State R&D Tax Credits Can Help Current and Future Growth in the Cannabis Industry

State R&D Tax Credits Can Help Current and Future Growth in the Cannabis Industry

Posted by Jeffrey Feingold on 09.07.18

William Mehi is a Shareholder, and Mark Pessolano a Director of Tax Point Advisors (TPA).  William and Mark together manage Tax Point Advisors’ National Cannabis Industry Specialization Practice.  They contributed to the research for this article.

With over half of the states in the U.S. passing laws allowing medical marijuana, and several states permitting recreational use of marijuana, as well as CBD products, cannabis-related businesses are rightfully looking into tax reduction opportunities in 2018.  Tax incentives at the state level are currently available, and cannabis businesses are now positioning themselves to take advantage of opportunities at the federal level in anticipation of the end of federal prohibition on marijuana. Many states are actively seeking to raise revenue through the encouragement of cannabis-related businesses, and the timing is now right to take advantage of the R&D tax credit at the state level. This is especially the case for cannabis-related businesses that already comply with state regulations and contribute to state tax revenues. 

Research and development is a critically important aspect of the cannabis industry’s current and future growth.  Cannabis growers conduct research to produce better quality plants, and they experiment to produce better strains of cannabis for introduction to the consumers.  For example, many cannabis growers and other cannabis-related companies aim to discover new methods and materials to maximize their crop yields, increase potency, prevent fungus growth, disease or pest infestation, and improve overall quality. Cannabis businesses may collaborate with manufacturers to design and prototype new equipment that can be used in cannabis extraction techniques, or software developers for testing and analysis of new or improved products and their potency.  Cannabis retailers on the recreational side often conduct R&D in packaging and consumer studies.   Pharmaceutical cannabis companies develop different types of tools, techniques, or processes to support their research when dealing with the aspects of the medicinal marijuana treatments for MS, Epilepsy, Alzheimer's and Cancer.  Experiments with indoor versus outdoor environments, lighting, soil, temperature control, watering or processing of the crops are other activities growers already perform and which can qualify for state R&D tax credits. 

Cannabis-related businesses conducting research and development activities may qualify for and benefit from R&D tax credits. Potentially eligible costs for state R&D tax credits include wages, cost of supplies, and cost of testing and contract research expenses.  As the majority of state R&D tax credits align with the federal R&D tax credit requirements, the activities and associated expenditures of a company can often qualify for state R&D tax credit if the activities meet the same four-part test required for claiming any a Federal R&D tax credit: 

  1. Qualified Purpose - The purpose of the research must be to create a new or improved product, process, or formulation, resulting in increased performance, function, reliability or quality. 
  2. Technological in Nature – The research must rely on the hard sciences, such as engineering, physics, chemistry, biology or computer science. 
  3. Elimination of Uncertainty – Activities must overcome some unknowns, such as uncertainty as to capability, optimal design, or optimal methodology. 
  4. Process of Experimentation – Experimentation can be demonstrated through test batches, simulations, systematic trial and error, or other methods of evaluating alternatives to achieve a desired result. 

Cannabis-related Businesses and the R&D Tax Credit 

The proper identification, quantification, and documentation for qualifying research activities and associated expenditures towards the R&D tax credit requires a thorough review of a company’s personnel and projects undertaken. Companies engaging in cannabis-related enterprises often expend time and resources on qualified research that enable taking advantage of the R&D tax credit. 

Some examples of cannabis-related business activities that may qualify for R&D tax credits include: 

  • Experimenting with lighting, fertilizers, plant spacing, and other variables to increase yield or production 
  •  Improving efficiency during growing and harvesting 
  • Developing new strains of cannabis via genetic and cross breeding techniques 
  • Exploring the use of LED lighting in growing indoors 
  • Developing automated systems for indoor growth 
  • Developing new concentrates 
  • More research into hybrid strains for medical use 
  • Cultivation techniques 
  • New and improved edible creations 
  • Topical creams and skin absorption techniques 
  • New oil products and extraction techniques 
  • New Smoking/vaping/dabbing technology 
  • Developing new ways to prevent mold or plant loss 
  • Testing of new filtration systems for air and water 
  • Developing improved technologies for delivery of cannabis-derived substances 
  • Develop new software analytical tools for strand identification 
  • Discovery of new medical treatment methods 
  • Development of new irrigation/hydroponic systems 
  • Testing new equipment to improve or speed up a harvest cycle 
  • Evaluating new or improved technologies in air purification, heating or lighting 
  • Studying cannabis uses for biofuels, textiles and other materials 
  • Implementing new or improved processes to get more accurate readings of a cannabis strain’s potency and related indicators, such as levels of THC and CBD 

Internal Revenue Code 280E 

One other issue to note is that, at the federal level, Section 280E of the Internal Revenue Code was passed in 1982 to specifically prohibit the deduction of otherwise ordinary and necessary business expenses from the gross income associated with the trafficking of Schedule I or II controlled substances within the meaning of the Controlled Substances Act. This leaves “plant-touching” cannabis-related businesses unable to deduct non-Cost of Goods Sold business expenses for federal taxes, as marijuana is still considered a Schedule I substance. This burdensome treatment at the federal level must continue to be complied with for federal taxes until a change in federal law in regards to the controlled substances status of marijuana. 

Exploring State Laws

Although there’s much red tape in the federal aspects of the marijuana industry, states have separate laws that should be explored. Over the past several years, some states, including California, have introduced and passed legislation making it legal to grow, manufacture and use both medicinal and recreational cannabis (also known as marijuana). In fact the California Revenue and Taxation Code (R&TC) conforms with the federal R&D tax credit rules regarding credit eligibility, however the ability of cannabis businesses to claim these credits is much different. On June 27th, 2017, Senate Bill 94, The Medical and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA), passed and partially repealed the previous law and established a new regulatory framework for cannabis businesses in California. The law took effect on January 1st, 2018, effectively legalizing the growing, manufacturing, selling, and use of marijuana (with limitations). Cannabis businesses and tax professionals in legal states should start tax planning around how they will identify and document their state R&D tax credits. Below is a map outlining which states have passed medical or recreational cannabis laws to use as reference when applying for state R&D tax credits. 

 

 

 

 

 

 

 

 

 

 

As Tax Point Advisors provides R&D tax credit study services and other specialty tax services to CPA firms and their clients throughout the United States, the current opportunity for exploration of R&D tax credits by cannabis-related businesses is at the state level. To learn more about R&D tax credits from the experts at Tax Point Advisors, please call us at (800) 260-4138.


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