The Research and Experimentation Tax Credit offers a route for hemp and CBD companies to find hidden money and increase their after-tax profits.
Alternately referred to as the R&D Tax Credit, it supports companies that create science-based jobs in our economy. The size of the tax credit is based on the amount of qualified research expenditures (QREs) incurred by a company. While some research expenditures related to supplies may count, by far and away the largest single factor is the W-2 wages of employees who perform job activities as defined by Internal Revenue Code Section 41.
There are specific definitions as to what activities constitute a QRE, but each category has room for interpretation. Some companies may be claiming a much smaller amount of tax credits due to adhering to a narrow list of qualifying categories, while others receive much more in tax credits by working with a specialist who can determine if a broader range of activities being performed meet the definition. In reality the process is subjective and the most important part is that all QREs can be defended upon audit. A qualified specialist will be able to both expand the definitions that capture the tax credit and defend each entry so that their long-term track record of tax credit capture has zero clawbacks or disallowances under audit.
It is important to note that the saying "you get what you pay for" rings true here. When evaluating R&D credit service providers, make sure to discuss the depth of scope for QRE definitions and the anticipated total credit amount alongside their fee structure. In some cases, a provider may charge more than a competitor but they plan to deliver significantly larger credits which still net more benefit to the business. Quality counts.
Many companies that create or update products are eligible to receive this tax credit and the legalization of hemp opened this benefit by making 280E, the IRS ban on write-offs related to illegal controlled substances, irrelevant. For most companies, full-time product development engineers' wages come to mind as an R&D expense, but a closer look at definitions and examples may lead to the inclusion of additional wages, supplies, or contract research, which can significantly increase the amount of the tax credit.
This does not yet apply to THC and cannabis until de-scheduling occurs, although that could happen sooner than many think.
Some tasks that can be performed within an organization that can qualify for the R&D Tax Credit are:
New product and process development
Developing new concepts or technologies
Software development or improvement
Automating and streamlining internal processes
Developing tools, molds, and dies
Developing or applying for patents
Design: layout, schematics, AutoCAD
Prototyping or modeling
Testing and QA: ISA 900X, UL, Sigma Six, etc.
Integration of new machinery (CNC, SLA, SLE, etc.) into existing processes
In December 2015, the Protecting Americans from Tax Hikes (PATH) Act was signed into law. It now makes billions of dollars of incentives and cost reduction programs available to startup companies who are not yet profitable.
The definition of a startup under the PATH Act is simply any company formed after 2010, receiving gross receipts for five years or less and with gross receipts less than $5 million in 2016 and each subsequent year the credit is claimed. Qualifying businesses may capture up to $250,000 of incentives and tax credits annually and be able to claim credits against payroll (employer FICA) taxes. Companies that don't meet this criteria still qualify for federal tax credits under the PATH Act with the expanded R&D Tax Credit against income taxes.
A small business qualifying under The PATH Act with a payroll of $250,000 would normally incur $15,500 in FICA payroll tax. An estimated R&D Tax Credit of $16,000 would offset their entire tax liability triggering a refund of employer FICA tax already paid. Many companies with eligible R&D expenses can receive tax credits for up to three years of prior tax returns which often results in a larger one-time cash infusion for the firm, although as of this time the IRS has not provided guidance as to whether 280E will apply for all of 2018 or not, so hemp businesses should focus on 2019 and beyond until guidance is available for prior years.
Lastly, make sure the service comes with significant documentation and an audit protection guarantee.
This is the second of a series of columns by Sean Covi, CFP. Sean works with businesses and their tax planners to help them implement underutilized expense controls that reduce tax and operational costs with an emphasis on improving profit and financial performance. The strategies he brings are often overlooked by CPAs because they are not directly accounting-related, they may not know which programs are allowed within the parameters of code section 280E, or in the case of hemp, they are no longer bound by CSA schedule I or 280E, so many business owners don't even know such tools exist to save them money. Call Sean at (303) 931-3697.