As the cannabis industry matures amid a patchwork of state legalization and conflicting federal laws, tax enforcement has emerged as a complex and critical issue for cannabis companies and their advisers. Central to these challenges is Internal Revenue Code (IRC) Section 280E, which prohibits standard business deductions for entities involved in federally controlled substances. Consequently, cannabis operators are burdened with significantly higher effective tax rates than their traditional business counterparts.

Recently, several prominent multi-state operators (MSOs) have adopted notably aggressive, albeit legitimate, tax positions in challenging IRS enforcement of IRC Section 280E. By filing amended returns as ordinary corporate taxpayers and requesting substantial tax refunds, these MSOs are deliberately confronting the traditional IRS approach of disallowing all cannabis-related expenses. Such strategies promise immediate financial benefits but inevitably raise substantial risks of lengthy and costly tax controversies.

MSOs challenging IRC section 280E typically employ sophisticated, multi-layered strategies that combine statutory interpretation, nuanced entity structuring, and meticulous internal documentation. In this article, we outline some of those strategies and the corresponding IRS risks.

Reinterpreting 'Trafficking' Under IRC Section 280E

At the core of MSOs' tax refund strategies is a novel interpretation of the statutory term “trafficking.” Cannabis businesses contend that evolving state legalization, coupled with shifting federal enforcement priorities, necessitates a reconsideration of what constitutes "trafficking" under federal law. By contesting that state-sanctioned cannabis operations no longer meet the historical definition of trafficking in controlled substances, these companies attempt to exclude themselves from IRC Section 280E’s harsh tax limitations altogether.

Similarly, the definition of cannabis has evolved in recent years. The Agriculture Improvement Act of 2018 made hemp legal. Recent opinions from the U.S. Court of Appeals for the Fourth and Ninth Circuit have clarified that the presence of hemp derivatives does not automatically turn a product into a controlled substance. MSOs have been able to use these rulings to justify deducting expenses related to the development of hemp products that contain derivatives such as THC-O. However, the IRS has chosen to not follow this appellate court precedent in certain situations.

Strategic Entity Structuring and Subsidiary Isolation

In addition to legal reinterpretations, MSOs leverage elaborate corporate structuring designed explicitly to minimize exposure to IRC Section 280E. Many operators isolate cannabis-touching entities from subsidiaries that provide management, intellectual property licensing, marketing, leasing, or branding services. These ancillary businesses, operating independently, assert entitlement to traditional business deductions. This separation is carefully designed and executed to comply with IRS transfer pricing rules under IRC Section 482, requiring that intercompany transactions reflect true arm’s-length terms. Extensive contemporaneous documentation and robust transfer pricing studies typically accompany such arrangements, preemptively addressing anticipated IRS challenges. MSOs must also consider whether the separate entities would need to be included on a consolidated return, which may impact the deductibility of nonrestricted expenses.

Maximizing Cost of Goods Sold (COGS): Leveraging IRC Section 471(c)

Perhaps the most nuanced—and increasingly contentious—strategy involves aggressive capitalization of operating expenses into cost of goods sold (COGS). Although IRC Section 280E explicitly denies deductions for ordinary business expenses, it does allow deductions for inventory-related expenses (COGS). Certain cannabis expenses can be categorized as COGS and expensed similar to IRC Section 162 expenses.

IRC Section 471(c), enacted under the Tax Cuts and Jobs Act of 2017 (Pub. L. No. 115-97), significantly altered inventory accounting flexibility for certain small taxpayers. Eligible businesses with average annual gross receipts under $25 million (indexed for inflation) for the preceding three years may adopt internal accounting procedures used in their financial statements or books and records, even if these methods substantially differ from generally accepted accounting principles (GAAP).

Cannabis companies leverage IRC Section 471(c) aggressively by adopting internal accounting methods that capitalize expenses traditionally viewed as selling, general, and administrative (SG&A) costs directly into inventory. By doing so, MSOs dramatically expand their deductible COGS, circumventing, at least partially, the constraints of IRC Section 280E. This sophisticated tactic depends heavily on internal documentation, precise cost-allocation policies, clearly articulated accounting procedures, and strong internal controls to withstand IRS scrutiny.

Yet, this strategy invites careful IRS attention. Auditors typically challenge these aggressive cost allocations by examining whether internally adopted methods genuinely reflect economic reality or are merely contrived mechanisms to bypass IRC Section 280E. Therefore, businesses pursuing this approach must maintain meticulous and contemporaneous financial records, supported by clear internal accounting policies.

Preservation of Refund Claims

MSOs pursuing these aggressive tax positions either claim these positions on an original return, or file amended returns and refund claims within statutory windows—typically three years from the original filing date or two years from tax payments—to safeguard their positions against statutory expiration. Such “protective” refund claims preserve potential recoveries pending favorable judicial or legislative outcomes. The IRS may deny or audit a refund claim, requiring MSOs to request an appeal with the IRS Office of Appeals, or file a suit for refund in district court or the Court of Federal Claims.

Potential IRS Scrutiny and the Future of IRS Enforcement

However, the strategies mentioned above inevitably attract intense IRS scrutiny. IRS audits frequently involve thorough examinations of corporate structuring, transaction substance, cost allocations, transfer pricing documentation, net operating loss calculations, and substantiation of expenses. These audits often require many rounds of document production and potential interviews. Adverse findings by the IRS may result in accuracy-related penalties under IRC Section 6662 if the IRS concludes that positions lack substantial authority or reasonable cause.

With the changing federal landscape, there will certainly be changes to how the IRS approaches enforcement. While DOGE has cut a portion of the IRS workforce, the IRS will likely continue to focus on the cannabis industry and adapt to a reduced budget and workforce. However, the aggressiveness of IRS enforcement will hinge on the selections for the new commissioner and chief counsel.

Practical Guidance for Legal and Tax Advisers

Given the inherent complexities and high stakes associated with aggressive tax positions in cannabis, advisers must proactively guide their clients. Essential best practices include maintaining robust transfer pricing documentation, developing comprehensive and defensible internal accounting policies regarding COGS, and preparing in advance for administrative appeals and potential litigation. Advising clients requires balancing potential short-term cash flow benefits against the significant long-term risks and costs of IRS enforcement actions. Formal tax opinions before tax returns are filed are also useful in fighting penalties in the event of an IRS audit.

While aggressive tax refund strategies under IRC Sections 280E and 471(c) present cannabis MSOs with appealing financial opportunities, the risks of IRS scrutiny remain formidable. Successfully defending these claims hinges on sophisticated statutory interpretation, meticulous entity structuring, and rigorous internal documentation. Legal and tax advisers play a pivotal role in helping cannabis companies navigate these complex issues, proactively managing both the potential upside and considerable enforcement risks associated with these aggressive positions. As IRS scrutiny intensifies, careful strategic planning, precise documentation, and thorough understanding of nuanced tax provisions will prove essential for the industry's continued maturation and success.

Reprinted with permission from the May 12, 2025 issue of The Legal Intelligencer© 2025 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.