Beyond 280E relief: The hidden tax audit risks of marijuana rescheduling

Gray Proctor (Courtesy photo)

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For as long as cannabis was classified as a Schedule 1 controlled substance, taxpaying operators relied on categorizing expenses as “cost of goods sold” whenever possible. That’s because COGS are not covered by Internal Revenue Code Section 280E.

COGS was better than nothing, but it did not provide the same tax benefits as a current deduction. Now that medical cannabis is Schedule 3 – and no longer subject to 280E – operators are moving from COGS to normal deductions.

But that’s not simple.

There are complications and risks – and especially when it comes to the Internal Revenue Service, an ounce of prevention is worth a pound of cure. Cannabis operators should be proactive in mitigating the audit risks, and be aware of the problems past strategies may pose today.

How cannabis rescheduling changed the tax picture

280E prohibits “any deduction or credit” to a business trafficking in controlled substances “within the meaning of schedule I and II” on their federal tax returns. The COGS technique was better than nothing but had limitations. COGS does not cover general or administrative expenses. And it could be taken only when the goods were sold, as an offset against gross income.

Change has been in the air for a long time. In October 2022, then-President Joe Biden requested a cannabis rescheduling review. The following August, the Department of Health and Human Services found that cannabis did not meet the criteria for Schedule 1 or 2, and recommended that cannabis be reclassified as Schedule 3.

Cannabis was still Schedule 1, but this led several large operators to disregard the 280E rules (and rack up a past-due tax bill of $1.6 billion and counting). They argued that 280E no longer applied, because 280E includes only substances “within the meaning of” Schedule 1 and 2, and cannabis had a currently accepted medical use in the U.S. The IRS disagreed, and this argument is now in the courts, most notably in the New Mexico Top Organics case in the Tax Court.

Meanwhile, rescheduling is now more than just a promise on the horizon.  In April 2026, the Trump Justice Department officially reclassified medical cannabis to Schedule 3.  The IRS has made the reclassification apply to the “full taxable year that includes the effective date of the Final Order.”   A decision is pending on whether adult use cannabis will be rescheduled as well; if so, it will be up to the IRS to apply the change to the entire tax year.

These changes are good news. But operators need to tread carefully.

What are the 280E tax risks posed by marijuana rescheduling?

One risk comes from having both medical and adult-use operations under the same business – a common state of affairs in California, Colorado and other states. Until adult-use cannabis is rescheduled, costs that apply to both lines – such as shared payroll, utilities and overhead – must be allocated between them in a defensible way.

Calendar year taxpayers may avoid this problem if DOJ acts before December 31 and the IRS applies reclassification to the entire year, as with medical use. But this is not guaranteed, and operators using fiscal year accounting may already have this problem.

There also is the danger of haphazardly moving last year’s COGS items into this year’s deductions column.

COGS is not an alternative to a deduction. The two are mutually exclusive.

And past COGS techniques may come back to haunt an unwary operator. An expense treated as COGS from prior years cannot be treated as a deduction now without a reasonable explanation. The IRS has the information it needs to detect inconsistent treatment from prior returns, and will use it.

Any discrepancies from prior returns may attract unwanted attention from the IRS, which will demand an explanation.

What tax risks beyond 280E are there for cannabis operators?

Apart from prior year returns, operators may have to disclose changes in tax accounting the IRS.

Changes that involve “the proper time for inclusion of the item in income or the taking of a deduction” are considered changes in accounting method, and the IRS could require a Form 3115 disclosing or requesting permission for the change. The form must be signed under penalty of perjury, which creates the potential for criminal liability if the government can make a case for willful misrepresentation.

If the taxpayer does not file voluntarily, the IRS may force a change, which will be an expensive process for operators.

Another problem is that COGS works differently when 280E doesn’t apply.

When Congress passed Section 280E in 1982, it “froze” the inventory cost and COGS analysis according to the then-current rules. Rescheduling unfreezes the law; thus, some of the costs that were considered deductions under Section 280E must be capitalized into inventory under modern uniform capitalization rules instead. This includes purchasing costs, handling, storage and the allocated share of “mixed service” general and administrative costs.

With this additional layer of complexity comes another opportunity to make a costly tax mistake.

These are only some of the risks that come with rescheduling.

How can cannabis operators prepare taxes after marijuana rescheduling?

Operators face additional tax, interest, penalties and even criminal liability for mistakes in transitioning into the new era. That makes it important to proactively minimize any audit risk related to past or current COGS allocations.

This requires reviewing prior returns, inventory schedules, and allocation records and comparing how costs were treated before and after rescheduling. From there, operators must identify whether each difference reflects changed facts, changed law or a changed method, and account for each.

Operators should also consider filing protective refund claims for the past three years to preserve their rights if litigants like New Mexico Top Organics win the legal battle and establish that cannabis was already outside of 280E.

On the front end, as an ounce of prevention, tax controversy counsel can help accountants evaluate potential exposure, determine appropriate correction procedures, and coordinate new filings with any existing audits, administrative appeals or refund litigation.

The result is likely to much better than paying for a pound of cure on the back end.

Gray Proctor is counsel at Kostelanetz LLP. He specializes in high-stakes tax disputes, including constitutional law and complex litigation in federal courts and constitutional challenges to tax laws.