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R&D Tax Credit for Cannabis Industry

The cannabis industry faces a variety of unique obstacles surrounding the research, financing, and other matters due to the legality—or more often illegality—of certain cannabis products at the federal level. As a participant in the cannabis industry, businesses will want to utilize all potential deductions and credits available to maximize income. One major opportunity for cannabis businesses could be research and development (R&D) tax credits.

What is a R&D Tax Credit?

Generally, an R&D tax credit is an incentive offered by the government to businesses that provides a credit for qualified research expenses and payments. R&D tax credits are available for federal tax purposes, and offered by many states as well. The credit incentivizes private businesses to invest their funds into research and development activities that may not have otherwise occurred. This may include experimenting with different fertilizers, plant spacing, climate, or other variables that could affect production. The R&D tax credit can be applied dollar-for-dollar against the company’s tax liability, up to a certain percentage.

Who Can Use the R&D Tax Credit?

The R&D tax credit is available to a broad range of industries and business-types, such as agriculture, food and beverage, manufacturing, finance, etc. Recent changes to the law have made the R&D tax credit more accessible to small- and medium-sized businesses; any business can take advantage of the R&D tax credit so long as the expenses and activities are qualified under the statute and regulations outlined by the IRS.

How Can the Cannabis Industry Benefit from the R&D Tax Credit?

As part of the Agriculture Improvement Act of 2018, Congress removed hemp and other cannabis products with less than 0.3% THC concentrations from the definition of “marijuana” under the Controlled Substances Act (CSA). Since some cannabis products, like hemp and CBD, have been removed from the CSA’s definition of marijuana, cannabis producers are able to utilize R&D tax credit for qualified costs and expenses related to hemp and other legal cannabis businesses.

Notably, cannabis products with significant amounts of THC—i.e., more than 0.3%C—are still considered illegal under federal law, and therefore, they do not qualify for any federal tax incentives. If a cannabis company is growing both federally legal and illegal substances as part of its business, meticulous recordkeeping, corporate entity structuring, and other divisions between the two substances may be required to allow the legal substance activities to benefit from the R&D tax credit. Businesses should consult with their tax and legal advisors to confirm the proper processes and legal requirements.

What Qualifies for the R&D Tax Credit?

To qualify for the R&D tax credit, usually the company must have engaged in qualified research expenses such as (1) wages paid or incurred for services performed by an employee; (2) amounts paid for supplies used to conduct qualified research; and (3) services consisting of engaging in qualified research.

A typical expense that would likely qualify for the R&D tax credit in a cannabis business could potentially include expenses such as:

  • Development of new products (e.g., testing a new formulation of cannabis topical cream; researching new ways to utilize hemp fibers);
  • Exploring the use of LED lighting for indoor growing;
  • New oil products and extraction techniques;
  • Cultivating new types of legal cannabis products;
  • Soil, fertilizer, and environmental experimentation for growing legal cannabis products;
  • Developing new ways to create, process, store, and improve shelf-life of products;
  • Creating a new, proprietary software to help manage the growth schedule and supply chain scheduling of the product; and
  • Studying cannabis for use as a biofuel, textiles, or other materials.

The U.S. Department of Treasury notes that “[w]hether 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.” In other words, the determination is very factual and the success, or failure, of the product being researched does not affect eligibility for the R&D tax credit. Each business will want to assess the activities completed and consult with their tax advisors and legal counsel to determine the best way to utilize available tax benefits.

What Does Not Qualify for the R&D Tax Credit?

Because the R&D tax credit is often determined based on the unique facts and circumstances of each business, there is not a general list of expenditures that do not qualify for the credit. There are, however, several notable exceptions:

  • Research conducted after commercial production of the specific product has already begun;
  • Research related to the adaptation of an existing business component to a particular customer's requirement or need;
  • Research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business components;
  • Any (i) efficiency survey; (ii) activity relating to management function or technique; (iii) market research, testing, or development (including advertising or promotions); (iv) routine data collection; or (v) routine or ordinary testing or inspection for quality control;
  • Research conducted outside the United States, Puerto Rico, or any possession of the United States;
  • Research conducted in social sciences, arts or humanities; and
  • Any research to the extent it is funded by a grant, contract, another person or governmental entity.

An Example Using the R&D Tax Credit:

Imagine that CannGrowers, Inc., a fictional company, creates a new 6,000 square foot facility intended to be used by the company’s master grower and his staff as a laboratory to research new ways to maximize the growing of their legal hemp product. As part of the research, the grow master tests the effect of new light fixtures with the goal of improving both the amount of time it takes to grow the hemp and increasing the amount of hemp produced.

Assume CannGrowers’ research resulted in $40,000 of qualified research expenses for the tax year. CannGrowers’ can calculate a R&D tax credit, using either the Traditional Method or the Alternative Simplified Credit Method.

Conclusion

Cannabis growers, processors, and other cannabis companies can take advantage of federal and state R&D tax credits, depending on what products they are growing, the legality of those products, and what incentives the company’s state specifically offers. Agricultural businesses may also qualify for more than the R&D tax credit.

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