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Cannabis legislation is working its way in many states, and some 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.

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.

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.

Illustration: The license is for an indoor grow, 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. 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 the expenses within the research facility are already deductible, even for a Section 280E company.  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 14 percent of a company’s eligible spending for new and improved products or processes.

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 will not 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, you 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.

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