The Complexities of Research and Development Taxation in California’s Cannabis Industry

LOS ANGELES– In recent years, the U.S. cannabis industry has experienced unprecedented growth, with a majority of states embracing its medical applications and an increasing number legalizing adult use. This surge in acceptance has been fueled, in part, by extensive research and development (R&D) efforts aimed at improving the quality of cannabis plants and exploring their therapeutic potential. However, the comprehensive nature of cannabis R&D comes at a significant cost, involving investments in personnel, procedures, software, and equipment.

In most industries, businesses can recoup some of these expenses through the federal R&D Tax Credit. Unfortunately, due to the classification of tetrahydrocannabinol (THC) as a Schedule I substance under the Controlled Substances Act, cannabis enterprises are barred from claiming federal R&D credits under the Internal Revenue Code (IRC) §280E, which disallows deductions and credits related to the “trafficking” of controlled substances. This limitation places significant restrictions on the ability of cannabis businesses to benefit from the federal R&D tax incentives.

However, California, known as the Golden State, offers a glimmer of hope for cannabis businesses seeking tax relief. Despite federal restrictions, the state of California provides a favorable environment for cannabis enterprises to claim deductions on their state income tax returns.

The evolution of California’s tax laws for cannabis businesses began with the passage of Proposition 64, legalizing both recreational and medicinal cannabis. Subsequently, the state introduced the Medicinal and Adult-Use Cannabis Regulation and Safety Act (MAUCRSA) to regulate the industry. However, at that time, California still adhered to IRC §280E, which limited the deductibility of business expenses beyond the cost of goods sold for cannabis businesses, except for C corporations.

The tide turned with the enactment of Assembly Bill 37 in October 2019, which eliminated California’s compliance with IRC §280E for licensed Personal Income Tax (PIT) cannabis businesses. This includes sole proprietorships, partnerships, PIT investors in S corporations, and Limited Liability Companies (LLCs) treated as partnerships and their members.

Under Section 17209 of the California Revenue and Taxation Code, licensed cannabis businesses can now deduct ordinary and necessary business expenses on their California income tax returns. This change applies to taxable years beginning on or after January 1, 2020, and before January 1, 2025.

It’s worth noting that businesses dealing with hemp-derived cannabidiol (CBD) products, which do not contain THC, can claim the federal R&D credit. These products were legalized under the Agriculture Improvement Act of 2018 or the 2018 farm bill, as long as they comply with federal and state regulations and are produced by licensed growers.

To qualify for the California R&D Tax Credit, research activities must be conducted within the state and meet the same criteria as the federal credit. These criteria include developing new or improved products, processes, or formulations and engaging in technological research that addresses uncertainties. The credit amounts to 15% of qualified expenses exceeding a base amount, plus 24% of basic research payments. Eligible R&D expenses typically include wages for employees involved in R&D activities, supplies and raw materials, and expenses paid to third-party contractors for R&D services.

C corporations, S corporations, LLCs, and partnerships can claim the California R&D Credit by submitting form FTB 3523, Research Credit, along with their California income tax return. If the credit exceeds the company’s state income tax or franchise tax liability for the year, any unused credit can be carried forward to future years until fully utilized.

It is essential to understand that claiming the California R&D Credit and documenting eligible expenses can be a complex process. Strict criteria must be met, and contemporaneous documentation establishing that the R&D occurred during the tax year for which the credit is claimed is required.

California’s progressive approach to cannabis taxation provides a promising outlook for businesses operating in the cannabis industry. These changes may also encourage other states to reevaluate their tax laws, potentially ushering in a new era of growth and prosperity for the cannabis sector across the United States.

Editor: We’d like to thank Abraham Finberg, Rachel Wright and Simon Menkes of 420 CPA – ABFinWright LLP for permission to reproduce this article originally made for posted on their 420CPA Blog