cost |
| Direct production labor (growers, trimmers, extraction techs) | Not applicable | Yes |
| Grow-room or production-area rent and utilities | No | Generally yes, the production share |
| Nutrients, growing media, packaging used in production | Not applicable | Yes |
| Depreciation on production equipment | Not applicable | Generally yes |
| Retail rent, budtender wages, marketing | No | No |
| General admin, executive pay, professional fees | No | Generally no |
This table is a general guide, not a ruling on any specific cost. How a particular expense is classified depends on your facts and how the cost is actually incurred. We dig into how this plays out by license type in How 280E Hits Dispensaries, Cultivators and Manufacturers Differently.
What counts as direct and indirect production cost?
For producers, getting the categories right is where the money is.
Direct costs
- Direct material: clones, seeds, growing media, nutrients, extraction inputs, hardware and packaging that become part of the finished product.
- Direct labor: wages and related payroll costs for people who physically produce the product, such as cultivation techs, trimmers, extraction and kitchen staff, and in-house packaging crews.
Indirect production costs
- The production share of rent, utilities and repairs for grow rooms, labs and processing space
- Depreciation on lights, HVAC, extraction equipment and other production assets
- Production supervisors and quality control staff
- Supplies consumed in production, like gloves, filters and cleaning materials used on the line
- Required testing of product before it can be sold, depending on how and when it's incurred
Usually outside COGS
- Selling and marketing costs, including sales reps and trade spend
- General and administrative costs: accounting, legal, HR, executive compensation
- Distribution costs after production is complete, for most taxpayers
- Retail store costs of any kind
Mixed-use costs, such as a building that houses both a grow and an office, need a reasonable allocation. Square footage is the common key for facilities; timesheets are the common key for people who split their day.
Can cannabis businesses use 263A to capitalize more costs?
Section 263A, the uniform capitalization rules, requires many businesses to capitalize more indirect costs into inventory than 471 alone would. For years, some cannabis advisors argued that a dispensary could use 263A to pull store payroll, rent and other costs into inventory and out of the reach of 280E.
The courts closed that door. In Harborside (Patients Mutual Assistance Collective Corp. v. Commissioner, Tax Court 2018, affirmed by the Ninth Circuit in 2021), the Tax Court held that a cannabis business could not use 263A to capitalize costs that 280E would otherwise disallow. Section 263A itself says a cost that couldn't be taken into account in computing taxable income isn't treated as a cost to capitalize. The court also confirmed that the reseller inventory rules under 471, not the producer rules, applied to Harborside's purchased product.
What that means in practice:
- A dispensary that buys finished goods is generally limited to the reseller cost rules.
- A producer gets the full absorption rules under 471, which can be broad, but that comes from 471, not from 263A.
- Any position that relies on 263A to rescue disallowed costs should be treated as high-risk.
You may also hear about Section 471(c), the small-business inventory method added in 2017. Whether it can be used to get around 280E is an aggressive, contested area. Don't adopt it without specific professional advice on your facts.
What does correct COGS look like in numbers?
An illustrative adult-use cultivator with $1,500,000 of revenue and $1,200,000 of total spending. The only question is how much of that spending properly belongs in COGS.
| Illustrative cultivator | Weak costing | Full absorption, documented |
|---|---|---|
| Direct materials | $220,000 | $220,000 |
| Grow and trim labor | $0 (left in payroll) | $380,000 |
| Production share of rent and utilities | $0 (left in overhead) | $210,000 |
| Production equipment depreciation | $0 | $90,000 |
| Total COGS | $220,000 | $900,000 |
| Gross income (taxable under 280E) | $1,280,000 | $600,000 |
Same business, same cash spent. The difference is whether the books capture production costs where they belong and whether the records prove it. A note of caution: this also assumes the costs relate to product sold in the year. Costs tied to unsold inventory sit on the balance sheet until that product sells.
What documentation supports cannabis COGS?
The IRS commonly focuses on COGS in cannabis exams, and the Tax Court has been unforgiving when records are thin. Build your support as you go, not at filing time.
- Written inventory costing policy.Which costs go into inventory, which don't, and why. One or two pages, reviewed annually.
- Time records for split roles.If a manager spends 60% of their day in the grow, you need timesheets or a documented study showing it.
- Facility allocation support.A floor plan with square footage by use, updated whenever layouts change.
- Seed-to-sale reconciliation.Inventory quantities in your tracking system should tie to your accounting records every month. Gaps here undermine everything else.
- Period-end counts and valuation.Physical counts and a costing method applied consistently, so beginning and ending inventory are defensible.
If your COGS has been built after the fact or lives in a single journal entry at year-end, that's worth fixing now. Our COGS and inventory costing service sets up the policy, cost pools and monthly process, and cleanup can rebuild prior periods where records allow.
Frequently asked questions
Is cost of goods sold deductible under 280E?
COGS is not a deduction at all; it reduces gross receipts to arrive at gross income. That's why 280E, which only disallows deductions and credits, does not block properly computed COGS.
Can a dispensary include budtender wages in COGS?
Generally no. A dispensary that buys finished product is a reseller, and reseller inventory cost is generally limited to the purchase price plus costs of acquiring the goods. Retail labor is a selling cost.
Can I use Section 263A to capitalize more costs into cannabis inventory?
Courts have said no. In Harborside, the Tax Court held, and the Ninth Circuit affirmed, that a cannabis business cannot use 263A to capitalize costs that 280E would otherwise disallow.
Does COGS still matter for medical cannabis after Schedule III?
Yes, for accurate margins and books, though the tax stakes changed. Medical activity has generally been outside 280E since April 28, 2026, so operating expenses there may be deductible going forward, while adult-use activity still depends heavily on COGS.