October 26, 2021

The R&D Tax Credit is an Untapped Resource in the Cannabis Industry

By Jill Scher, Partner, Tax & Business Services

The R&D Tax Credit is an Untapped Resource in the Cannabis Industry Research & Development Tax Credit

The Research and Development (R&D) tax credit is designed to reward innovation and problem-solving. It incentivizes businesses to invest in creating new or improved business processes, products, or components within the United States. The application of this credit can result in billions of dollars in tax savings to US businesses. Until recently the R&D credit was not a viable option in the cannabis industry, but now, the federal government is allowing cannabis growers, retailers, and ancillary businesses to take advantage of these potentially significant tax savings opportunities.

R&D tax credits directly offset a company’s federal and, potentially, state tax liabilities. There is no limit on the amount of credit that can be claimed for qualified R&D expenses, and any excess credit beyond a company’s liability may be carried forward to future years.

Eligible pre-revenue and startup companies may also be able to apply their federal R&D credit to offset up to $250,000 payroll taxes in their first five years of operation. This means that start-ups have access to these funds immediately, even if they can’t offset taxable income tax profits.

On top of the federal R&D, most states also offer their own R&D tax credit that eligible companies can apply against their state income taxes.

A New Opportunity for the Cannabis Industry

The number of states that have legalized adult use of recreational marijuana is growing steadily and others have decriminalized adult recreational marijuana use. However, tetrahydrocannabinol or THC — the psychoactive compound in marijuana — remains a Schedule I substance to the Controlled Substances Act and is therefore illegal on all accounts at the U.S. federal level. This not only makes it difficult for cannabis companies to access banking services, there are also obstacles preventing these companies from taking advantage of certain tax deductions. As applied to THC, the law denies cannabis businesses any U.S. federal income tax deduction for ordinary and necessary business expenses, despite being duly licensed as a legal business in their state of operation.

Typically, the ability to deduct ordinary business expenses means a business is subject to federal tax on its net income (i.e., gross receipts minus expenses). However, under Internal Revenue Code Section 280E, as related to its THC business line a cannabis company may be prevented from taking advantage of tax deductions for actual economic expenses incurred in the ordinary course of business, which results in a significantly higher effective tax rate as compared to other businesses.

However, the Agriculture Improvement Act of 2018 has changed the landscape for the cannabis industry. This federal act legalized the business activity of growing, selling, possessing and transporting hemp-derived and cannabidiol (CBD) products. CBD is a natural compound found in the flower of hemp and marijuana plants. The difference is that CBD derived from hemp does not contain THC.

Consequently, while federal law still prohibits the cultivation and sale of marijuana, hemp and CBD are legal at the federal level, so long as the hemp is produced by a licensed grower in a manner consistent with the 2018 Act and associated federal and state regulations. Companies compliant with these requirements can now claim eligible federal tax credits, including the R&D tax credit.

Even better, a handful of states that have legalized the sale of THC may allow a tax credit against income tax liabilities related to the production, distribution and sale of THC. Currently these states include California, Colorado, Illinois, and Massachusetts, but the list is growing.

R&D Tax Credits in the Cannabis Industry

The following list provides examples of potentially qualifying hemp and CBD industry activities. Cannabis growers, processors, and many other vertically integrated organizations performing one or more of these functions may also qualify for the R&D credit.

For Growers:

  • Experimentation with new strains of plants, hemp varieties and characteristics
  • Experimenting with soil, lighting, humidity, and other variables to increase yield
  • Research with new fertilizer formulation
  • Design and development of new or improved irrigation systems or hydroponic techniques
  • Investigation with new ways to manage pest control
  • Developing new ways to prevent mold or plant loss
  • Experimentation with hybridization or gene transfer
  • Design and development of new drainage or filtration systems
  • Testing new farming methods to grow healthier, stronger plants or increase crop yield

For Processors:

  • Identifying new applications for hemp or cannabis-derived substances
  • Developing new hemp-related products
  • Testing new CBD oil products and extraction techniques
  • Exploring hemp uses in textiles, biofuels, and manufacturing
  • Developing new topical creams and skin absorption techniques
  • Designing new packaging and shelf-life methodologies
  • Automating parts of the growing process and creating process improvements
  • Creating alternative drying/curing methods to increase production and/or plant quality

Other Qualified Activity:

  • Designing and integrating new or improved processing equipment or systems
  • Developing custom enterprise resource planning (ERP) or inventory and production management software
  • Lighting innovation including the development of new technologies for yield optimization, automation, consuming less electricity, saving space and higher productivity
  • Vaporizer pen innovation and development, including ability for user to inhale cannabis vapor instead of combusted smoke
  • Innovative edibles such as THC chewing gum, gummies, frying oil and applications
  • Tech products such as affordable automated systems for home growing and mobile apps for ordering and analyzing products
  • Implementing new software analytical tools for strand identification
  • New point-of-sale equipment to speed purchases, RFID tags to track plants during transportation, and air filters that plug into home electrical outlets
  • Software analytics providing the ability to navigate data easily

Qualified R&D expenses for the industrial hemp and CBD industries fall into three expense buckets:

  1. Payroll for employees performing R&D activities, including those with direct involvement in R&D, as well as managers who directly supervise or support R&D activities.
  2. Third party contractor R&D expenses for services provided to the company.
  3. Supplies and raw materials consumed during the R&D process, including amounts paid for seeds, fertilizer and pesticides, and selected other supplies.

Some Words of Warning

Federal and state R&D tax credits provide valuable opportunities to increase cash flow, but claiming the R&D tax credit and documenting your expenses can be complex. Leveraging R&D tax incentives requires a technical understanding of IRS rules and regulations. Thorough tax planning and preparation is needed before claiming a credit. Penalties and interest can apply if a credit claim is insufficiently supported or fails to follow the applicable rules and guidance. Consult your Marcum tax professional for guidance based on your specific facts and circumstances.