Trafficking Expenses – IRC Sec. 280E

Trafficking Expenses – IRC Sec. 280E

The tortured evolution of Trafficking Expenses – IRC Sec. 280E, the denial of the deduction of otherwise ordinary and necessary business expenses is particularly punitive for the cannabis industry. It arises from what was at the time, seemingly inconceivable, that the sale of cannabis would become legal in certain states while remaining illegal under Federal law. 

Background to IRC Sec. 280E

In 1970, Congress created a regime2, the Comprehensive Drug Abuse Prevention and Control Act of 1970, or CSA, to curtail the unlawful manufacture, distribution, and abuse of dangerous drugs (referred to as “controlled substances”). Congress assigned each controlled substance to one of five lists, referred to in the law as Schedules. (Schedule I through Schedule V). These schedules are found in section 812 of the CSA. Marijuana is included in Schedule I, which also includes: (a) opiates; (b) opium derivatives (e.g., heroin; morphine); and (c) hallucinogenic substances (e.g., LSD; marihuana (a/k/a marijuana); mescaline; peyote). The definition in schedule I states that drugs on this schedule have “…. a high potential for abuse….(have) no currently accepted medical use in treatment in the United States, (and) (t)here is a lack of accepted safety for use of the drug or other substance under medical supervision.”

While all practitioners already know this, it needs to be mentioned here that gross income for federal income tax purposes means “…all income from whatever source derived”. The regulations specifically state that this includes gains from illegal income.

Edmondson v. Commissioner 

Jeffrey Edmondson was “self-employed in the trade or business of selling amphetamines, cocaine, and marijuana” during 1974, the year at issue. In response to a jeopardy assessment from the IRS, Edmondson filed a 1974 income tax return in June of 1975. Edmonson did not keep contemporaneous books and records of his activities, presumably since the activity was illegal. On his income tax return, Edmondson took an adjustment for cost of goods sold, and then deducted his ordinary and necessary business expenses under IRC 162(a): business use of the home, 19,433 miles driven on his personal car, travel and meals for a business trip, a percentage of his home telephone, and a small scale.

In the end, the Court found his oral testimony credible and allowed the cost of goods sold adjustment and all the claimed expenses save for the business trip and meals since he lacked 274(d) substantiation. This decision was handed down in 1981, during the height of the Nancy Reagan “Just Say No!” media blitz and the era of Drug Awareness Resistance Education programs in elementary schools. The decision occurs fifteen years ahead of the legalization of marijuana in California. Public outrage over a ‘drug dealer’ taking tax deductions led to hearings in the U.S. Senate.

There is sharply defined public policy against drug dealing. To allow drug dealers the benefits 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.”

Enactment of IRC Sec. 280E

Ultimately, The Tax Equity and Fiscal Responsibility Act, P.L. 97-248, added Sec. 280E to the Code in 1982:

“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.”

It is important to note that The Tax Equity and Fiscal Responsibility Act passed fourteen years ahead of the first medical marijuana law in California. Congress had not conceived of the potential for marijuana to be sold legally.

The interaction of the calculation of a number of inter-related provisions including:

Impact of CHAMP Decision

The situation was further complicated by the decision in CHAMP  128 T.C. 173, (2002) — the IRS denied all of the G&A deductions of a medicinal marijuana facility. The facility was able to score a partial victory, however, by convincing the court that only a portion of its business involved the trafficking of marijuana, with the rest of its business focusing on counseling customers on which type of marijuana would best treat their particular ailment. As a result, the business expenses attributable to the “consulting” arm of the business were not barred by Section 280E.

In 2011, however, a Marin County California medicinal facility was not as lucky; the IRS denied all of the company’s G&A deductions for 2008 and 2009, resulting in an assessed tax in the “millions and millions” according to the facility’s founder and director.

Just weeks later, the industry suffered another defeat at the hands of the IRS and Section 280E in Olive v. Commissioner, 139 T.C. 2 (2011). In Olive, the taxpayer was denied all of its G&A deductions under Section 280E. 

The Internal Revenue Service [“IRS”] finally provided guidance through the issuance of a Chief Counsel’s Memorandum which appears at the bottom of the page. The impact of the CCM has been the subject of intense debate, but there are overall conclusions that might be drawn. 

  • The IRS Office of Chief Counsel is directing cannabis dispensaries to determine COGS using the applicable inventory-costing regulations under IRC §471 as they existed when §280E was enacted.
  • A cannabis retailer using an inventory method to account for income is to capitalize the price paid for the cannabis he or she resells, less of course trade or other discounts, plus transportation or other necessary charges incurred in acquiring possession of the cannabis including purchasing, handling, and storage expenses.
  • A cannabis distributor or manufacturer using an inventory method is to capitalize the following:
    • direct material costs (cannabis seeds or plants),
    • direct labor costs (e.g., planting; cultivating; harvesting; sorting
    • Category 1 indirect production costs as defined by (§1.471-11(c)(2)(i)), including: Repair expenses, Maintenance, Utilities, such as heat, power and light, Rent, Indirect labor and production supervisory wages, including basic compensation, overtime pay, vacation and holiday pay, sick leave pay not subject to IRC SEC §105(d), Indirect materials and supplies, Tools and equipment not expensed, and Costs of quality control and inspection to the extent these costs are necessary for production or manufacturing operations and/or processes.
    • Category 3 indirect costs as defined by (§1.471-11(c)(2)(iii))to the extent adequate and reflective financial records.
    • Trafficking Expenses - IRC Sec. 280E
      Trafficking Expenses – IRC Sec. 280zrscraand spoilage, Factory administrative expenses, Officers’ salaries, and Insurance costs.Records are kept including Taxes, Depreciation/depletion, Employee benefits, Costs attributable to strikes, rework labor,             s



  • IRC Sec.263A is a timing provision that does not change the character of an expense from “nondeductible” to “deductible,” or vice versa.  So you should not rely on it as substantial authority to assert a claimed deduction unless you want to challenge the IRS in Court because that is where this issue is headed.
  • Cannabis retailers fundamentally speaking operate on a cash basis because they cannot as of yet have bank accounts and quite literally transact a preponderance of their business in cash.
  • Cannabis retailers should keep their records and report the income to the IRS using an accrual method taking into consideration applicable inventory costing regulations under IRC SEC 471 without consideration of items that are considered to be trafficking under IRC SEC 280E.
  • Generally speaking, a cannabis distributor or manufacturer should be permitted to deduct wages, rents, and repair expenses attributable to its production activities, but should not be permitted to deduct wages, rents, or repair expenses attributable to its general business activities or its marketing activities.

Actions To Take

  • Keep detailed books of account of all transactions that are reliable and consistent year over year. Hire a CPA and utilize an accounting method that accounts for inventory and produces a cash flow statement regularly and consistently complete with a financials that tie out to recorded receipts.
  • Consider selling other products besides weed in your retail establishment and minimizing the area where you actually sell the cannabis so as to minimize the non-deductible rent expense associated with “trafficking”.
  • Have a few people (aka employment expense) “doing” the “illegal trafficking” or said otherwise taking the customers money and handing the customer the cannabis.
  • if you sell fully legal products under federal law as well as state law consider branding your advertising in the realm of holistic services or something similar.
  • Follow the guidelines in the CCM until they change.




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