How the 280E transition affects cannabis payroll records and labor cost documentation

For years, the way a cannabis company allocated labor costs on payday had a direct effect on how much federal tax they owed. That's what IRC Section 280E did.

As of April 2026, that's changing. And the transition has payroll implications worth understanding.

What 280E was, and why it shaped how cannabis companies ran payroll

Section 280E has been on the books since 1982. Congress wrote it to stop drug traffickers from deducting business expenses on illegal income. However, when states started legalizing medical cannabis, state-licensed operators got caught in it too.

The rule was blunt: no deductions, no credits. The only thing a cannabis business could subtract from revenue before calculating taxable income was the cost of goods sold — the direct costs of producing whatever they sold.

COGS included production labor, cultivation costs, processing and packaging, and raw materials. But more importantly, what didn't count was everything else: rent, marketing, administrative salaries, sales staff. None of it was deductible.

Essentially, cannabis businesses were paying federal income tax on gross revenue minus production costs — which is a very different calculation than net income.

What Section 280E meant for cannabis payroll operations day-to-day

280E turned labor cost tracking into a tax survival function. Here's why.

If you could document that an employee's wages were tied to production — cultivation, processing, packaging — those wages could go into COGS. COGS reduces the income you're taxed on. Every dollar you could legitimately allocate to production was worth real money.

If you couldn't document it clearly, you couldn't claim it. And if an IRS examination disagreed with your allocations, the cost of that disagreement was significant. The IRS has historically scrutinized cannabis businesses closely, as reflected in multiple Tax Court cases under 280E.

In practice, that meant cannabis payroll operations needed:

• Earning codes separated by function. Production wages tracked distinctly from non-production wages — not collapsed into a single payroll line.
• Cost accounting that tied labor to activities. The ability to show which employee costs mapped to cultivation, processing, or packaging versus administrative roles.
• Records that could hold up under scrutiny. Payroll data retrievable by date range, employee, and activity — without a manual reconstruction effort if questions came up.
• Multi-state compliance on top of all of it. State withholding and reporting requirements don't pause because your federal tax situation is complicated.

Most generic payroll systems weren't built for this. Cannabis operators with complex payroll needs often found themselves working around their systems rather than through them.

What changed in April 2026

In April 2026, Acting Attorney General Todd Blanche signed a Final Order rescheduling certain cannabis products from Schedule I to Schedule III. The order covered two categories:

• Marijuana subject to a state medical marijuana license
• Marijuana contained in FDA-approved drug products

Treasury and the IRS announced plans to issue guidance addressing the federal tax consequences of the order, indicating they expect rescheduling to remove 280E for covered operators. For those eligible, they expect payroll, rent, and other ordinary business expenses to be deductible — though formal guidance has not yet been issued.

That's a meaningful shift. For state-licensed medical cannabis operators, the tax math is fundamentally different going forward.

Treasury also signaled two things to watch for in forthcoming guidance:

• A transition rule. Treasury expects rescheduling to apply to the full taxable year that includes the effective date. For calendar-year taxpayers, that means 280E relief back to January 1, 2026 — not just from April forward. Formal guidance confirming this has not yet been issued.
• An apportionment approach. For businesses with both medical and adult-use operations, guidance is expected to clarify how 280E applies only to the Schedule I or II portion of those activities.

One important distinction: adult-use and recreational cannabis is not covered. Products outside the state-licensed medical system remain on Schedule I, and 280E still applies in full for recreational operators.

What this means for payroll records going forward

The transition doesn't make documentation simpler. In some ways, it adds complexity.

Here's the picture for each operator type:

State-licensed medical cannabis operators

For covered operators, 280E is expected to no longer govern deductions going forward. But it will still govern your prior years. If those returns get examined, they're evaluated against the old rules — and the payroll records that supported your COGS allocations need to be there.

Your transition-year records also matter. Treasury's anticipated guidance covers the full taxable year, which means 2026 records need to reflect both the environment you were operating in and the one you're moving into. Operators with clean, function-level payroll data going into that guidance are in a different position than those who need to reconstruct records after the fact.

Mixed-license operators (medical and adult-use)

This is the most complex situation. 280E will apply to the adult-use portion of operations but not the medical portion. Treasury has flagged that guidance will address how expenses get apportioned between those lines.

The documentation that supports that apportionment — which labor costs belong to which activities, tracked clearly in your payroll system — is directly relevant to how that guidance applies to you.

Adult-use and recreational operators

Nothing has changed. 280E applies as it always has. The documentation requirements that governed last year govern now.

What a payroll system needs to handle through the transition

The underlying capability that 280E forced — clean, function-level, audit-ready payroll documentation — doesn't stop being useful because the tax environment is shifting. It just serves a different purpose.

A payroll system built for cannabis complexity should be able to:

• Separate earning codes by function. Production versus non-production, with enough granularity to support COGS allocation and expense apportionment — whichever applies to your situation.
• Tie labor costs to activities and cost centers. In a way that flows into your general ledger and ERP without manual reconciliation.
• Produce retrievable records by date range. If someone asks for all production labor costs for Q2 2025, the system should produce that without a reconstruction project.
• Handle multi-state compliance. State withholding, unemployment, and new hire reporting requirements are independent of federal tax classification. They haven't changed.

Greenshades Payroll is built for this. Earning code separation, cost accounting integration, multi-state compliance, and records that are auditable without workarounds.

Note: This information is for informational purposes only and does not constitute formal tax, legal, or compliance advice. Always consult with qualified tax advisors, legal counsel, and your organization's internal teams for guidance specific to your situation. Additional regulations may apply. For the most accurate and up-to-date information, refer to official government resources and regulatory agencies.