Consider the legal landscape for cannabis businesses:
- Cannabis remains a Controlled Substances Act Schedule I substance.
- Cannabis businesses operating in states where they have been legalized are denied federal tax deductions for ordinary and necessary business expenses under Internal Revenue Code 280E.
- The Agriculture Improvement Act of 2018 legalized the business activity of growing, selling, possessing, and transporting hemp-derived and cannabidiol (CBD) products.
Now consider a potentially favorable scenario for hemp and CBD businesses: a tax credit for companies engaging in qualified research and development activities (the “R&D Credit”). It is important to note that due to the federally illegality of THC, businesses involved in the production or sale of THC are not eligible for this credit.
Section 1.174-2 of the U.S. Treasury Regulations state that, “whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents.” Under the regulation, qualified activities include developing a new or improved product, developing new technology, creating a new production process, or improving current processes.
Notably, the efforts do not need to be successful to qualify for the R&D Credit. Nor does the product or process need to be unique to the industry. It only needs to be new or improved for the business conducting the research and development.
Qualified R&D expenditures can include operating expenses such as wages, materials, and payments to third-party contractors if the activity that gives rise to the expenditure is a qualified research activity. Examples of qualifying activities include:
- Cultivating new varieties and/or characteristics
- Developing new growing methods and procedures
- Devising new or improved ways to process and harvest plants
- Experimenting to grow healthier, stronger, and better quality plants
- Developing and testing new filtration or irrigation systems
- Testing new farming methods to increase crop yield
- Investigating new ways to use industrial hemp fibers
- Developing new products
- Formulating new topical creams and other absorption methods
- Testing new CBD oil products and extraction techniques
- Exploring alternative uses for hemp
- Designing and incorporating new or improved processing equipment or systems
- Developing custom enterprise resource planning (ERP) or inventory and production management software
- Designing and integrating new or improved processing equipment, systems, and software, including custom enterprise resource planning (ERP) and inventory and production management software
Examples of qualifying costs include, but are not limited to, those incurred in performing the qualifying activities, such as:
- Compensation paid to employees or contractors involved in the process or activity, whether directly or in a supervisory or management capacity
- Raw materials and supplies consumed during cultivation
- Solvents, testing materials, and materials employed during processing
- Supply costs
Using the R&D Credit
Note a nonrefundable credit can only be used to reduce a taxpayer's liability to zero. However:
- Any credit not used in a current year can be carried back one year or carried forward for up to 20 years. Amended tax returns can be prepared and filed for years where qualifying activities can be documented.
- Startup companies without an income tax liability may be able to take the R&D Credit against up to $250,000 in employer payroll taxes during the first five years of operations.
- Most states conform to the rules for taking the federal credit. Some states conform, but they have their own rules that must be followed.
As with most deductions and credits taken by taxpayers, documentation and substantiation is imperative. Contact HBK for information and assistance.