With the medical use of cannabis products now legal in 37 states and nonmedical (recreational) use legal in 18 states and the District of Columbia, the fast-growing, multibillion-dollar cannabis industry is poised to continue expanding in the coming years. However, since THC, the psychoactive compound in marijuana, remains illegal at the federal level as a Schedule I controlled substance, cannabis companies must navigate a complex legal framework.
Due to the incongruence between federal law and the laws of many states, these businesses face significant limitations when it comes to claiming federal tax incentives—but with the right strategic planning and professional guidance, some of these limitations may be circumvented, thereby opening the door for powerful tax saving opportunities.
Section 280E and Cannabis Companies
Added to the federal tax code in 1982 during the “War on Drugs,” §280E prohibits taxpayers who are engaged in the business of trafficking Schedule I and II controlled substances from deducting ordinary business expenses associated with those activities. This includes virtually all tax deductions and credits unrelated to the cost of goods sold (COGS). As a result, many cannabis companies find themselves facing significantly higher tax burdens than those in other industries as a result of §280E—despite the legality of marijuana according to the states in which they operate.
Fortunately, there is one key way to reduce the impact of §280E. Cannabis-industry businesses may be divided into those that “touch” the plant and its derivative products—such as those that perform cultivation, lab testing, distribution, and sales—and those that do not. The latter group, also referred to as ancillary businesses, includes construction companies that build dispensaries and other cannabis-related buildings, landlords, companies that create packaging for cannabis products, companies that provide software and tech products to help cannabis businesses operate, and many others. Companies that touch the cannabis plant are subject to §280E, while ancillary businesses are exempt from it. In addition, businesses that only work with hemp-derived and non-THC cannabidiol (CBD) products—which are now legal at the federal level—are exempt from §280E.
By setting up a corporate structure that separates the plant-touching side of the business from the non-plant touching side, cannabis companies can avoid some of the limitations of §280E and significantly reduce their tax burdens. For instance, companies may create a separate corporate entity under which real estate assets are held. The real estate company—which is not subject to §280E—then leases property to the plant-touching aspects of the business. The key is to establish as much separation between the entities as possible, and keep meticulous records relating to expenses and employees’ activities. By doing so (with the assistance of tax and legal advisors who have experience in the cannabis industry), companies may be eligible for valuable tax savings opportunities such as the Research and Development (R&D) Tax Credit, the §179D deduction, and Cost Segregation.
R&D Credit for Cannabis Companies
Created in 1981 with the goal of incentivizing technological advancement and innovation, the R&D Tax Credit remains one of the federal tax code’s most lucrative incentives for businesses. The Credit rewards a broad range of activities related to the development of new or improved products, processes, or software, as long as the activities satisfy a four-part test:
- The purpose must be to create new or improve existing functionality of a business component.
- The taxpayer must seek to discover information that would eliminate uncertainty regarding the development or improvement of the business component.
- The taxpayer must engage in a systematic process of experimentation, ranging from an informal trial and error process to implementation of the scientific method, designed to evaluate one or more alternatives.
- The process of experimentation must be technological in nature, fundamentally relying on principles of the physical or biological sciences, engineering, or computer science.
For businesses in the cannabis industry, a wide variety of activities may satisfy this test, including those related to growing plants, designing or improving equipment, developing new consumer products, and many others. In order to qualify for the federal R&D Credit, however, it is essential that the company and employees performing the R&D activities are not involved in the plant-touching aspects of the business. This may be done by a separate entity or consulting firm that is not involved in the actual manufacturing of the cannabis.
In light of the federal limitations, cannabis companies may have the highest chance of success by pursuing state R&D credits. Activities that meet the qualifications for the federal credit will typically qualify for state-level credits, which may be even more generous than the federal version.
179D Deduction for Cannabis Companies
Now a permanent part of the federal tax code, §179D provides a deduction of up to $1.80 per square foot (indexed for inflation) for the installation of qualifying energy efficiency measures in commercial and public buildings. Specifically, the deduction is worth up to $0.60 per square foot each for improvements to a building’s interior lighting systems, HVAC and hot water systems, and the building envelope.
For cannabis-industry businesses seeking to claim the §179D deduction, it’s essential to take the deduction through a separate, non-plant touching entity (which then leases the building in question to the plant-touching business). To qualify for §179D, measures installed must reduce energy and power costs by 50% or more compared to a building that meets the minimum requirements set by the ASHRAE 90.1 Standard that was in effect two years before construction began. Projects must be certified by a third party, such as CRG, using Department of Energy-approved software.
Cost Segregation for Cannabis Companies
Companies that own their buildings may also benefit from Cost Segregation, an IRS-approved strategy that yields more substantial and immediate depreciation deductions by simply reclassifying certain assets within a building. Typically, real property is depreciated over a 39-year period, while tangible personal property is depreciated over 5, 7, or 15 years. A Cost Segregation study examines certain assets within a building and identifies those that could be reclassified as personal property. For cannabis companies, these assets may include grow lighting, specialty systems for climate control, and irrigation systems, in addition to standard building features such as floor and wall coverings, plumbing fixtures, and electrical wiring.
By reclassifying real property assets as personal property, Cost Segregation allows the building owner to take advantage of the shorter depreciation lives and claim accelerated deductions, thereby minimizing taxation and boosting cash flow. While Cost Segregation is available for any commercial buildings that were placed into service after December 31, 1986, the optimal time to perform a study is within the first year after the building has been purchased, built, or remodeled in order to begin maximizing depreciation deductions as soon as possible.
For businesses in the cannabis industry seeking to reduce their tax burdens, the key is to work with experienced tax and legal advisors in order to set up the right corporate structure and take the proper steps to ensure that they are staying compliant with state and federal law. At CRG, our team has the skill and expertise needed to help clients in this burgeoning industry maximize savings through incentives such as the R&D Credit, the §179D deduction, and Cost Segregation. Contact us today to schedule a consultation!
(Sources: https://www.ncsl.org/research/health/state-medical-marijuana-laws.aspx,https://www.jdsupra.com/legalnews/section-280e-and-the-taxation-of-5068426/,https://www.cannabisbusinesstimes.com/article/r-and-d-tax-credit/,https://www.leafly.com/news/industry/cannabis-business-models-101).