The Agriculture Improvement Act of 2018—also known as the 2018 Farm Bill—federally legalized growing industrial hemp, as well as the sale, transport, or possession of hemp-derived and CBD products. This act not only opened the door for massive growth and innovation in the industrial hemp and CBD industries, but also created the opportunity for companies in these industries to claim eligible federal tax credits, including the R&D tax credit.
The R&D credit has the potential to offset taxable income, helping to reduce a company’s tax burden and increase cash flow. Many companies use these credit benefits to invest in other objectives—such as improving or expanding production, hiring or retaining employees, or developing the next line of innovative products and processes.
What is the R&D tax credit?
The R&D tax credit is available to a broad range of companies in the industrial hemp and CBD industries developing new or improved products or processes.
R&D credits apply directly to offset a company’s tax liability, with the potential to reduce tax liability to $0 for eligible small businesses. There’s no limit on the amount of qualified R&D expenses and credit that can be claimed each year. If the R&D credit can’t be used immediately or completely because the credit exceeds the company’s tax liability, any unused R&D tax credit can be carried forward for up to 20 years. In addition, previously filed tax returns can be amended for up to three years to claim the R&D credit retrospectively, providing an avenue to recoup previously paid taxes.
Startup companies or small businesses in their first five years of gross receipts may also be eligible to apply the R&D credit to offset a portion of the company’s federal payroll tax liabilities, even if the company has minimal-to-no federal income tax liability.
The R&D credit is also available at the state level, with approximately 40 US states offering an R&D credit to offset state tax liability.
How much can a company save with R&D tax credits?
The more a company spends on innovation and development, the more they can potentially recoup in credits. Some clients save a few thousand dollars each year, while others save millions.
The specific amount of credit a company can claim depends on several factors. Generally, the amount of federal credit equals 5%–10% of a company’s R&D expenses for that year, though in some cases the federal credit can be as high as 11%. A company’s total R&D credit benefit can also be much higher if they operate in states with applicable R&D credits as well.
Eligible startup companies and small businesses may also be able to apply their federal R&D credit to offset the company’s portion of payroll taxes if they have little-to-no federal income tax liability. These companies can apply up to $250,000 per year, for up to five consecutive years, of their federal R&D credit to offset payroll taxes.
That’s a potential $1.25 million in immediate applicable benefit to start-up companies and small businesses.
What types of activities qualify for the R&D credit?
The R&D tax credit can include expenses related to a broad range of R&D activities for companies in the hemp and CBD industries. To be eligible for the credit, your company’s activities must meet a series of qualifying criteria, and additional specific exclusions may also apply.
The following list includes examples of potentially qualifying hemp and CBD industry activities companies may be engaging in at each stage of the production lifecycle. Additional development activities may also qualify for the R&D credit.
- Cultivating new hemp varieties and characteristics
- Developing new growing methods and procedures
- Devising new or improved ways to process and harvest hemp
- Experimenting to grow healthier, stronger, and better-quality plants
- Developing and testing new filtration or irrigation systems
- Testing new farming methods to increase crop yield
- Investigating new ways to use industrial hemp fibers
- Developing new hemp-related products
- Formulating new topical creams and other absorption methods
- Testing new CBD oil products and extraction techniques
- Exploring hemp uses in textiles, biofuels, and manufacturing
- Designing and integrating new or improved processing equipment or systems
- Developing custom enterprise resource planning (ERP) or inventory and production management software
What are qualified R&D costs?
Potentially qualified R&D costs are those costs directly related to the R&D activities. For the industrial hemp and CBD industries, those costs generally fall into these categories:
- Taxable wages paid to employees for performing qualified R&D activities, including employees with direct involvement in R&D, as well as employees that directly supervised or supported the R&D projects, such as managers, supervisors, and production teams.
- Contractor expenses for services provided to the company related to qualified R&D activities.
- Payment for supplies consumed during the R&D process, such as seed, fertilizer, and pesticides related to developing new hemp varieties or growing techniques; or materials related to developing new harvesting technologies, processing technologies, or products.
- In some cases, equipment costs if the equipment was custom designed and manufactured or substantially modified. There are several factors that must be evaluated to include equipment costs in qualified expenses, but, if the expenses are qualified, they frequently result in a substantial increase in credit benefit.
What are the next steps?
Documentation is Key
If your company plans to claim the R&D tax credit now or in the future, it’s important to document potential products, projects, or processes that could qualify. Your company’s preparation process should include the following steps:
To start, collect documents that:
- Substantiate R&D expense amounts, including financial, tax, and payroll records—most commonly W2 reports, general ledgers, and fixed-asset reports, though production or project cost detail reports can also be used.
- Establish nexus between the expenses and the R&D activities performed, such as project accounting or time-tracking records.
- Identify and support that the R&D activities qualify for the credit, such as development reports or journals, meeting notes, design documents, patents, and testing documentation.
Seek Professional Advice
Federal and state R&D tax credits provide valuable opportunities to increase cash flow, but claiming the R&D tax credit and documenting your expenses can be complex.
Leveraging R&D tax incentives requires a technical understanding of:
- IRS rules and regulations, including documentation requirements
- Products and processes that are the basis for credit claims
- Recent case law and guidance that have changed the interpretation and application of the rules and regulations
- Impacts of recent legislation on R&D credit utilization and other related tax opportunities
Thorough tax planning and preparation should go into this process before claiming a credit. Penalties and interest can apply if a credit claim is insufficiently supported or fails to follow the applicable rules and guidance.
We’re Here to Help
R&D will be instrumental in helping companies explore different ways to cultivate and produce new products in the hemp and CBD industries, or enhance production to gain a competitive advantage in emerging markets. At the end of 2019, approximately 47 states had enacted legislation to establish industrial hemp cultivation and production programs.
However, with increased IRS scrutiny around R&D credits, it’s crucial to understand what’s necessary to substantiate a credit claim. To learn more about R&D tax credits, see our article, Five Misconceptions About R&D Tax Credits—and Whether You Qualify; our comprehensive guide to federal R&D tax credits; or request a credit benefit estimate to see how much your company could save.