How to Make Use of R&D Tax Credit for the Cannabis Industry
Cannabis legislation is working its way in many states, and some — including California — have made it legal to use, possess and share cannabis. Tax professionals need to know how recent legislation on the drug can affect a taxpayer’s return, such as for growers on how they can make use of research and development expenses as a tax credit.
What I did this summer was meet with an emerging company on the cannabis forefront in the Northern California area, whose thoughts on cannabis were completely different from any other cannabis business that I have run across. Most outsiders see legal cannabis, whether medicinal or recreational, as a few things. Some people are in it for the money that they think they are going to make; they see it as the new gold rush.
The reality is that states allow cannabis because the industry is taxed so heavily, by both the state and the municipality that these cannabis companies operate in, that they are willing to run afoul of federal law. While others see cannabis as a way for current users to either get high by making up pretend medical conditions to get their prescription. (Editor’s note: Read this article on the difference in using the words cannabis and marijuana.)
This company has an entirely different approach; they are going after the new license that California is offering, called a Micro-Business License, which allows the business to grow cannabis, transport the drug, and open a dispensary all with one license. For those of us in the accounting world, we can see that whoever controls all of these costs and taxes can also control the market with price.
This is important to the company’s Master Grower because he wants to devise different strains of the cannabis plant to find the best medicinal product to give to patients. (On a side note, Master cannabis growers have the education and experience necessary to successfully cultivate [and sometimes breed] large, resinous flowers that have few [if any] seeds. They know how to control every aspect of cannabis' life cycle, and they are knowledgeable about the best ways to deliver water, light, and nutrients according to the preferences of different cannabis strains.) They seek to deliver the medicine that these patients need at a price they can afford. Having worked intimately within the cannabis industry, I can appreciate this admirable approach.
The first step for this developing start-up was to evaluate the initial costs. I got heavily involved in price negotiations with the owner and outlined different models and ideas whereby they could save money (about 60 percent on their start-up costs) and still get the supplies they need. Soon after that, they asked me to join them on their journey. Now I’ve been asked to be in business with clients before and have worked out various deals through the years. Sometimes they pan out, other times not so much. In this case, I not only wanted to be there for the ride, I wanted to make my client’s dream come true.
I was watching 60 Minutes one Sunday and saw a story about how the federal government wanted to study the effects of cannabis and its medicinal properties. But since cannabis is a Federal Schedule I drug, it doesn’t grow enough to do research. Enter the universities. My alma mater, UCLA, has the Cannabinoid Affinity Research Institute (a cannabinoid is a derivative of the cannabis plant). There are different types of cannabinoids that can do different things, such as CBD oils, which are currently sweeping the country.
Here is where it gets interesting: There are different types of CBD oils. Those that are being shipped across the country contain trace amounts of the substance in cannabis that creates the user’s high, called THC. These oils are mostly derived from the hemp plant (which is related to the cannabis family). However, there are other CBD oils that contain various levels of THC that cannot be shipped across state lines.
The makers of any CBD oils are subject to Internal Revenue Code §280E, which was put on the books in the early 1980s by Congress and affects those in the legalized cannabis business today. Basically, Section 280E states that anyone involved in the illegal drug trade (on a federal basis) can only deduct the cost of goods sold (COGS) of the product. There are several court cases that address all of this, but this isn’t an article on Section 280E. This one is about how this Northern Californian Company is going to make these research and development expenses a tax credit.
The California company that I am involved with is starting with the “grow facility first, rolling out the other models later” approach. That being said, we are working on the land — which happens to be located right behind a police station — and providing the attorneys. The situation elicits quite a few chuckles at the irony.
The license is for an indoor grow, so in working with my partners to design the facility, we need to build a 12,000-square-foot facility. About 4,000 square feet of this will be dedicated to the research facility, which will act as the Master Grower’s laboratory, if you will. Within those confines, the Master Grower is allowed enough room to experiment with different fertilizers, lighting equipment and other things to make better strains of cannabis.
All of the expenses within the research facility are already deductible, even for a Section 280E company. However, I want a tax credit. Those costs will provide both an expense through COGS, and a Federal Research and Development (R&D) Credit — that is, dollar for dollar against what the company’s tax liability would normally be.
Enacted in 1981, the R&D Tax Credit allows a dollar-for-dollar tax credit of up to 13 percent of a company’s eligible spending for new and improved products or processes. Before leaving office, President Obama made the often-misunderstood R&D Credit a permanent fixture of the tax credit landscape.
To qualify for the R&D Credit, qualified research must meet the following criteria:
- New or improved products, processes, or software
- Technological in nature
- Elimination of uncertainty
- Process of experimentation
Eligible costs include wages, cost of supplies, cost of testing, contract research expenses, and costs associated with developing a patent. Briefly, these expenses are deductible, but they qualify for a potential dollar for dollar tax credit for any company involved in these processes.
With a grower using Generally Accepted Accounting Principles (GAAP), which is just the accrual method of accounting, most expenses within the grow would be deductible as COGS. For example, the cost of seeds, water, rent of the land, labor to cultivate the land, utilities, even owner’s salary if they are involved in the harvesting of the plant, would be deductible. However, there will be some expenses that won’t be allowed.
For instance, transport to the buyer of the cannabis would not be deductible because it is considered drug trafficking. Salaries and wages for office staff would not be deductible. Nor would the state and local taxes that are paid on the cannabis.
That being said, there will be Federal Income Tax for the grow facility to pay. However, when the research portion is up and running, we will have to segregate those expenditures because they will be used as a credit to offset any taxes that may be owed by the grow division.
Shockingly, there are more and more companies that are subject to the R&D Credit. I have landed clients due to the simple fact that I knew they were subject to the R&D rules.
Cannabis is definitely subject to those credits, so why not use them?
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Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...