The Maryland Medical Cannabis Commission (“the MMCC”) recently reported to the Maryland legislature on “the deleterious effects of the federal tax code on medical cannabis businesses.[1]”  As stated in its report, I.R.C. § 280E creates significant additional tax costs not faced by other industries and limits the industry’s ability to offer discounted supply to veterans and other underserved groups.  To both serve their purpose and maximize profitability, Maryland canabusinesses must have an understanding of I.R.C. §280E and the attendant planning opportunities.  In particular, cannabusinesses must (1) properly differentiate between cost of goods sold and other expenses and (2) properly define separate “trades or businesses.”[2]    

As alluded to in the MMCC’s analysis, Section 280E of the Internal Revenue Code provides 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 the law of any State in which such trade or business is conducted.

Since the sale of marijuana is considered “trafficking” as interpreted by the courts, any expenses incurred in the business of selling marijuana – even if permitted under state law – are not deductible at the federal level and, without legislative change, at the state level either.  This can drastically impact profitability.

Cost of Goods Sold or Potentially Deductible Expense?  

While I.R.C. § 280E impairs the ability to claim deductions from gross income, the cost of goods sold are used to arrive at the gross income. That is, I.R.C. § 61(a)(3), consistent with the Sixteenth Amendment, provides that “[g]ains derived from dealings in property,” such as sales of marijuana, means gross receipts less the cost of goods sold. Treas. Reg. § 1.61-3(a). This is further explained in IRS CCA 201504011, “[t]he ‘cost of goods sold’ concept embraces expenditures necessary to acquire, construct or extract a physical product which is to be sold; the seller can have no gain until he recovers the economic investment that he has made directly in the actual item sold.”  Therefore, to minimize the effect of I.R.C. § 280E, cost of goods sold should be properly documented and preferred to classification as general overhead and the like.  See, e.g., Alterman v. Commissioner, T.C. Memo. 2018-83 (recordkeeping requirements for costs of goods sold require maintenance of inventory records, costs of production, etc.).

Even after understanding this basic premise, the delineation between costs of goods sold and indirect expenses is still not clear.  At least on the issue of state excise taxes, the Internal Revenue Service has indicated that these costs are also properly included as the cost of goods sold. See IRS CCA 201531016 (Washington marijuana excise tax paid considered a reduction of gross income).  In general, Treas. Reg. § 1.471-3(c) provides that costs of goods sold may include the “cost of raw materials and supplies entering into or consumed in connection with the product, “expenditures for direct labor,” and “indirect production costs incident to and necessary for the production of the particular article, including in such indirect production costs an appropriate portion of management expenses, but not including any cost of selling or return on capital.”  The borders of these classifications have yet to be consistently tested in the context of cannabusinesses.  See, e.g., Alternative Health Care Advocates v. Commissioner, 151 T.C. No. 13 (December 20, 2018) (analyzing potential deduction under I.R.C. § 263A for expenses covered by I.R.C. § 280E and potential converted to cost of goods sold for “producers”). 

And, since most payments that could arguably be considered as “direct labor,” “indirect production costs, and “management expenses” are typically a reduction to income from a tax perspective – whether as cost of goods sold or as a deduction – the boundaries have not been thoroughly tested.  From the perspective of the Internal Revenue Service, resellers may not capitalize inventory expenses under I.R.C. § 263A that would otherwise not be deductible.  IRS CCA 201504011.  This may be a correct conclusion; however, it has not been thoroughly tested in the courts.  For manufacturers, while Treas. Reg. § 1.471-11 indicates that certain soft costs may be included in inventory costing (as cost of goods sold) if in conformity with GAAP, there is no bright line test applicable to cannabusinesses. 

As a basic rule, soft costs directly relating to the production of goods will reduce income as cost of goods sold and, for cannabusinesses, any other type of “expense” will not reduce taxable income.  Businesses looking to maximize their cost of goods sold need a clear understanding of the ground rules.  Further, since this can be a highly fact-specific inquiry, a professional opinion may provide value in defending against tax penalties in the context of an audit or litigation.

What Are Separate “Trades or Businesses”? 

While the demarcation between costs of goods sold and indirect expenses has not been thoroughly tested, recent tax cases involving cannabusinesses illustrate potential planning for separate “businesses.”  That is, even though the Service has successfully argued that cannabusinesses may not claim business deductions as a result of I.R.C. § 280E, that provision will not disallow deductions of a wholly separate business.  For instance, consider a situation where a single entity controls both a marijuana dispensary and a restaurant.  While the wages paid to employees of the marijuana dispensary may not be deductible, wages paid to a server in the restaurant are related to a wholly separate business and should be deductible notwithstanding the application of I.R.C. § 280E to other entity expenses.  The goal is to expand the amount of expenses relating to the latter category, and thus reduce after-tax income.

While a marijuana dispensary and a restaurant may clearly be considered separate businesses, there are often many closer calls in the marijuana industry.  For example, is the sale of marijuana considered to be a separate business from the provision of certain medical or health services?  This issue was discussed in Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173 (2007) (“CHAMP”).  In that case, CHAMP was a public benefit corporation that provided both medical marijuana to patients and provided non-marijuana-related counseling and caregiving services.  The Court held that the rule against the deduction of business expenses relating to drug trafficking (i.e., I.R.C. § 280E) did not preclude the deduction for non-drug-related business activities of the same taxpayer.  Moreover, in that instance, caregiving services constituted a separate trade or business for purposes of deductions. 

Accordingly, in CHAMP, expenses allocable to the provision of medical support, consultations regarding medical issues, and providing household products, could still be deducted if the allocation of expenses was properly substantiated.  Certain payroll costs and rental payments, which could be attributed to multiple profit-motivated activities and could be applied and deducted on the basis of pro-rata allocations, were therefore allowed. In making this determination, the Tax Court relied upon Commissioner v. Heininger, 320 U.S. 467, 474 (1943), which provided that “[i]t has never been thought…that the mere fact that an expenditure bears a remote relation to an illegal act makes it non-deductible.” 

However, in Olive v. Commissioner, 792 F.3d 1146 (9th Cir. 2015), the Ninth Circuit affirmed the elimination of deductions relating activities other than the sale of marijuana (e.g., yoga, massages, movies, etc.).  Since the sale of marijuana was inseparable from the other services and the other services were not profit-generating, they could not be considered a business with deductible expenses.  See also Alterman v. Commissioner, T.C. Memo 2018-83 (sale of non-marijuana merchandise and related expenses were not deductible as a separate business; separateness analysis consists of review of the “economic interrelationship” of the activities, including the percentage sold and whether they were complementary).  Analogizing the case to a bookstore, the Court indicated that a bookstore selling books a providing food for free would only be one business.  On the other hand, if the bookstore sold books and had a café area selling food, two businesses could be present for tax purposes.

For a marijuana dispensary, these holdings illustrates the importance of properly planning and documenting expenses that may be related to a supplemental line of business.  If multiple activities or businesses are performed (e.g., sale of marijuana and provision of medical services), owners should consider operating through separate entities.  This will at least mark the intended boundaries and may limit the scope of an audit.  Alternatively, if a single entity is used, cannabusinesses should separately track expenses relating to each business so as to avoid the need for subjective allocations.  Accounting systems should also carefully track the description of expenses so that they can easily be assigned to the business unaffected by I.R.C. § 280E.  Since proof of deductibility is the burden of the taxpayer (in terms of both business purpose and substantiation), cannabusinesses must take extra care that a minimal lapse in recordkeeping does not jeopardize the deductibility of all expenses for the non-marijuana-related business.

Litigation surrounding the coverage of I.R.C. § 280E and related issues continues to progress through the federal courts.  Until a more definitive answer can be provided legislatively, cannabusinesses must keep abreast of developments in tax law that are unique to their industry and must plan to minimize their disparate tax treatment.  Rosenberg Martin Greenberg is experienced in all aspects of federal and state tax laws, including developments germane to the legalization of marijuana in Maryland.  For a free consultation, please contact Brandon N. Mourges at or 410.951.1149. 

[1] Available at:,%20%C2%A7%2013-3303.1,%20Compassionate%20Use%20Fund%20Report_MMCC.pdf.  This report is a follow up to an earlier analysis performed by the MMCC in 2015.  Letter from Maryland Medical Marijuana Commission to President Miller and Speak Busch, “Medical Marijuana Commission Report on Taxation of Medical Marijuana and Financial Transactions for Medical Marijuana,” (February 7, 2015).  Available at:  Within that letter, the MMCC illustrated the negative impact of federal and state income taxes on the medical marijuana industry in Maryland.

[2] Aside from proper planning for the sake of accurate tax reporting, cannabusinesses should also consider the effect of potential penalties for inaccurate reporting.  See, e.g., I.R.C. § 6662 (20% penalty for negligent underreporting or substantial omissions).  These penalties may be mitigated if there is reasonable cause for such failures, including good faith reliance on a professional.  Treas. Reg. § 1.6664-4.  See also Alterman v. Commissioner, T.C. Memo 2018-83 (indicating that reasonable cause could not exist if there was not an investigation of the potential issues and thoughtful consideration of the issue).