Cannabis Audit Guide: 280E, Inventory and Cash Controls

A cannabis operator is one of the few audit clients where the tax line can exceed pretax income. The reason is Section 280E, which turns inventory costing into the most important accounting policy in the file. The rest of the engagement follows the usual path for a cash-heavy retailer or a manufacturer, with added controls over the product itself.

What Section 280E says

Section 280E provides that no deduction or credit is allowed for any amount paid or incurred during the taxable year in carrying on a trade or business if the trade or business consists of trafficking in controlled substances, within the meaning of schedules I and II of the Controlled Substances Act, which is prohibited by federal law or the law of any state in which the business is conducted.

The statute disallows deductions and credits. It does not tax gross receipts, so cost of goods sold reduces revenue before the disallowance applies. That is why the inventory computation carries the tax result. The audit team documents, period by period, the client's controlled substance status for each product line, the tax position taken, and the basis for it. Where a company has plant-touching and ancillary activities, the structure of those entities is part of the analysis.

Rescheduling in 2026. In April 2026 a DOJ/DEA order moved two categories from Schedule I to Schedule III: FDA-approved drug products containing marijuana, and marijuana under a qualifying state-issued medical license. Section 280E applies only to Schedule I and II substances, so activity in those categories should fall outside it. Adult-use marijuana and other marijuana remain in Schedule I, and 280E still applies to them. Sources differ on the effective date and on whether relief reaches prior years, which depends on IRS guidance. A client with both medical and adult-use activity needs the analysis split by activity, and the tax position and any uncertain tax position conclusion should be dated to the facts.

Tax Court guidance on inventory costing

The Tax Court's Harborside decision involved a California medical marijuana dispensary. The court held that the company had one trade or business, trafficking in a controlled substance, and that its other activities were not separate businesses because of their close and inseparable relationship with the marijuana sales. On inventory, the court held that Section 263A, the uniform capitalization rules, does not apply to drug traffickers, because that section cannot make a cost capitalizable if it would not otherwise be deductible. The company had to compute cost of goods sold under the Section 471 regulations. The court also treated the dispensary as a reseller, not a producer, on the facts, because it gave members clones it had bought from nurseries, later bought back their bud, and had no ownership interest in the plants in between. A reseller's cost of goods sold is limited to the price paid for inventory plus transportation and other charges necessary to acquire possession. Indirect production costs that a producer could include were not allowed.

For the audit, three consequences follow.

Producer or reseller status changes what can be in cost of goods sold. Obtain the facts: who owns the plants and product at each stage, and under what agreements.
Costing method for tax needs support separate from the book method.
Cost pools that mix indirect costs, such as rent, utilities and supervisory labor, need an analysis for each pool. The tax classification decides whether they are inventoried or disallowed.

The tax provision under ASC 740

Treat the 280E position as a potential uncertain tax position and evaluate it in every file. The ASC 740-10 standard page covers recognition and measurement, and the ASC 740 guide for private companies covers the general provision. Specific points for cannabis:

Current tax is computed on income after cost of goods sold and without other deductions, so it runs far above the book rate.
The disallowed deductions are permanent differences. State returns follow or depart from federal treatment, and the provision needs each jurisdiction separately.
Cost classification between inventory and expense affects both the tax and the book gross margin that lenders and investors read.

Worked example (illustrative numbers, C corporation, 21 percent federal rate, state taxes ignored). Revenue is $10,000,000. Cost of goods sold allowed under Section 471 is $5,200,000. Operating expenses are $3,300,000.

Book pretax income: 10,000,000 - 5,200,000 - 3,300,000 = $1,500,000.
Taxable income under 280E: 10,000,000 - 5,200,000 = $4,800,000, because the operating expenses are not deductible.
Federal tax: 21 percent x $4,800,000 = $1,008,000.
Effective rate on book pretax income: 1,008,000 / 1,500,000 = 67.2 percent.

If an additional $400,000 of cost was wrongly expensed that belongs in allowed inventory cost, taxable income falls by $400,000 and tax by $84,000. If $400,000 of indirect cost was wrongly inventoried, the reverse is true and the tax is understated. The audit tests the allocation both ways.

Inventory: book accounting and existence

Book inventory follows ASC 330. The firm's inventory costing guide covers cost flow and net realizable value. The industry adds a layer: product exists in many forms, from plants in cultivation to flower, trim, extracts, edibles and finished packaged goods, and conversion between forms creates yield and loss.

Observation. Count with the state seed-to-sale or track-and-trace records open, and compare the count to the system by tag or batch. See inventory observation procedures.
Track-and-trace reconciliation. Reconcile the company's inventory subledger to the state system at year-end. Differences are shrink, unrecorded waste, or data entry errors.
Yield and waste. Test conversion yields by batch, and tie waste destruction records to relief from inventory. Waste with no destruction record, or destruction with no waste entry, needs explanation.
Net realizable value. Test aged and expiring product, products affected by price compression, and recalled or failed-test batches.
Capitalized costs. Tie cultivation labor, nutrients and utilities to batches, and test the allocation of facility cost between cultivation, processing and retail.

Revenue and cash

Retail revenue is point-of-sale cash and card, so the audit follows the standard retail path under ASC 606: test POS completeness, reconcile daily deposits, and test gift card and loyalty liabilities. Wholesale revenue needs contract review, return rights and credit terms.

Cash is the control risk. Operators with limited banking access handle large amounts of cash, so the file needs observation of cash counts, armored carrier receipts, deposit reconciliation to POS, and safe and vault logs. Test whether bank statements and the cash flow statement agree, and whether cash held on premises at year-end is supported by a count. See the fraud risk assessment guide, since misappropriation and skimming risks are high in cash businesses.

Other risk areas

Licenses and regulatory compliance. State license status, notices of violation and fines. Assess whether loss contingencies and going concern are affected.
Related parties. Management companies, real estate lessors and licensed-holder arrangements are common and priced by agreement among related parties. See related party procedures.
Legal and contingencies. Obtain attorney letters that cover licensing, tax and any pending enforcement.
Leases. Test whether rent is above market, which affects both the lease accounting and the related party analysis.

PBC list

State license documents and compliance correspondence
Producer or reseller analysis, with ownership agreements for plants and product
Inventory subledger, seed-to-sale export and the reconciliation
Batch costing files, yield reports and waste destruction logs
Tax inventory computation and the 280E provision workpapers
POS reports, deposit reconciliations and cash count logs
Armored carrier and vault logs
Wholesale contracts, returns and credit memo detail
Management company and lease agreements
Attorney letters and tax correspondence

Red flags

Gross margin that improves with no pricing or mix change, which can signal indirect costs pushed into inventory
Seed-to-sale differences that persist at year-end
Waste that is high at the batch level and low at the company level, or the reverse
Deposits that do not match POS cash
Round-number journal entries that move cost between inventory and expense at quarter-end
A tax provision at the statutory rate for a client with 280E exposure

Sources

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Cannabis Company Audits: Section 280E, Inventory Costing and Cash Controls