In this episode, Jim breaks down how cannabis companies can take advantage of Research and Development (R&D) Tax Credits.
- Mitigating 280e conflicts
- Which expenses qualify
- Which activities (that you’re already doing) will qualify
If you would like to take advantage of the R&D Tax Credits, then please reach out to us at https://GreenGrowthCPAs.com/get-started or call 800-674-9050
Hey, everyone. Thank you again for joining. For today’s Webinar, we’re gonna be talking about R&D tax credits for the cannabis industry. My name is Jim Breese and I’m the Chief Marketing Officer here at GreenGrowth CPAs. And I want to give you a little bit of color and context around who we are at GreenGrowth CPAs. So, we are a cannabis only compliance tax finance firm, right? We only work with cannabis clients, nobody else. And so we specialize in technical accounting, operations, finance, audit services, IPO services, business formation. Pretty much anything that has to do with the cannabis industry we can help you out with. We’ve helped prepare over 1,200 annual tax returns for cannabis operators spread across all verticals, dispensaries, distribution, cultivation, manufacturing, delivery and testing. We have over 350 cannabis business clients spread across 12 states and over the past two years we’ve done 15 audit and valuation related projects.
So, helping people do M&A deals and make sure that their companies are being valued at the proper valuation, doing the due diligence for the people that are buying those companies as well. We have a thorough and deep understanding of tax compliance and assurance related requirements for the cannabis industry. So, anything you need for your cannabis business, we can help you out with that, or we can put you in contact with the right skilled team that can help you out with that task. So, before we hop into today’s presentation, I need to let you know that the information contained in this webinar presentation is meant for guidance purposes only and not as professional legal or tax advice. And further, it does not give any personalized legal tax investment or any business advice in general. So, with that out of the way, let’s hop right into today’s agenda.
So, first we’re going to cover the history of R&D tax credits and then talk about the conflicts that it has with 280e –our favorite thing to talk about, right? And why use R&D tax credits? Then we’ll define what R&D actually means, “research and development.” When you hear that you probably think lab coats and really high tech bits and bytes and gadgets and all that. But I’ll actually pull the cover back and show you what R&D actually stands for and the IRS’s eyes. And then we’ll define what qualified research actually is, give you some indicators and examples of qualified research. And then we’ll talk about which expenses actually qualify or QRE (qualified research expenses). And then we’ll talk about the R&D study methodology.
So, let’s just quickly go over the history of R&D tax credits. So, it was initially introduced in 1981 in the basis of it was to incentivize companies to invest in US innovation. They want to reward companies for doing that research and that R&D state side. And it did expire, but it keeps coming back year after year. The IRS keeps renewing it and that’s a great thing for companies just like yours. And one thing to understand is this not a tier one issue, which means it’s not subject to audit scrutiny. So, once you take this credit, it doesn’t necessarily trigger an audit for your company, which is good. It gives you some kind of peace of mind and some air cover to know that you can take these credits without triggering an audit and creating more problems for yourself.
One of the biggest things that happened in 2004 was that there was an update to it and what it said was that the R&D that you’re doing doesn’t have to be new to the world. It just has to be new to you, the taxpayer. Another update from there is that it doesn’t have to be just for products. They also opened it up to process improvements and these can be ongoing process and improvements in year after year. You can take advantage of these credits, and a third aspect of that expansion and update was it an expanded who the qualifying employees are. So, it used to be just the people that were directly doing the R&D or doing the research and development, but they realized that a lot of time is being taken up by support and supervisory roles and people that are actually making sure the research and development actually happens. So, the IRS expanded who you could claim under qualified research expenses, the wages and the salaries of supervisory and support roles. So, that’s very, very good for you and your company. It expands the scope of how you can take advantage of the R&D tax credits.
So, as we all know, 280e it’s the biggest tax code that has to do with anybody dealing with a Schedule 1 Substance, which cannabis is, and so, 280e disallows any credits or deductions that are not COGs (or cost of goods sold). So, to help take advantage of R&D tax credits, what you can do is create a separate entity just for R&D, which would become a third-party, which we’ll talk about later in this presentation. And when you do create that third-party R&D firm for your cannabis company, it’s a whole separate legal entity, you create a contract manufacturing service relationship with that company and then you can start to take advantage of these R&D tax credits. So, as you can see in the map here, a map from kbkg.com, many, many states, nearly all of the states offer some type of R&D tax credits in some capacity. Some offer them for longer terms, some have higher deductions you can take from them. But as you can see here, if you have a cannabis company that is based in one of those maroon states, and the R&D is taking place in one of those states, then you can take advantage of the R&D tax credits for your cannabis company.
So, you may be asking, “hey, why should we even take the time to take advantage of R&D tax credits?” Well, right away it’s immediate cash. You get $0.13 back for every dollar spent on qualified research in California at 6.5%. And at the federal it’s also 6.5%. What this can do is a dollar-for-dollar tax credit. So, it reduces your taxes at a federal and a state level. So, if you have $1,000 tax bill and you have $1,000 in tax credits, you now have a zero tax bill, which is great. So, that’s a main reason of taking advantage of R&D tax credits. Now what’s good is that it’s available for open tax years, meaning that if you didn’t take advantage of it in prior years, you’ll be able to go back and reclaim those credits. So, for the federal, it’s three years back, and then for California it’s four years back. You can check with all the other states. So, if you’re based in Oregon or you’re based in Michigan, or any other state you’ll have to check with that statute is. But for California it’s four years. Another thing that is great is it can be carried forward. So, if you’re a startup and you’re not having revenues, so you have no tax exposure on that end, then you can carry these things forward. So, for federal taxes, it’s 20 years, you can carry it forward. And for California it’s indefinitely you can carry it forward.
Now understand that this is applicable to any vertical in the cannabis industry. You’re pretty much eligible in any part of the industry. 95% of the people that are eligible, probably even 98%, don’t claim these credits because they don’t even know that these exist. And a lot of people ask us, “hey, is this even a real thing?” Yes, these are real credits. Just because you haven’t heard of it or you think that your business doesn’t do technology or some kind of research and development that you can’t take advantage of this–yes, you can. And it’s in your best interest to at least do an initial study to see if a claim or a credit is available for your company.
So, let’s define what R&D actually is. You know, I want you to understand that it’s not what you think in your mind, but it’s what the IRS defines R&D, right? It’s not just lab coats or world-changing technology, 5G LTE, small little boards and whatever. These kinds of things that you think in your head are R&D. It’s not limited to just that. So, the IRS says it has to be a new or improved business component to the taxpayer and not to the world. So, a product, a process, a technique, a formula, an invention or a software item. So , I’m sure as you start to hear them you’re like, “hey, we have products.” “Hey, we have processes, we have new formulas, we’re inventing things. We build software.” Yes, that is R&D and it doesn’t have to be big or world changing and it doesn’t have to be successful either. Sometimes when you’re developing new processes or new products, they don’t ever see the light of day. They never get to market. But you did have expenditures of doing R&D and trying to figure out a problem and relieve uncertainty in your business and you can still claim tax credits even if your project wasn’t successful.
What’s great about the R&D is that it’s not just in one phase, it covers from start to finish. What we’ll talk about here is a 4-part test and one of those parts of that test deals with uncertainty. So, all the expenses that you put out while dealing with uncertainty, it covers from the start of that uncertainty to the end of that uncertainty, which is great for you because again, it goes over time and it can be staggered year, over year, over year, and it takes a 4-part test to qualify and define what R&D is. And we’ll hop into understanding that process right now. So, qualified research, it’s a 4-part test, alright? I think I said that three times now, but it’s a 4-part test. And so, the four components of it are basically this. It needs to be a permitted purpose.
So, again, it’s gotta be for a product, a process, a technique, a formula, invention, or a software item, and this has to be new or improved. So, again, it doesn’t have to be new to the world, it can be just new to your company, or if you’re doing process improvement that works as well. Or technique improvement or improving a formula that works as well. That would qualify under the first part. And I didn’t say this yet, but you have to hit all four pieces of this test. It’s not just one or two or three. You have to hit all four pieces of this test. So, as long as you’re starting out with the permitted purpose, great, you’ve got one checkbox done there.
Now the second part, it has to be technological in nature, which means that it has to rely on hard sciences like engineering, chemistry, the physical sciences, mathematics, physics, biology, computer science, things like that, right? Not things like social sciences, like arts or humanities. So, if you’re developing a new business component as technological in nature, boom, we’ve got two boxes checked off here.
Now the third part is you have to eliminate uncertainty. So, when you’re doing something, an activity must be undertaken to discover information related to uncertainties regarding the capability or method for developing or improving a product or a process. Uncertainty may exist as to the capability of the methodology or design. You may be asking questions like, “hey, is it possible to develop the business component at all? What is the optimal design of the product or the process, and what is the best way to achieve our desired results?” There’s going to be a risk of failure there. If there’s an understanding that there’s that risk and you qualify for that third part of elimination of uncertainty, right? When you have multiple options or multiple ways to accomplish something and you are doing business activities to relieve that uncertainty, you qualify under that third part there.
Now the fourth part of this test is actually the process of experimentation. So, you must test one or more ideas or concepts to overcome that uncertainty. You can’t just think about it, you actually have to do it. So, something like setting goals, and then brainstorming with your team on what you want to do, and then creating a detailed development process or plans, and then go into prototyping out those plans and be creating processes or products. And then you actually test those out and you look at the data, and analyze the data and make conclusions, and you modify whatever that process is. And then you repeat that testing, and you continually iterate over this product or this process until you finally relieve that uncertainty. So, if you hit all four of those permitted purpose, technological in nature, elimination of uncertainty and process of experimentation, then that is qualified research.
So, now that you understand the 4-part test, let’s give you a few more things to think about, right? Some indicators of qualified research that your company may be doing. So, do you have an R&D department, people that are actually doing research and development? You almost surely have some ability to take R&D tax credits. Do you employ scientists or chemists or product engineers? How about process engineers? What about doing product development? I’m sure most people that are in the cannabis space since it’s been, you know, sitting on the fringes of society, not many people have been out there doing new and great product development. There’s been a lot of great product development. I don’t want to make light of any of that. But you’re seeing more and more and more product development, process development, software development coming out there because people are now seeing this is not a gray industry, it’s becoming more black and white. It’s becoming more accepted as a place to work at. Do you have technology that you’ve been developing and getting patents on? These points here are indicators that your company is doing qualified research and development for tax credits.
So, let’s make it a little more concrete. I want to give you some examples of qualified research, even talking about some products or things that you may be doing in your cannabis company already. So, there’s a lot of manufacturing out there creating new products. So, think about maybe you as a cannabis manufacturer have done pilot runs. You’ve done, “hey, we’re going to create 1000 units of something or 300 units of something to see if it actually works, from going from 3D printing to some kind of manufacturing process?” All right, great. So, that qualifies potentially as R&D tax credits. But then you say, “all right, we did a thousand units, we want to go to 10,000 units.” That’s called a scale-up for production. What that does is it introduces new external factors that create even more uncertainty. So, you may be able to get qualified R&D credits or research under that scale-up process because of that uncertainty, right? You have to create new process improvements. You have to create new manufacturing equipment, potentially, you have to do quality assurance processes for your product and make sure that it’s actually performing the way you thought it would perform from that prototype to the small test and now to this scale-up. So, a lot of you manufacturers out there, you may be able to claim R&D tax credits.
Now there’s a lot of people here engineering new consumer products. So, you’re designing something totally new or maybe it’s an improvement on a current product out there in the market and you’re going out there to get patents for it. This could be an example of qualified research for your cannabis company. Now think about agriculture and cultivation. What if you’re doing improved irrigation techniques. You’re finding a drip system that works for your company and for your grow operation. Maybe you’re having to dig new wells and improve on that irrigation or water saving techniques. Now what about thinking about totally new growing and harvesting techniques? Are you guys figuring out new ways to grow the plant to increase the yield per plant or for the space or for the height or whatever you’re thinking about doing? Or do you have these new harvesting techniques? That could be qualified research potentially.
Now if you’re in California, you’re very well aware of track-and-trace. And under this qualified research, track-and-trace methodology, especially if you have to do a full custom process, especially for these vertically integrated partners out there and businesses out there, where you have to go from raw materials to distribution all the way out to that end consumer. You may be able to qualify for these tax credits because you’re developing that full custom process, how you actually integrate metric, which is the track-and-trace system out in California into your business. You may have to develop something very, very custom and detailed in nature. There’s processes that come along with that.
And lastly, software. Now this is kind a gray area due to how are you actually using this software? Is it for internal processes or for external use as the customer? So, if you’re developing software, you have to think about, well there’s a lot of stuff that goes along with that. QA and Dev and testing and planning out what is the best implementation for the code base and creating the source code in this way or testing out few libraries for it.
So, these are examples of qualified research and hopefully they start to get your wheels turning like, “hey, we do some of these things.” “Hey, our cannabis company actually participates in these activities.” All right, so now you understand the activities. What expenses are actually qualified research expenses? Well, it hits into three different prongs. So, we’ll start first with salaries and wages and this is the bulk of the credit, okay? So, with this breaks out to is if someone who is a qualified employee that’s working on a project for you and 50% of their time is spent on that project, then 50% of their taxable wages is going to be qualified research expenses.
Now there is this thing out there called the “substantially all” rule. And what it says is that there is a break at 80% if someone is spending 80% of their time working on a project and you could reasonably claim 100% of their wages are qualified research. The second part of qualified research expenses is supplies and this is non-capitalized expenditures. So, things that are consumables and raw materials. And it qualifies if when they were used, uncertainty was involved in the process, right? So, it’s not the ongoing of, “now that you scaled up your manufacturing, all the kinks are worked out and you want to start qualifying ‘ongoing expenses’ that are not part of your uncertainty,” that’s not going to work out. So, non-capitalized expenditures that had uncertainty involved in the process of using them–that qualifies.
And then lastly, third-parties, we talked about this earlier. Hey, 280e is going to throw a wrench in this because you can’t take credits as a person who is conducting business with a Schedule 1 Controlled Substance. Well, this is where that third-parties come in. So, #1 if you are engaging another third-party that you do not own, that’s fine too. So, third-parties or someone who does the R&D on your behalf and that work needs to be done in the U.S. and the state of the tax return that you’re going to be filing that credit for. And I believe that is going to be 65% of the payments to that third-party. So, it’s in your best interest to start thinking about this because if you start thinking, “hey, we spent $200 thousand, $800 thousand, $3 million on potential R&D, wow, that is some good money,” dollar-for-dollar tax credits that you can get back and save a ton of money for your cannabis company that you can actually reinvest into your company, pay back to your employees as bonuses or whatever you’d like to do with that money.
So, how does the IRS know that you’re not just making this all up? There’s gotta be some way that you document this, right? What are the methodologies behind all of this? So, the IRS knows that you weren’t planning to do R&D to get a tax credit, right? So, they have created a set of acceptable methodologies in reasonable ways to document your R&D to make sure that you can qualify for these tax credits and depends on the materiality of the credit, right? So, someone who’s taking $1,000 in R&D tax credits versus someone who’s taken $10 million in R&D tax credits, actual documentation and methodology will have to be a little more robust there. So, what you need to do is capture the supporting information around your R&D projects.
So, if you’re starting off, you’re new, I would highly suggest you get a project accounting system. It’s the most ideal way to do this. And what that is is that R&D activities, and pretty much any activity, is tracked by employee and by project. So, costs for the supplies, cost of person’s time, third-party expenses that go out there. Right? This is a very, very detailed way to do it. If you’re a startup, it’s easier to implement this way, because you’re new and you don’t have a bunch of antiquated systems that are holding you back.
But time allocation studies are actually the most common way, and what this is, is pretty much a breakdown of testimony from employees. We say, “hey, we interview them and they say, ‘hey, I spent 10% of my time working on this project. I spent 18% of my time working on this project,’ and whatever that’s going to be.” And then you get supporting documentation to create a connection between the qualifying employees, the supplies, and the contractor costs with specific projects that meet that 4-part tests we talked about earlier in this presentation, right? Qualify documentation can be project plans, test results, design review, meeting minutes, emails, calendars, all those kinds of things that go along with attaching real results or participation and effort into qualified projects that can be considered documentation in drawing that connection between the employees, the project, the costs and all that stuff related to the project.
Now, you may be saying, “hey, we’re a startup. We have no taxable income. What’s the reason for doing these tax credits? What does it matter? We are not going to be reducing our tax burden.” Good point. But if you think about it from a tax perspective and something I talked about earlier, the “carry forward.” Okay, so keep documenting and capturing all of your expenses. Maybe make journals. If you don’t want to create a project accounting system, keep detailed journals, make sure you don’t delete any emails, keep all of the project plans and the test results and your review meeting minutes. Because if you start to do that and capture that, once you start to generate revenue, we can carry forward these expenses again in the federal for 20 years and in California, for indefinitely, right? So, make this part of your workflow asap, right away. Especially if you’re doing this R&D as a manufacturing company, as a product company, it’s in your best interest to do this. It’s not hurting you. It’s pretty much a small little diary that could pay off huge dividends in the future. So, how do we actually perform an R&D study, right? So, it’s not too intense. Actually, you can be as involved or as distant as you want as the cannabis business operator, right? We’re going to help create a team that’s going to come out to your business and help you do this, okay? And what we’re going to do is we’re going to meet and interview key team members, the technical people, the financial people of your business, and see what you actually do. Go through all of the details and see if a credit is available and can even be utilized by your company.
All right, so then if we see that, hey, there’s a potential for an R&D tax credit for your company, then we’ll step into the implementation phase. This combines a lot more interviews, so what we’re going to do is meet with more people within your company, more technical people, more financial people to identify and qualify all of the people and projects that could fall under qualified research. Then we’ll take the time to quantify the costs, discuss and review the documentation involved in this R&D tax study, and then we’ll perform the calculation for you. I don’t want to get too detailed into the calculation part of it, but we’ll do all those calculations for you. And once that’s done, we’ll produce a technical report for you that you can use as a roadmap for the IRS and for audit support. It’ll include the methodology, again, audit support information, and then we work with your CPA, if we’re not your CPA already, to help amend and file returns for those prior years, and then create a schedule, especially if you are a startup now going forward for that “carry forward.”
And then one of the most important parts is that will help to build and implement processes for going forward so that you have the ability to document at a more granular level and more accurate way of what qualifies under these R&D tax credit, so that you can continue to take advantage of this year, after year, after year. So, the work we do at the beginning will help pay off for years and years ahead. Again, you can be as involved or distant in this process that you want. Some people that we work with say, “hey, just come in and do it.” And some businesses want to be real deep in their nitty gritty, but I get it. You’re busy. You don’t have a lot of time to do and be involved in this R&D tax credit. And that’s why you pay us to come and save you this money.
What’s great about this is that it’s not a flat fee. It’s just a percentage of what we can save you. So, we’re incentivized to find the most things because we get paid more when we help you save more. So, that’s what the best part about this is, is that our incentives are aligned. We’re trying to help you, not just now, but again for the future and help you build and save and save and reinvest into your company.
So, let’s discuss some key takeaways about R&D tax credit. So, I really need you to understand this. Lots and lots of projects qualify for R&D tax credits. Again, it doesn’t have to be groundbreaking, world-changing technology. It doesn’t have to be new to the world. It just has to be new to you, the taxpayer, okay. And it has to come in, fall under, and qualify under this 4-part test, okay.
The 4-part test is permitted purpose, technological in nature, has to have the elimination of uncertainty as it’s goal, and a process of experimentation has to happen. And what falls under qualified research expenses is salary and wages, supplies that are not capitalized and third-party vendor costs. And these can be recovered from three to four years back depending on federal or state level and which state you’re in, as well as, carry forward for 20 years or even indefinitely if you’re in the state of California. So, it’s in your best interest to get this R&D tax study done for your business.
So, if you’re interested in taking advantage of R&D tax credits in getting an R&D tax study for your cannabis company, then, please, reach out to GreenGrowth CPAs by going to our website at greengrowthcpas.com or giving us a call at (800) 674-9050. We’d love to help you take advantage of this very little known tax credit and really help your business and help you level up and even jump ahead of your competition. If you’re able to take advantage of $10,000, $100 thousand in credits, what could that do for your business? How would that change your business? So, again, thank you for taking the time to sit and listen and understand and try to learn about these tax credits. Hopefully this video and this presentation has brought you some value. Again, give us a call at (800) 674-9050 or visit our website at greengrowthcpas.com. Thank you, again. Have a great day and we’ll talk to you soon.