The Research and Development (R&D) Tax Credit remains one of the best opportunities for businesses to substantially reduce their tax liability.
For what amounts to their daily activities, companies from a wide-range of industries can qualify for federal and state tax savings high to enough to allow companies to hire new employees, invest in new products and service lines, and grow their operations. Now, due to numerous modifications and expansions (especially with the TCJA), more companies than ever before can benefit from this valuable incentive, particulary cannabis businesses.
The cannabis industry, however is currently one that is not using this credit to its full potential. The reason for that is IRC §280E, which states:
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.
However Section 280E has to do with income tax. With the PATH Act of 2015, and specifically the TCJA, qualified small businesses (QSB), can use the R&D credit to offset their payroll taxes. A QSB is described as a company with gross receipts of less than $5 million.
For those still unwarre, the Research and Development Tax Credit is a government-sponsored tax incentive that rewards companies for conducting R&D in the United States. The credit was implemented to incentivize innovation throughout the economy and to keep technical jobs here in the U.S.
However, what constitutes R&D with regard to the credit is much more expansive than business owners realize, with activities related to applied sciences and other technical projects qualifying companies from numerous industries.
If your client does any of the following, they likely qualify for the R&D Tax Credit:
• Develops or designs new products or processes
• Enhances existing products or processes
• Develops or improves upon existing prototypes and software
The payroll-tax offset can only be applied to the Social Security portion of payroll taxes. Companies are required to pay Social Security tax of 6.2 percent on up to $132,900 of each employee’s salary in 2019. For example, a company that employs 50 employees with an average salary of $75,000 would pay approximately $232,500 in Social Security payroll taxes.
Accordingly, a company would need to have more than $4 million in annual payroll subject to Social Security tax and $2.5 million in eligible R&D costs to offset the maximum $250,000 in payroll taxes each year under the new law.
Most employers are required to deposit their payroll taxes to the federal government on a monthly or semiweekly basis as well as file a quarterly payroll tax return via Form 941. However, the credit will be applied against the Social Security tax on the quarterly return—not when it’s deposited monthly or semiweekly.
The IRS is still formulating a plan for how this process will be formally implemented. Instead of the risky part of taking the R&D Credit through COGS, cannabis companies can use it to offset their payroll taxes.
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...