How can IRC 471(c) cost accounting help a cannabis business under Section 280E?
Where 280E applies, Cost of Goods Sold is the main deduction left, so the costs a business properly includes in inventory directly affect its federal taxable income. Section 471(c) lets businesses under the gross receipts threshold use a simpler inventory method that follows their books. In this engagement we reviewed a three-location dispensary's cost allocation, restructured its accounting, amended a prior-year return and documented the method so it could be defended under examination.
The situation
In 2024, a cannabis dispensary operating three retail locations came to us with a high effective federal tax rate driven by Section 280E. Its Cost of Goods Sold was a small share of revenue, so most of its gross receipts were being taxed with no offset for rent, salaries or other operating costs.
The problem
The business recorded its costs the way a typical retailer would. Costs that could properly be part of inventory under IRC 471 were sitting in operating expenses, where 280E disallowed them. The chart of accounts did not separate inventory-related costs from selling and administrative costs, and there was no written allocation method to support the numbers on the return.
What we did
- Reviewed current cost allocation. We examined how every cost was split between Cost of Goods Sold and operating expenses, and identified costs that could legitimately be included in inventory under IRC 471: inventory handling labor, facility costs for storage areas, packaging materials and labor, and quality assurance work.
- Selected the inventory method. We evaluated whether a 471(c) method or traditional 471(a) cost accounting fit the business better, based on its gross receipts, complexity and growth plans.
- Restructured the chart of accounts. We redesigned the accounts so inventory-related costs are captured separately from operating expenses at the point of entry.
- Documented the method. We wrote down the allocation method: the bases used, the percentages and the procedure for applying them each period. IRS examinations focus on whether allocations are reasonable and consistently applied, so the documentation is as important as the numbers.
- Set up ongoing monitoring. We review allocations monthly so they stay accurate and defensible as the business changes.
Results
| Tax year | Federal income tax compared with the prior cost allocation |
|---|---|
| 2023 (amended return) | About $100,000 lower |
| 2024 | About $100,000 lower |
| 2025 | About $100,000 lower |
| Three years | About $300,000 lower |
Results vary. Past results do not guarantee future outcomes. These figures are for one three-location dispensary, tax years 2023 to 2025, measured against the federal tax its prior cost allocation would have produced. The outcome for any other business depends on its costs, licenses, entity type and how Section 280E applies to it.
Our approach
Cost of Goods Sold work is not a one-time project. The method has to fit the business, be applied the same way every month, and be supported by records that tie to the books and to the seed-to-sale system. We aim for positions that are proper and documented, not aggressive.
Since April 28, 2026, medical-only operators have the clearest path out of 280E, while adult-use activity remains subject to it and relief for operators with both licenses is unresolved. For adult-use operators, inventory costing remains one of the most important parts of federal tax planning. Our rescheduling tracker follows the latest developments.
Frequently asked questions
What is IRC Section 471(c)?
It is a small business provision in the inventory rules. Businesses that meet the gross receipts test in Section 448(c), a threshold adjusted for inflation each year, can treat inventory as non-incidental materials and supplies or follow the method used in their applicable financial statements or, if they have none, their books and records. For a cannabis business subject to 280E, the method chosen affects which costs reach Cost of Goods Sold.
How is 471(c) different from 471(a)?
Section 471(a) is the general rule, with detailed regulations on which costs must and may be included in inventory, and those regulations differ for producers and resellers. Section 471(c) is an alternative for smaller businesses that ties inventory accounting to their financial statements or books. Neither is automatically better for a cannabis operator; the right choice depends on your size, your activities and how your books are kept.
What costs can be included in Cost of Goods Sold?
Generally direct materials such as cannabis and packaging, direct labor in cultivation, processing and packaging, and for producers, overhead allocable to production such as production facility costs, equipment depreciation, production utilities and quality control. Selling and general administrative costs stay out. The rules differ between producers and resellers, so the allocation method has to fit what each part of your business does.
Will a large Cost of Goods Sold allocation trigger an IRS audit?
The IRS does examine cannabis businesses and often focuses on Cost of Goods Sold. The question is not how large the allocation is but whether it is proper: based on a reasonable, consistently applied method and documented. That is how we build every position, so it can be explained and supported if examined.
Does 471(c) still matter after the 2026 rescheduling order?
Yes, for adult-use activity. Medical-only operators have had the clearest path out of 280E since April 28, 2026, but adult-use cannabis remains Schedule I, so 280E and inventory costing still drive federal tax for adult-use operators. Changing an inventory method generally requires filing Form 3115 with the IRS; see our 2027 tax deadlines for timing.