Knowing the rules is one thing. Making sure you applied them correctly when the IRS pulls your return for an audit is another. Part 3 of my cannabis COGS series is about the work that turns a good COGS position into one that survives. In cannabis, you should assume the audit is coming. The IRS has said the industry is a priority, and a big tax refund on paper is exactly what draws attention.
The fight almost always lands in the same place. Cost allocation. Picture a building that holds both a grow and a retail counter. The grow side costs can ride into inventory. The retail side cannot. So how you split the rent, the power, and the payroll across that one building decides thousands of dollars in tax. Get the split right and it holds. Guess at it and the IRS will pick its own number, usually one that costs you more.
So how do you make the split defensible? Measure it. If cultivation uses 60 percent of your square footage, document the 60 percent with a floor plan and real measurements. If a worker splits time between growing and selling, track the hours. Use time studies, not gut feel. Keep the records as you go, not scrambled together the week before the return is due. Contemporaneous is the word the IRS cares about. It means you wrote it down when it happened.
Underneath all of this, you need a real inventory system. Not a spreadsheet someone updates when they remember. A perpetual system that tracks product from seed or purchase all the way to the sale, with costs attached at each step. This is where your accounting and your seed-to-sale tracking should line up. When they do not match, that gap is the first thing an examiner circles.
The mistakes that sink operators are predictable. Dumping selling and admin costs into COGS because it lowers the bill. Allocating far more of a shared building to production than the space supports. Changing your method year to year to chase a lower number. Keeping no backup for the allocations you claimed. Every one of those is an easy win for an examiner, and every one turns into back taxes and penalties when it is pulled.
The recent move of medical marijuana to Schedule III adds a new level of complexity. If you sell both medical and recreational product, you now may have to split costs not just between production and retail, but between a medical line that may sit outside 280E and a recreational line still stuck inside it. That is more sorting, more documentation, and more room to get it wrong. The Treasury has not issued guidance yet, so build clean, separate records now. That way you are ready to claim what you are owed the moment the rules are clear.
This is a lot to carry while you are also running the business. So who owns that number on your team today? Here is the thing. Cost accounting in cannabis is not bookkeeping you hand to whoever is cheapest. It is the single biggest driver of your federal tax bill. A finance leader who knows this industry will build the allocation method, tie it to your inventory system, keep the documentation an examiner will accept, and quantify your exposure before the IRS does. That is the work a fractional CFO does, and in cannabis it usually pays for itself in the first tax year.
So do not wait for the audit letter to find out whether your numbers hold. Build the system now, document as you go, and treat cost of goods sold like the tax strategy it is. Your margin depends on it.
Want an assessment of your COGS optimization and defensibility? Reach out to High Rock Accounting today to ensure you are ready before the end of the year.
Melissa Diaz, CPA
Co-Owner & Partner, High Rock Accounting
High Rock Accounting delivers outsourced accounting, tax strategy, and fractional CFO services to cannabis operators. Melissa is a 2026 Forbes Best-in-State CPA.
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