“Cannabis companies should consider various pitfalls to ensure not only legal compliance, but to maximize potential benefits.”
By Meeren Amin, William Bogot and Douglas W. Charnas, Fox Rothschild LLP
With rescheduling of medicinal marijuana and potential relief coming for recreational use, cannabis companies should be aware of tax benefits available to the industry.
One such incentive for companies not subject to Internal Revenue Code (IRC) § 280E—which blocks tax benefits to entities that sell Schedule I and II substances—is the IRC § 41 R&D (research and development) tax credit. The R&D tax credit provides a dollar-for-dollar reduction of tax owed for qualifying companies. It is not industry specific and can be claimed by a qualifying company in any sector, including cannabis.
The R&D tax credit was enacted in 1981 to incentivize U.S. companies to increase R&D activity. For years the credit was extended temporarily by Congress at the end of each calendar year. However, in 2015, Congress made it permanent. And then in 2025, lawmakers breathed even more life into the credit by eliminating the requirement that R&D expenditures be amortized over a five-year period.
Now, with IRC § 280E on the chopping block as cannabis moves toward Schedule III status, certain companies in the industry can claim the credit that others have taken advantage of for years. Having said that, careful planning is required when considering the R&D tax credit.
Cannabis companies should consider various pitfalls to ensure not only legal compliance, but to maximize potential benefits.
Pitfall #1: Thinking you don’t qualify for the credit because you don’t do research in a laboratory.
The R&D tax credit is not industry specific. Instead, to qualify for the credit, a company must meet each part of a four-part test:
- A company needs to develop a new or improved product, process, software, technique, formula or invention. Practically, this means that many cannabis companies can qualify by developing a new or improved product.
- The research needs to eliminate uncertainty about a product’s capability, method or appropriate design. Often, research will qualify by means of having uncertainty as to a product’s ultimate design.
- The research must involve a process of experimentation. This does not need to be in a laboratory, but instead simply requires evaluating alternatives through system trial and error.
- The research must be technological in nature, in that it requires the use of principles of hard science.
This formulaic approach to determining qualification for the credit allows companies in many industries—from pharmaceutical companies to architectural firms—to claim the R&D tax credit. Cannabis companies involved in breeding, cultivation, growing, extraction and product development could potentially qualify for the credit if they meet the four-part test and do not fall under any applicable exclusions.
Pitfall #2: Not maintaining proper records of research activities and expenditures.
The Internal Revenue Service (IRS) commonly attacks R&D credit claims for a lack of substantiation. Taxpayers have the burden to prove they are entitled to the credit, so they must adequately substantiate their claims.
Cannabis companies that qualify can claim the tax credit on qualified wages or supply costs. However, companies must have evidence of wages and supply costs to claim the R&D tax credit.
Evidence of supply costs includes receipts of goods and logs showing how supplies are used in the research process. Since supplies that are later sold to customers would not qualify for the credit, cannabis companies need to track how research supplies are used.
Evidence of wages usually requires detailed activity logs. Most small and mid-sized operators do not require employees to keep a log of activities, but to be able to withstand IRS scrutiny, companies should require employees involved in research to track their time using a consistent methodology.
Maintaining detailed records or R&D activities is difficult for rapidly growing businesses. While granular level records may not be necessary, it is important for cannabis companies to consult with their tax advisors on the level of detail needed and how to implement tracking systems.
Pitfall #3: Relying on unscrupulous or shady promoters of R&D tax credits.
The R&D tax credit is complicated and can be overwhelming. There are a number of reliable firms that can determine qualification, draft a study and calculate the credit. Unfortunately, there are a large number of firms that do not perform the necessary due diligence and are not credible. These firms sometimes charge large contingency fees and make guarantees about eligibility. Their calculations are often greatly overstated for the purpose of generating high fees. These firms may seem credible but can be overly aggressive in their approach.
With the emergence of the cannabis companies as potential new credit claimants, these companies will likely be aggressive in their pitch. However, poor work on the front end can lead to adverse determinations by the IRS.
Cannabis companies need to properly vet the firms they hire to conduct R&D studies and then have those studies reviewed by a third party. Credit experts can analyze the work done by firms to help strengthen the front-end studies. Companies that are not careful face the risk of losing the credit, while also owing promoters huge fees.
Pitfall #4: Not separating non-IRC § 280E and IRC § 280E activities.
As of now, only state-licensed medical marijuana is not subject to IRC § 280E and thus eligible for the R&D tax credit. That means research related to recreational use marijuana is not eligible for the R&D tax credit.
This makes it difficult for most eligible companies who are involved in both medicinal and recreational uses, as they need to separate their research activities relating to the two. This may be almost impossible for vertically integrated companies. But other companies can use entity structuring to help allocate costs and ensure segregation of qualifying and non-qualifying research activities.
The R&D tax credit is a very powerful incentive that certain cannabis companies can now claim. However, it is a major area of focus for the IRS due to the complexity of the credit and the aggressive positions pushed by certain promoters. While this may cause concern to companies seeking to claim the credit, careful due diligence and reliance on advisors can help businesses ensure that their credit claims are well supported.
Meeren Amin is a partner in the Taxation & Wealth Planning Department at Fox Rothschild. William Bogot is co-chair of the Cannabis Law Practice at Fox Rothschild. Douglas W. Charnas is counsel in the Taxation & Wealth Planning Department at Fox Rothschild.
Photo courtesy of National Institute of Standards and Technology.
