Advanced level overview of IRC Sec. 280E

1. A Methodology for Cost and Expense Allocations for IRC Sec. 280E
Cannabis businesses come in all shapes and sizes. Each one is a little different. One couldargue each
is unique. All cannabis businesses share one attribute. Every cannabis business is subject to the
potential disallowance under IRC Sec. 280E1 of otherwise deductible ordinary and necessary business
expensesunder InternalRevenue Code [“IRC”]Sec. 162(a)2. The language in IRCSec. 280Ereferences
the Comprehensive Drug Abuse Preventionand ControlAct of 1970 [the “ControlledSubstances Act”
or “CSA” 3. Cannabis has been listed as a “Schedule I” drug since IRC Sec. 280E became law. We will
1 “No deductionorcredit 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.”
2 IRC Sec. 1 62(a)IN GENERAL There shall be allowed as a deduction all the ordinary and necessary expenses paid or
incurred during the taxable y ear in carry ing on any trade or business, including—
(1) a reasonable allowance for salaries or other compensation for personal serv ices actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are lavish
or extravagant under the circumstances) while away from home in the pursuit of a trade or business; and
(3) rentals or other payments required tobe made as a condition tothe continued use or possession,for purposes
of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he
has no equity .
3 In the Controlled Substances Act, 21 U.S.C. Sec.801–971 (1970), Congress created a regime to curtail the unlawful
manufacture,distribution,and abuse of dangerous drugs (“controlled substances”).Congress assigned each controlled
substance toone of fiv e lists (Schedule Ithrough Schedule V). See Sec. 812 of theCSA.Schedule Iincludes: (a) opiates;
(b) opium derivatives (e.g.,heroin;morphine);and (c) hallucinogenic substances (e.g.,LSD; cannabis(a/k/a cannabis);
mescaline; pey ote).
The CSA’s Schedules are:
 Schedule I - drugs, substances, or chemicals are defined as drugs with no currently accepted medical
use and a high potential for abuse. Some examples of Schedule I drugs are: heroin, lysergic acid
diethylamide (LSD), cannabis (cannabis), 3,4-methylenedioxymethamphetamine (ecstasy), methaqualone,
and pey ote
 Schedule II - drugs, substances, or chemicals are defined as drugs with a high potentialfor abuse, with use
potentially leading to sev ere psychological or phy sical dependence. These drugs are also considered
dangerous. Some examples of Schedule II drugs are: combination products with less than 15 milligrams of
hy drocodoneper dosage unit (Vicodin),cocaine,methamphetamine,methadone,hydromorphone (Dilaudid),
meperidine (Demerol), oxy codone (Oxy Contin), fentany l, Dexedrine, Adderall, and Ritalin
 Schedule III - drugs, substances, or chemicals are defined as drugs with a moderate to low potential for
phy sical and psy chological dependence. Schedule III drugs abuse potential is less than Schedule I and
Schedule II drugs but more than Schedule IV. Some examples of Schedule III drugs are: products containing
less than 90 milligrams of codeine per dosage unit (Tylenol with codeine), ketamine, anabolic steroids,
testosterone
 Schedule IV - drugs, substances, or chemicals are defined as drugs with a low potential for abuse and low
risk of dependence.Some examples of Schedule IV drugs are: Xanax, Soma, Darvon, Darvocet,Valium,Ativan,
Talwin, Ambien, Tramadol

2. revisit the inter-relationship between IRC. Sec. 280E, the status of medical and adult-use cannabis
under state law, and the potential consequences of cannabis being reclassified from Schedule I to
Schedule II under CSA at a later point.
Introduction
The potential scope of IRC Sec.280E is likely to come as a surprise to many involvedin the cannabis
industry, just as Congress certainly couldnever have contemplatedthat medical and ultimately adult-
use of cannabis would have become legal under the laws of individual states4.
The draftersof the statute couldnever have contemplatedthe current situationwhere cannabis is legal
for medical use in the majority of states, for recreational use in an increasing number of states, and
remains illegal under Federal law. There was a period of relative calm after the issuance of the Cole
Memorandum and the IRS Chief Counsel Memorandum [“CCM”] 201504011. However, Attorney
General Jeffrey Sessions rescinded the Cole Memorandum5 with the release of Dept. of Justice Press
Release 18-8 in early 2018.6.
 Schedule V - drugs, substances, or chemicals are defined as drugs with lower potential for abuse than
Schedule IV and consist of preparations containing limited quantities of certain narcotics. Schedule V drugs
are generally used for antidiarrheal,antitussive, and analgesicpurposes. Some examples of ScheduleV drugs
are: cough preparations with less than 200 milligrams of codeine or per 1 00 milliliters (Robitussin AC),
Lomotil, Motofen, Ly rica, Parepectolin.
4 Under Explanation of Prov ision,the Senate Report reads as follows: All deductions and credits for amounts paid or
incurred in the illegal trafficking in drugs listed in the Controlled Substances Act are disallowed. Topreclude possible
challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is
not affected by this provision of the bill. S. REP. NO. 97-494 (Vol. I), at 309 (1982). The Senate bill was adopted in
conference. CONF. REP. NO. 97 -7 60, at 598 (1 982), 1 982-2 C.B. 661 .
5 In 2013 Deputy Attorney GeneralJim Cole issueda formalstatement of priorities for federalprosecutors operating in
states where the drug had been legalized for medical or other adult use. The Cole Memorandum represented a major
shift from strict enforcement toa more hands-off approach solong as thecannabis related activity didn’t threaten other
federal priorities, such as prev enting the distribution of the drug to minors and cartels.
6 The release prov ides:
“The Department of Justice today issued a memo on federal cannabis enforcement policy
announcing a return to the rule of law and the rescission of previous guidance documents.
Since the passage of the Controlled Substances Act (CSA) in 1970, Congress has generally
prohibited the cultivation, distribution, and possession of cannabis.
In the memorandum, Attorney General Jeff Sessions directs all U.S. Attorneys to enforce
the laws enacted by Congress and to follow well-established principles when pursuing
prosecutions related to cannabis activities. This return to the rule of law is also a return of
trust and local controlto federal prosecutors who know where and how to deploy Justice
Department resources most effectively to reduce violent crime, stem the tide of the drug
crisis, and dismantle criminal gangs.
“It is the mission of the Department of Justice to enforce the laws of the United States, and
the previous issuance of guidance undermines the rule of law and the ability of our local,
state, tribal, and federal law enforcement partners to carry out this mission,” said
Attorney General Jeff Sessions. “Therefore, today’s memo on federal cannabis
enforcement simply directs all U.S. Attorneys to use previously established
prosecutorialprinciples that provide them all the necessary tools to disrupt criminal
organizations, tackle the growing drug crisis, and thwart violent crime across our
country.”

3. The cannabis industry has historically beenan underground industry. Many involvedin the industry
under-reported gross income or did not report at all. With the passage of Proposition2157 in 1996in
7 California Proposition 215, also known as the Medical Use of Cannabis Initiative or the Compassionate
Use Act, was on the Nov ember 5, 1 996 general election ballot in California as an initiated state statute where it
was approved.
The passage of Proposition 215is considered a significant victory for medical cannabis.It exempts patients and defined
caregivers who possess or cultivate cannabis for medical treatment recommended by a physician from criminal laws
which otherwise prohibit possession or cultiv ation of cannabis.
In May 2009, the U.S.Supreme Court declined tohear an appeal of a California state appellate ruling from 2008 that
upheld Proposition 215 and concluded that California can decide whether to eliminate its own criminal penalties for
medical cannabis regardless of federal law.The appellate ruling came about because of lawsuit against Proposition 215
filed by San Diego and San Bernardino counties.
These counties objected toProposition 215on the grounds that it requires them,in their view,tocondonedrug use that
is illegal under federal law. They also challenged a law that requires counties to issue identification cards to medical
cannabis patients, so these patients can identify themselves to law enforcement officials as legally entitled to possess
small amounts of cannabis. [ San Francisco Chronicle, "Solanotoallow medical cannabis ID cards,"June 24, 2009]
Proposition 215alsoled tothe lawsuit, People v.Kelly This case was decided in January 2010by the California Supreme
Court, which ruledthat the state of California cannot, through the legislative process, impose a state limit
on medical cannabis that is more restrictive than what is allowed under Proposition 215. People v Kelly
helps define laws governing theinitiativ e process in California especially as it relates to legislativ e tampering.
The language that appeared on the ballot stated:
 Exempts patients and defined caregivers whopossess or cultivate cannabis for medicaltreatment recommended
by a phy sician from criminal laws which otherwise prohibit possession or cultiv ation of cannabis.
 Prov ides physicians who recommend use of cannabis for medical treatment shall not be punished or denied any
right or priv ilege.
 Declares that measure not be construed to supersede prohibitions of conduct endangering others or to condone
div ersion of cannabis for non-medical purposes.
 Contains sev erability clause.
In 2004,theCalifornia StateLegislature passed theMedicalCannabis ProgramAct (MMPA). The MMPA was intended
toclarify which specific practices with regard tomedical cannabis were tobe considered lawfulin the state.TheMMPA:
 Established a v oluntary statewide identification card sy stem;
 Set limits on the amount of medical cannabis each cardholder could possess;
 Laid out rules for the cultiv ation of medical cannabis by collectiv es and cooperativ es.
In 2007, the California Fourth Appellate District ruled against the City of Garden Grove, and in favor of a medical
cannabis patient (Felix Kha), say ing that "it is not the job of the local police to enforce the federal drug laws."
The case resulted from the seizure of medicalcannabis from Kha by the Garden Grov e police force in June 2005.
Kha was pulled over by the Garden Grove Police Department on June 10,2005, and cited for possession of cannabis,
despite Kha showing the officers proper documentation of his status a s a medical cannabis patient.
The charge against Kha was subsequently dismissed, with the Superior Court of Orange County issuing an order to
Garden Grove that the city must return toKha 8 grams of medical cannabis that was seized from him by the police. The
police, backed by the city of Garden Grov e, refused to return Kha's medicine and the city appealed.

4. California, medical cannabis dispensaries began appearing. The public appearance of suchbusinesses
came to the attention of the Internal Revenue Service (“IRS”).
Income from illegal sources is taxable8. In the eyesof the IRS, medical cannabis dispensaries were a
particularly attractive target. The Department of Justice couldfind such dispensaries. The targetsof
the Department of Justice, whether or not they were put out of business, were subject to IRC Sec.280E.
Suchdispensaries had substantial income tax liabilities as a consequence of IRC Sec.280Eevenif they
broke-even.
As a result of the focus of the IRS on dispensaries, substantially all of the reported income tax cases
involve dispensaries. The cases reported to date are not particularly instructive, however, regarding
the proper contours of IRC Sec.280E because of the manner in which most dispensaries have been
operated.
Medical cannabis dispensaries are largely cash businesses9. Most lack adequate internal accounting
controls over cash. The books and records which are the financial record-keeping systems for the
businesses have been historically weak. Those medicalcannabisdispensaries with systemsof internal
accountingcontrolsand financial record-keepingsystems typicallyhave lapsesinthe enforcement and
maintenance of those systems. The IRS provides taxpayers with detailed suggestions for the types of
records which they are required to keep10. The IRS further describes how records should be
In the 2007 state court decision,the court ruled that the federalControlled Substance Act of 1 970, enacted tocombat
recreational drug abuse and trafficking,did not intend toregulate the practice of medicine,"a taskthat falls within the
traditional powers of the states."
Before the California Fourth District Court of Appealissued its decision,California Attorney GeneralJerry Brown filed
a "friend of the court"brief on behalf of Kha's right topossess his medicine.The justices noted they were convinced by
Brown's arguments that local agencies are bound by state laws in approaching medical cannabis.
The California Supreme Court denied a case review in March 2008, and Garden Grove then went tothe United States
Supreme Court, which turned the case down in late Nov ember 2008.
Medical cannabis advocates calledthe decision a huge victory in clarifying law enforcement's obligation touphold state
law – in this case, Proposition 21 5.
8 IRC Sec. Sec.61(a)does not differentiate between incomederived from legalsources and income derived from illegal
sources. See, e.g., James v. United States, 366 U.S. 213, 218 (1961). Under the Sixteenth Amendment to the United
States Constitution (“Sixteenth Amendment”), Congress is authorized to lay and collect taxes on income.
In a series of cases, the UnitedStates Supreme Court hasheld that income in the context of a reseller or producer means
gross income,not gross receipts.In other words,Congress may not tax the return of capital. See,e.g.,Doylev Mitchell
Bros. Co., 247 U.S. 179, 185 (“As was said in Stratton’s Independence v. Howbert, [citation omitted], ‘Income may be
defined as the gain derived from capital,from labor,or from both combined.’”);New ColonialIce Co. v .Helvering,292
U.S. 435, 440 (1934)(“The power totax income like that of the new corporation is plain and extends tothe gross income.
Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear
prov ision therefor can any particular deduction be allowed.”).
9 The IRS has specific reporting requirements for business transactions involving over $10,000 in cash. Specifically,
y ou must fileForm 8300,Report of Cash Payments Over $10,000 Received in a Tradeor Business,if you receive more
than $10,000 in cash in one transaction or twoor more related business transactions. Cash includes U.S. and foreign
coin and currency. It also includes certain monetary instruments such as cashier's and traveler's checks and money
orders. For more information, see IRS Publication 1544, Reporting Cash Payments of Ov er $10,000 (Received in a
Trade or Business).
10 The IRS prov ides guidance about the purposes of records, uses of records, and outlines their expectations about the
ty pes of records that they expect taxpay ers to maintain. We hav e prov ided an ov erv iew:

5.  Monitor the progress of y our business. - You need good records to monitor the progress of y our business.
Records can show whether your business is improving, which items are selling,or what changes you needto
make. Good records can increase the likelihood of business success.
 Prepare your financial statements. You need good records to prepare accurate financial statements.
These include income (profit and loss) statements and balance sheets. These statements can help you in
dealing with your bank or creditors and help you manage your business. An income statement shows the
income and expenses of the business for a given period of time. A balance sheet shows the assets, liabilities,
and y our equity in the business on a given date.Identify source of receipts.You will receivemoney or property
from many sources. Your records can identify the source of y our receipts. You need this information to
separate business from nonbusiness receipts and taxable from nontaxable income.
 Keep track of deductible expenses. You may forget expenses when you prepare your tax return unless
y ou record them when they occur.
 Prepare yourtax returns. You need good records toprepare your tax returns. These records must support
the income, expenses, and credits you report. Generally,these are the same records y ou use tomonitor your
business and prepare y our financial statements.
 Support items reported on tax returns. You must keep your business records available at all times for
inspection by the IRS. If the IRS examines any of y our tax returns, you may be asked to explain the items
reported. A complete set of records will speed up the examination.
 Electronic records. All requirements that apply to hard copy books and records also apply to electronic
storage systems that maintain tax books and records. When you replace hard copy books and records, you
must maintain the electronic storage systems for as long as they are materialtotheadministration of tax law.
An electronicstorage system is any system for preparing or keeping your records either by electronicimaging
or by transfer to an electronic storage media. The electronic storage sy stem must index, store, preserve,
retrieve, and reproduce the electronically stored books and records in legible format. All electronic storage
sy stems must prov ide a complete and accurate record of y our data that is accessible to the IRS.
Electronicstorage systems are alsosubject tothe samecontrols and retention guidelines as those imposed on
y our original hard copy books and records. The original hard copy books and records may be destroyed
prov ided that the electronic storagesystem has been tested toestablish that the hard copy books and records
are being reproduced in compliance with IRS requirements for an electronic storage system and procedures
are established to ensure continued compliance with all applicable rules and regulations. You still have the
responsibility of retaining any other books and records that are required to be retained.
The IRS may test y our electronic storage system, including the equipment used, indexing methodology,
softwareandretrievalcapabilities. This test is not considered an examination and theresults must be shared
with y ou. If y our electronic storage sy stem meets the requirements mentioned earlier, y ou will be in
compliance.If not, you may be subject topenalties for non-compliance,unless you continue tomaintain your
originalhard copy books and records in a manner that allows you and the IRS todetermine your correct tax.
For details on electronic storage sy stem requirements, See Rev enue Procedure 97 -22
 Specific Records to Keep - Purchases, sales, payroll, and other transactions y ou have in your business
generate supporting documents. Supporting documents include sales slips, paid bills, invoices, receipts,
deposit slips, and canceled checks. These documents contain information you need torecord in your books. It
is important tokeep these documents because they support the entries in your books and on y our tax return.
Keep them in an orderly fashion and in a safe place.
 Gross Receipts. Gross receipts are the income you receive from your business. You should keep supporting
documents that show the amounts and sources of y our gross receipts. Documents that show gross receipts
include thefollowing.Cash register tapes.Bank deposit slips. Receipt books. Invoices. Credit card chargeslips.
Forms 1 099-MISC.
 Inventory. Inventory is any item you buy and reselltocustomers.If y ou are a manufacturer or producer,this
includes the cost of all raw materials or parts purchased for manufacture into finished products. Your
supporting documents should show the amount paid and that the amount was for inventory. Documents

6. maintained11 and how long the recordsmust be retained12 This may well change in the near future as
there are a couple of United States Tax Court cases pending decision that are likely to provide
significant guidance on the application of IRC Sec.280E to cannabis dispensaries.
Finally, the agencies within the State of California with primary responsibility for oversight of the
cannabis industry for regulatory compliance, which are the Bureau of Cannabis Control [“BCC”] for
Retail [Dispensaries, Offsite Event and Distribution licensees, the California Department of Food and
Agriculture’s [“CDFA”] CalCannabis Unit for Cultivation licensees, the California Department of
Public Health’s [“CDPH”] Manufactured Cannabis Safety Bureau [“MCSB”] for Manufacturing,
Extraction and Testing Laboratories and the California Department of Tax and Fee Administration
[“CDTFA”], have issued a significant number of administrative pronouncements, regulations and
Special Notices that expand upon the IRS’s requirements for financial records, recordkeeping,
reporting the cost of inventory include the following.Canceled checks.Cash register tape receipts.Credit card
sales slips. Inv oices.These records willhelp you determine the value of y our inventory at the end of the year.
 Expenses. Expenses are the costs you incur (other than the cost of inventory) tocarry on your business. Your
supporting documents should show the amount paid and that the amount was for a business expense.
Documents for expenses include the following. Canceled checks. Cash register tapes. Account statements.
Credit card sales slips. Inv oices. Petty cash slips for small cash pay ments.
11 Recording Business Transactions, A good recordkeeping sy stem includes a summary of y our business
transactions. (Your business transactions are shown on the supporting documents just discussed.) Business
transactions are ordinarily summarized in books called journals and ledgers.You can buy them at your localstationery
or office supply store. A journal is a book where you record each business transaction shown on y our supporting
documents. You may have to keep separate journals for transactions that occur frequently. A ledger is a book that
contains the totals from all of y our journals. It is organized into different accounts.
Whether you keep journals and ledgers and how you keepthem depends on the type of business you are in.For example,
a recordkeeping system for a smallbusiness might include the following items.Business checkbook.Daily summary of
cash receipts. Monthly summary of cash receipts. Check disbursements journal. Depreciation worksheet. Employee
compensation record.
12 You must keep your records as long as they may be needed for the administration of any provision of the Internal
Rev enue Code. Generally,this means you must keep records that support an item of income or deduction on a return
untilthe period of limitations for that return runs out.The period of limitations is the period of time in which you can
amend y our return to claim a credit or refund, or the IRS can assess additional tax.
The following table provides a basic summary of record retention requirements:
IF YOU THEN THE RETENTION PERIOD IS
1 . Owe additional tax and situations (2), (3), and (4),
below, do not apply
3 Years
2. Donot report income that you shouldreport,and it is
more than 25% of the gross incomeshown on the return
6 Years
3. File a fraudulent return Not Limited
4. Do not file a return Not Limited
5. File a claim for credit or refund after you filed your
return
Later of: 3 y ears or 2 y ears after tax was paid
6. File a claim for a loss from worthless securities or a
bad debt deduction
7 Years

7. document formats, retention requirements and audit guidelines. The creationof a seed to sale “Track
and Trace system, known as METRC13 is particularly onerous and detailed.
13 METRC Regulations
Sec. 8400. Record Retention. -For the purposes of this chapter, thetermrecord includes allrecords, applications,
reports or other supporting documents required by the department.
(a) Each licensee shall keep and maintain the records listed in subsection (d) for at least seven (7)years from
the date the document was created.
(b) Records shall be kept in a manner that allows the records to be prov ided at the licensed premises or
deliv ered to the department, upon request.
(c) All records are subject to rev iew by the department during standard business hours or at any other
reasonable time as mutually agreed to by the department and the licensee. For the purposes of this section,
standard business hours are deemed to be 8:00am - 5:00pm (Pacific Standard Time). Prior notice by the
department to rev iew records is not required.
(d) Each licensee shall maintain all of the following records on the licensed premises,including but not limited
to:
(1) Department issued cultiv ation license(s);
(2) Cultiv ation plan;
(3) All records evidencing compliance with the environmental protection measures pursuant tosections
8304, 8305, 8306 and 8307 of this chapter;
(4) All supporting documentation for data or information input into the track-and-trace sy stem;
(5) All UIDs assigned to product in inventory and all unassigned UIDs. UIDs associated with product
that has been retired from the track-and-trace sy stem must be retained for six (6) months after the
date the tags were retired;
(6) Financial records related tothe licensed commercial cannabis activity, including but not limited to,
bank statements, tax records, sales inv oices, and sales receipts;
(7) Personnel records, including each employee’s full name, social security, or individual tax payer
identification number, date of beginning employment, and date of termination of employment if
applicable
(8) Records related to employee training for the track-and-track system or other requirements of this
chapter.Records shall include,but are not limited to, the date(s)training occurred,description of the
training prov ided, and the names of the employ ees th at receiv ed the training;
(9) Contracts with other state licensed cannabis businesses;
(10)Permits, licenses, and other local authorizations to conduct the licensee’s commercial cannabis
activ ity ;
(11) Records associated with composting or disposal of cannabis wa ste.
(12) Documentation associated with loss of access to the track-and-trace system prepared pursuant to
section 8402(d) of this chapter.
(e) All required records shall be prepared and retained in accordance with the following conditions:
(1 ) Records shall be legible; and
(2) Records shallbe stored in a secured area where the records are protected from debris,moisture,
contamination, hazardous waste, fire and theft.

8. Sec. 8401. Sales Invoice or Receipt Requirements. The licensee shallprepare a sales invoice or receipt for every
sale, transport, or transfer of cannabis or nonmanufactured cannabis product to another licensee. Sales invoices and
receipts may be retained electronically but must be readily accessible for examination by the department, other state
licensing authorities, any state or local law enforcement authority, and the California Department of Tax and Fee
Administration. Each sales inv oice or receipt shall include all the following:
(a) Name, business address, and department issued license number of the seller;
(b) Name, business address, and department issued license number of the purchaser;
(c) Date of sale or transfer (month, day and y ear). The date of any sale or transfer of cannabis and
nonmanufactured cannabis products shall be the date of transfer to the licensee receiv ing it;
(d) Inv oice or receipt number;
(e) Weight or quantity of cannabis and nonmanufactured cannabis products sold;
(1) Weight. For the purposes of this section a licensee must use wet weight or net weight.Wetweight
and net weight shall be measured,recorded and reportedin U.S.customary units (e.g., ounce or
pound); or International Sy stem of Units (e.g., kilograms, grams, or milligrams).
(2) Weighing Devices.A licensee shallfollow weighing device requirements pursuant tosection8213
of this chapter.
(3) Count. For the purposes of this section, “count” means the numerical count of the individual
plants or units.
(f) Cost to the purchaser,including any discount applied tothe totalprice,shall be recorded on the inv oice.
(g) Description for each item including strain or cultiv ar, and all of the applicable inform ation below:
(1) Plant;
(2) Flower;
(3) Leaf;
(4) Shake;
(5) Kief; and
(6) Pre-rolls.
(h) Signatureof the seller, or designated representative of the seller,acknowledging accuracy of the cannabis
and nonmanufactured cannabis products being shipped.
(i) Signature of the purchaser, or designated representative of the purchaser, acknowledging receipt or
rejection of the cannabis or nonmanufactured cannabis products.
Sec. 8408. Inventory Audits. The department may perform an audit of the physical inventory and inventory as
reported in the track-and-trace system of any licensee at the department’s discretion. Audits of the licensee shall be
conducted during standard business hours or at other reasonable times as mutually agreed toby the department and
the licensee. For the purposes of this section standard business hours are 8:00am – 5:00pm (PacificStandard Time).
Prior notice of audit is not required.
Sec. 8501. Inspections, Investigations and Audits. The department shall conduct inspections, investigations
and audits of licensees including, but not limited to, a review of any books, records, accounts, inventory, or onsite
operations specific to the license.
(a) The department may conduct an inspection, inv estigation or audit for any of the following purposes:
(1) To determine accuracy and completeness of the application prior to issuing a license;

9. The application of Sec.280E to dispensaries is, however, the tip of the iceberg. IRC Sec.280Eapplies
to “any trade or business if such trade or business (or the activities which comprise such trade or
business) consists of trafficking in controlled substances...”. The unequivocal language of IRC
Sec.280E, however, is equally applicable to cultivators, processors, manufacturers, distributors and
cannabis delivery-services.
There may be some limits to the application of IRC Sec.280E to the cannabis industry. It appears
unlikely the IRS will stretch IRC Sec.280E to apply its disallowance to a service business, such as
marketing or representation businesses, or professional services such as attorneys, certified public
accountants, that does not actually “touch the cannabis”. The use of the word “trafficking” suggests
that IRC Sec.280E is solely applicable to in-line businesses that are directly involved in the series of
activitiesthat move an agriculturalmaterial fromcultivationto the sale of the material to a consumer.
Consider, however, whether a cannabis transportation-only service business is subject to IRC
Sec.280E.
MMRSA was followed by clean up legislation and Proposition 64 [“Prop. 64”] was passed California
became a state that permittedadult use cannabis. Following Prop. 64, the Californialegislature passed
the Medical and Adult-Use Cannabis Regulation and Safety Act [“MARUCRSA”]. MAUCRSA was the
foundation for multiple agencies to write of regulations for oversight of the cannabis industry in
California.
California has moved from a largely unregulated cannabis market to a comprehensively regulated
(2) Todetermine compliance with license requirements including,but not limited to, the cultivation
plan;
(3) To audit or inspect any records outlined in section 8400 of this chapter;
(4) To respond to a complaint(s) receiv ed by the department regarding the licensee;
(5) To inspect incoming or outgoing shipments of cannabis and nonmanufactured cannabis
products; and
(6) As deemed necessary by the department.
(b) All inspections, investigations and audits of the licensed premises shall be conducted during standard
business hours or at other reasonable times as mutually agreedtoby the department and the licensee.For the
purposes of this section, standard business hours are 8:00am – 5:00pm (Pacific Standard Time).Prior notice
of inspection, inv estigation or audit is not required.
(c) No applicant, licensee, its agent or employees shall interfere with, obstruct or impede the department’s
inspection, inv estigation or audit
.
This includes, but is not limited to, the following actions:
(1) Deny ing the department access to the licensed premises;
(2) Prov iding false or misleading statements;
(3) Prov iding false, falsified, fraudulent or misleading documents and records; and
(4) Failing to prov ide records, reports, and other supporting documents.
(d) Upon completion of an inspection, investigation or audit, the department shall notify the applicant or
licensee of any v iolation(s) and/or action(s) the department is taking.

10. industry in three years. The transition is a work in progress14. A myriad of agencies are involved,
Numerous questions remain unanswered with details to yet to be addressed. The transition to
regulated markets in California is a complex tale which has yet to have its conclusion revealed.
IRC Sec. 280E Interpretation
Asis notedabove, substantially alllitigationinvolvingIRC Sec.280Ehasinvolveddispensaries [“Retail
Licensees”]. The application of IRC Sec.280E to businesses other than dispensaries is beyond the
scope of this brief memorandum. This memorandum has been written in order to describe a general
methodology for the application of IRC Sec.280E to the expenses of a dispensary that will minimize
the adverse impact of the provision. It is worthy of note before moving on from general observations
relating to the applicationof IRC Sec.280Ethat the application of this statute to a cannabis distributor
[“Distribution” licensee] may be far more onerous than to a cannabis dispensary.
The IRS has formally agreed those costs and expenses that are properly included in Cost of Goods
Sold15 (“COGS”) can be utilized to reduce Gross Revenue in the determination of Gross Profit for a
14 The Medical Cannabis Regulation and Safety Act [“MMRSA”], which went intoeffect in 2016,included a multitude
of regulatory procedures involving many agencies, but much of the regulation of cannabis growing willnow fall under
the CDFA on both state and local levels. Regulations willinclude not only compliance with environmentalrequirements
such as the regional water board cultivation permits, but with regulations concerning pesticide use, testing, sales,
distribution,and a host of other standards akin tothose faced by commercialagriculturalproducers around thestate.
California Governor Jerry Brown signed the MMRSA intolaw on October 09,2015,and it became effective on January
01 , 2016.The Act, composed of 3 bills (AB266,AB243, and SB 643) established a licensing and regulatory framework
for the cultivation, manufacture, transportation, storage, distribution, and sale of medical cannabis in the State
of California. The MMRSA established the MedicalCannabis Cultivation Program within the California Department of
Food and Agriculture [“CDFA”]tolicense cultivators,establish conditions under which indoor and outdoor cultivation
may occur, establish a track and trace program for reporting the movement of medical cannabis items through the
distribution chain, and assist other state agencies in protecting the env ironment and public hea lth.
Subsequently, California voters passed the Adult Use of Cannabis Act (Proposition 64), which also designated
responsibilities for ov ersight of commercial cannabis to multiple state agencies.
 CDFA was granted the authority to establish a cannabis cultivation licensing process for thestate and develop
a track-and-trace system torecord themovement of cannabis and cannabis products through thestate’s supply
chain.
 CDFA created a new division called CalCannabis Cultivation Licensing,which is tasked with overseeing these
projects.
On June 27,2017, California Governor Jerry Brown signed a trailer bill(alsoknown as California Senate Bill 94). This
Bill was drafted for the purpose of merging the regulatory scheme of MMRSA with the regulatory provisions of Prop.
64, into one streamlined bill. The laudable purpose was to have one comprehensive state law provide a more unified
and efficient regulatory process gov erning both medicinal and adult -use (recreational) cannabis.
15 Cost of Goods Sold [“COGS”]is not a deduction but actually,an adjustment which is taken intoaccount in arriving
at gross income. Reg. Sec. 1.61-3(a) provides, “gross income” means “…the total sales, less the cost of goods sold.”
Although IRC Sec. 280E disallows any deduction for a cannabis seller’s ordinary and necessary business expenses,the
legislative history fails toincludethe cost of goods sold in this rule. Theliterature suggests that Constitutionalconcerns
of the Sixteenth Amendment, which taxes ‘incomes’, are the reason for this exclusion.

11. cannabis business. The IRS generally seeksto minimize COGS in order to maximize the impact of IRC
Sec.280Eon a cannabis dispensary. Of greater significance, the IRS generally takes the position that
IRC Sec.280E requires the disallowance of any deduction for costs and expenses incurred by a
dispensary that are not properly included in COGS. We believe that the total disallowance of all
expenditureswhich are not included in COGS is a draconianapproach that doesnot comport with the
language of IRCSec. 280E, or the intent of Congressas articulatedin the Committee Reports. Inthose
states where the sale of cannabis is legal under state law, this approach is patently absurd.
We believe that such position is unreasonable with respect to costs such as legal advice, tax and
accountingadvice and executive management, as well as all comparable coststhat relate to all aspects
of the business as awhole. Further, expenditures suchasrent, utilities, payrolland comparable general
expenses are properly subject to allocation on a number of bases.
We believe that the argument advanced by the IRS is particularly weak, because the IRS’ position
ignores the unusual wording and structure of IRC Sec.280E. The disallowance language is clear and
unequivocal,
In the Senate hearings prior to passing IRC Sec. 280E, discussion suggested including the cost of goods sold in the
‘disallowed’ expenses for drug traffickers. However, the feeling that this could create a constitutional issue leading to
court challenges (and delays)prevailed, and cost of goods sold remainedan availableadjustment todrug traffickers.
Although the IRS has not issued regulations related toIRC Sec. 280E,the IRS allows the adjustment for Cost of Goods
Sold on the tax returns of businesses engaged in drug trafficking. On November 24, 2010,U.S.Representatives Fortney
Pete Stark, Barney Frank, Jared Polis, Linda Sanchez, Raul Grijalva, and Sam Farr wrote to the office of the Chief
Counsel of the IRS, asking the service to create guidance for regulations related to deductions for state-licensed
cannabis businesses.
The Chief Counsel’s Office replied to the Congressman on December 16, 2010, stating that the IRS is unable to issue
regulations for IRC Sec. 280E since neither the CSA nor IRC Sec. 280E makes an exception for medical cannabis.
Further, the Chief Counsel places blame on Congress to change either IRC Sec. 280E or the CSA.
Cost Method for Cost of Goods Sold
A business must use an inventory method of accounting whenever “the production, purchase or sale of goods is an
income-producing factor. Under an inventory method, costs related to producing, acquiring, storing, and handling
goods are not currently deductible.These costs must be included in the costs of inventory anddeducted when inventory
is sold. In the typical business, tax professionals look to minimize current income by taking deductions during the
current period.
IRC Sec. 263A does not magically transform otherwise disallowed costs under IRC Sec. 28 0E intoallowed capitalized
costs, although the tax professional should look to m aximize the number of expenditures which can be justifiably
capitalized. Generally, the current year inventory costs are added to the beginning of the year inventory amount and
reduced by the costs of inv entory on hand at the end of the y ear to calculate costs of goods sold for the y ear.
IRC Sec. 471 and methods required by IRC Sec. 263A provide that marketing,advertising and selling expenses are “not
required” tobe treated as inventory costs.Under Reg. Sec.1.471–11, 6(a),taxpayers must include as inventoriable costs
all direct (e.g.,the cost of inventory and delivery,and the cost of materials and labor for manufactured inventory)and
indirect production costs (e.g., rent and utilities related to inv entory )

12. “[n]o deduction or credit shall be allowed for any amount paid or incurred
during the taxable year in carrying on any trade or business . . . .”
It is the unusual terminology utilized in the statute to describe the scope and application of the IRC
Sec.280E disallowance that creates confusion. The disallowance of a deduction pursuant to IRC
Sec.280E applies to amounts paid or incurred “in carrying on” any trade or business that is
“trafficking” in a controlled substance. The phrase “in carrying on” suggests that IRC Sec.280E
applies solely to amounts directly connected to the activity of “trafficking.” The substitution of the
word “of” or the phrase “in connectionwith” for “in carryingon” illustrates this point. Both the word
“of” and the phrase “in connection with” would provide greater support for IRS’s assertion that IRC
Sec.280Edisallows any deduction for any cost or expense incurred by a dispensary in a taxable year.
The unusual language used to describe the taxpayerssubject to IRCSec.280Eprovidesfurthersupport
for this narrower application of the disallowance language. The statute describes the taxpayers to
which it applies as, “any trade or business if such trade or business . . . consists of trafficking in
controlled substances.” The proper interpretation of this statement is complicated by the
parenthetical language which was omitted from the quotation, “or the activitieswhich comprise such
trade or business.” The utilization of both the statement and the parenthetical to describe the
taxpayersto which IRC Sec.280E applies indicates the disallowance of costsor expensespursuant to
IRC Sec.280E should be narrowly limited to the amounts directly paid or incurred in “trafficking” in
controlled substances by the taxpayer. The meaning of the word “trafficking” as applied to cannabis
for the purpose of applyinglaws, of course, includesallof the activitiesfromthe cultivation of cannabis
to the sale of cannabis to a consumer.
A Defensible IRC Sec.280E Methodology
Historically Californiacannabisdispensarieshave purchasedcannabis flower in bulk and preparedthe
flower for retailsale at the dispensary. Insome instances, dispensaries have also purchasedoil in bulk
and packagedthe oil for retailsale. More frequently oilis purchasedby a dispensary already packaged
for retail sale. California dispensaries generally also sell items other than cannabis and cannabis
products. California cannabis dispensaries, of course, sold only medical cannabis and medical
cannabis productsuntil 2018, althoughthe differencesbetweenmedicaland recreationalcannabisare
irrelevant for the purposes of this memorandum16.
For the purpose of describing a defensible methodology for allocating costs and expenses of a
dispensary to determine the disallowance pursuant to IRC Sec.280E, it will be assumed a storefront
dispensary makes all sales on-site and all of the revenue of the dispensary is generated by such sales.
It is also assumed for the purposes of this memorandum 80% of the total sales of merchandise by the
dispensary are sales of cannabis and cannabis productsand 20% of the sales are of other productsnot
subject to IRC Sec.280E.
Further, it is assumed the dispensary purchasessubstantially all of itscannabis and cannabis products
in bulk and processesand packagesthe bulk material for retailsale. It is assumed thirty percent of the
16 However, if any of the following changes were to occurat the Federal level such as:
 Reclassification of cannabis by the Drug Enforcement Administration or if Congress were to pass
legislation causing cannabis to be transferred from CSA Schedule I to CSA Schedule II or
 Congress were to enact legislation with provisions such that the laws of state which had provided for the
legal use of cannabis for medical or adult-use purposes were to be respected by the Federal government.
the legal validity of any application of IRC Sec. 280E in such states would be substantially undercut.

13. total square footage of the dispensary is devotedto the processing, packaging and storage of cannabis
material held for retailsale, thirty percent of the square footage is devotedto management, back-office
record-keeping and personnel needs.
The dispensary has sales revenue from the sale of cannabis and cannabis products as well as from the
sale of non-cannabis products. Both these classes of products will have associated COGS. For the
purposes of this memorandum, it is assumed the non-cannabis products are purchased by the
dispensary and packagedand labeledfor retail sale on site. Based on this assumption, all additions to
COGS for costsand expensesincurred by the dispensary for the processingand packagingof products
for retail sale will be added to the COGS for the cannabis and cannabis products.
The first allocation of the costsand expenses of the dispensary that must be made is the allocationof
costsand expensesbetween operatingexpensesand COGS. As a starting point, it is assumed all of the
costs and expenses of the dispensary will be allocated among three functions:
(1) costsand expensesassociatedwiththe processingand packagingof cannabis and cannabis
products for retail sale;
(2) costs and expenses associated with the general administration and management of the
dispensary; and
(3) costs and expenses associated with the retail sale function.
Direct costs and expenses must be first allocated among these three functions as a first step. As a
second step the indirect costsmust be determined and allocated. As a third step, costsand expenses
allocatedto generaladministration and management must in turn be allocatedbetweenthe processing
and packaging function and the retail sale function.
Some specific costs and expenses will be directly attributable to one of the three functions described
in the precedingparagraph. Other costsand expensesare only indirectly allocable among these three
functions. In some instances, a specific type of cost or expense may be partially attributable to one of
the functions as a direct cost and partially allocable among the functions as an indirect cost. For
example, if an item of equipment that utilizes a substantial amount of power in connection with
processing and packaging, the cost of power for this equipment could be directly attributed to this
function while the balance of the power cost was attributed to the facilities and allocated among the
three functions as an indirect cost.
Each item of cost or expense must be separately examined, although the variousitems will fall into a
fairly limited number of categories for the purposes of attribution among the functions.
Each specific item of cost or expense must be classified into categories for the purpose of attributing
these costs to the appropriate functions of a business. Labor costs are useful for illustrating the
methodology that should be followed. Labor costs are a significant portion of the total cost of the
operation of a dispensary and a portion of the labor costs generally will be allocable to each of the
functions of a business operation. The compensation of the employeesof a dispensary generally can
be allocated based on job title and time expended in connection with a particular function.
In the case of a dispensary, the compensation of most of the employees should be easily allocated
among the processingand packaging function, the general administration function, and the retailsale
function, based on the activities of employees. The associated employment costs relating to these
employees should be allocated in proportion to the compensation costs in most instances. There is
one category of compensation cost for most dispensaries that must be separately considered. Most
dispensaries will also have a significant compensation cost for security personnel. Inthe instance of a
California dispensary that has a substantial processing function, a strong argument can be made that

14. the entire cost of compensation for security personnel is allocable to the processing and packaging
function.
Each specific item of cost or expense that is financially significant should be examined in a manner
similar to the evaluation given to labor costs in the preceding paragraph. Items of cost and expense
that are not specifically allocable to processing and packaging function or to the retail sale function
should be allocated to the general administration function. When each specific item of cost and
expense has been allocated to one of the three categories, the total amount of the cost and expense
attributed to the general administration function should be allocated between the processing and
packaging function and the retailsale functionbased on the relative proportionsof the compensation
allocated to the two functions.
The total amount of the direct and indirect costs and expenses are allocated to the processing and
packaging function. The total amount of these costs and expenses will be an addition to COGS. The
total amount of the direct and indirect costs and expenses allocated to the retail sale function must
then be allocatedbetween sales of cannabis and cannabis productsand sales of other products. Based
on the assumptions described above 80% of the total amount of the direct and indirect costs and
expenseswill be allocatedto the sale of cannabis and cannabis productsand not deductible pursuant
to IRC Sec.280E.
The methodology describedabovecanbe readily appliedto the unique factsof the conduct of business
by any cannabis dispensary. Thisprinciples that are the foundationfor this methodology canalso be
readily adapted to other cannabis businesses. Of course, as material movesup the chain of commerce
from cultivator to dispensary, the acquisition cost for each step will be the starting point for the
computation of COGS for the next step in the chain of commerce.