As a general matter, taxpayers cannot deduct business expenses associated with activities that are illegal under federal law, even when those expenses (like rent or payroll) would otherwise be permissible deductions. This is specifically the case for those trafficking Schedule I or Schedule II controlled substances, as specified in Section 280E of the Internal Revenue Code, whether or not state-licensed cannabis operators are operating in full compliance with state law. The practical effect is that a cannabis retailer cannot deduct rent, payroll, utilities, marketing, insurance, or any other ordinary business expense, leaving firms taxed on gross income rather than net income. The only relief available under §280E is the cost of goods sold deduction, which allows cannabis businesses to reduce their taxable gross receipts by the direct costs of producing or acquiring the inventory they sell.
This legal situation yields effective federal income tax rates for cannabis businesses that could significantly exceed the 21 percent statutory corporate rate. The interaction with state law is fundamentally asymmetric: states that have legalized adult-use cannabis have generally conformed their own tax codes to allow ordinary business deductions, meaning that a cannabis operator in Colorado or California pays state income tax on something approximating net income while simultaneously paying federal income tax on an inflated taxable base. This creates a burden with no analogue in any other legal industry and has been widely cited as the largest impediment to transitioning the cannabis industry away from cash-intensive operation (and tax noncompliance) toward the formal sector that state legalization was intended to create.
Under either of the policy counterfactuals considered in this article, the burden of Section 280E would be lifted. This would likely cause some businesses to fully transition into the formal sector. However, in the absence of data with which to model shifts on this margin, we do not include any such effects in our calculations.
The Budget Lab is grateful to Adam Hoffer for insightful feedback on an earlier draft.
Some non-substantive edits were made to a small portion of the text on August 18, 2026. None of the calculations were altered.