To say 2019 has been a monumental year for industrial hemp doesn’t fully capture the sweeping changes the industry has seen. Thanks to the 2018 Farm Bill, hemp was removed from the Controlled Substances Act, making it a federally legal crop. With that change, existing and emerging hemp businesses moved into new tax territory, free from the federal tax burdens associated with cannabis.With this newly legal industry’s first tax season approaching, Hemp Grower spoke with four certified public accountants (CPAs) fluent in hemp, cannabis and traditional agriculture for tips on how hemp growers can take advantage of this major shift in industry regulations and significantly improve their bottom lines.
1. Put Section 280E behind you
Prior to 2019, hemp growers were subject to Section 280E of the Internal Revenue Code, which limited business deductions to costs of goods sold. Van Asten emphasizes those restrictions applied to hemp businesses’ 2018 returns, but these businesses are free of 280E for the 2019 tax year.
While businesses growing cannabis crops that exceed 0.3% tetrahydrocannabinol (THC) are still subject to Section 280E, “now, a hemp company is able to deduct all of their normal operating expenses like any traditional business can,” Van Asten says. He also points out that hemp businesses no longer have to contend with the numerous cannabis-specific state and municipal excise taxes.
2. Know your state regulations
Even though hemp is federally legal, cultivation requires a license issued under a U.S. Department of Agriculture (USDA) plan or in a state with a USDA-approved industrial hemp production plan. Not all states have approved programs, though. Van Asten stresses staying informed and in-line with your state regulations to ensure you’re entitled to licensed hemp cultivation tax benefits.
“Know your regulatory environment. Obtain your special licenses,” he says. “Several states have limited pilot or research programs. Others have prohibited hemp production. Several states held off commercial growing until 2020.”
3. Stay current on testing requirements
Van Asten underscores the importance of THC testing. Hemp, as defined in the 2018 Farm Bill (formally called the Agriculture Improvement Act of 2018), can’t exceed THC concentrations of 0.3%, and state regulatory programs have provisions for destroying crops that exceed those limits.
“If your crop tests out above 0.3%, you’re technically no longer growing hemp. You now have a Schedule I drug growing in your field,” Van Asten says. Staying compliant avoids potential conflicts—tax-related and otherwise.
4. Explore separate business entities
With hemp’s new standing as a legal crop, Van Asten says choice of business entity, such as sole proprietorship or limited liability corporation, now holds different implications for hemp growers, and they must decide which is best for their operations.
“It’s more a strategic decision, like a traditional business,” he explains. “But farmers who grow hemp along with other crops may want to set up a separate business entity for the hemp portion of their farm.”
Van Asten says this separates the business risks of hemp versus more established crops, but it also segregates the hemp business with outside investment in mind. “An investor may not be interested in a traditional farm, but they might have more interest and willingness to invest in a hemp operation they know is scalable,” Van Asten says.
5. Understand your tax obligations
Hopkins says many hemp farmers operate as sole proprietors. As such, they’re required to make quarterly estimated tax payments. “For self-employed [owners], nobody’s withholding for you, and you need to make those payments yourself or face penalties,” she says.
Fulfilling your income tax withholding obligations as an employer is also important. Hopkins says this can become a little muddy for self-employed farmers who hire family members. Income tax withholding rules differ depending on the relationship.
The IRS states that all children employed by a sole proprietor parent are subject to income tax withholding. However, children under age 18 are not subject to social security (FICA) or Medicare taxes. Similarly, children under age 21 are not subject to Federal Unemployment Tax Act (FUTA) taxes. Different rules apply for spouses and for parents employed in farming activity as well.
If you’re not operating the business as a sole proprietor, family members are likely employees of the business, not of you as the business owner. As such, the exclusions available under sole proprietorships no longer apply. Special rules also apply to contracted crews and foreign ag workers on seasonal visas. “If you’re new to it, find a good payroll provider to help you,” Hopkins advises. A good payroll provider can help you correctly navigate tax withholding requirements for all types of employees.
6. Take advantage of farmer-focused tax credits
Federal tax credits available to traditional agriculture extend to farmers legally growing hemp. One credit Hopkins recommends seizing is the fuel and road use credit. This allows farmers, under certain conditions, to get a refund of excise taxes paid on specific fuels used for farming.
Hopkins explains that diesel fuel for cultivating agricultural or horticultural commodities, including hemp, could qualify for this credit, as could diesel used in the handling and storing of raw materials. “This one you definitely don’t want to miss because you’re [probably] paying excise taxes you’re not subject to,” Hopkins says.
7. Deduct allowable expenses for soil and water conservation
When non-ag businesses improve land to prevent erosion and flooding, expenses typically go unreimbursed. “But if you’re a farmer, you can elect to deduct some of those expenditures,” Hopkins says. “Having this ability can really help a farm reduce their tax burden.”
Hopkins says expenses for grading, constructing and/or protecting waterways, eradicating brush and planting windbreaks all potentially qualify. Improvements must be done under a plan approved by the Natural Resources Conservation Services (NRCS)—either a farmer’s individual plan or an existing county or state program. (For more information, visit the NRCS website.)
8. Claim your qualified business income deduction
As part of the Tax Cuts and Jobs Act of 2017, certain trades and businesses can deduct up to 20% of the net income of a qualified business activity. “This is not related to specific expenditures, and there are a lot of nuances, but farmers are eligible,” Hopkins says. “That’s one you really don’t want to ignore.”
9. Don’t overlook the basics, such as a business plan
Many of Velazquez’s clients were entrepreneurs in other industries, yet they struggle as first-time hemp operators. “It starts with the real basics, the business plan,” she says. “What is your goal? How are you going to accomplish it? What’s your timeline? You need to put those basics to paper.
“Entrepreneurs have great conceptual vision of what they want to do with the business line, but I’ve found that many fail to drive that through a real business plan,” she adds. “The most successful ones I’ve seen have that plan in place and live by it. It’s updated frequently, like a living document.”
10. Get the right people on board
Non-hemp experience doesn’t always translate well for entrepreneurs launching a hemp business. “They may be entrepreneurs, but hemp is new [to them],” Velazquez says. “They need a crash course in how to run this type of new business. If they don’t have the skill set, they need to ensure they have people on the team who do.”
For example, a financially savvy relative with zero farming experience doesn’t automatically make a great chief financial officer. “Inefficiencies in your operation end up in the financials,” she says. “You need the right people in your organization, in the right places, doing the right things.”
11. Plan for ERP software
To be competitive, Velazquez believes hemp business owners should look to enterprise resources planning (ERP) software, which integrates various types of separate business applications into a single management system. “We have a variety of disparate systems doing different things,” she says. “You need one place where you can see all the details for the enterprise as a whole.”
When business applications don’t communicate, business owners may not always see the big picture until it’s too late to make adjustments. For example, if labor and production applications aren’t integrated, the impact of unexpected labor on final production costs may not be apparent until tax time. “When you look at things in a silo, the financials are not as good as they can be,” Velazquez says. “You’re only as good as the information you have.”
12. Investigate federal business tax credits
Velazquez underscores that general business tax credits now apply to legal hemp businesses. “Many hemp clients are just not aware that these exist,” she says.
Some examples include:
- Research and Experimentation Credit. Properly documented research and development (R&D) activities could potentially qualify for this credit. “A lot of hemp operators are doing some very new and cool things. They’re breeding genetics, what we would consider in the tax world to be true research and development,” Velazquez says.
- Opportunity Zone Credit. This credit benefits businesses that invest in economic development and job creation in IRS-specified zones, typically distressed communities. “These are credits that would reduce, dollar for dollar, their tax liability,” she says.
- Domestic Production Activities Deduction. Also known as the Section 199 deduction or the manufacturing deduction, this deduction incentivizes businesses to keep manufacturing activities on U.S. soil. With hemp no longer a Schedule I substance, Velazquez says vertically integrated hemp businesses and hemp processors could qualify.
13. Understand cash versus accrual accounting
Under cash-based accounting—the traditional method for farming operations—taxes are paid when cash is received, and expenses are deducted when they are paid. With accrual-based accounting, revenues and expenses are recorded when they’re earned rather than when they’re paid.
Hale says many hemp farmers have contracts with buyers who are fronting money to farmers during the growing process. “Most of those farmers are going to be cash basis farmers, so they’re going to pay income tax on that money when they receive it, regardless of when they deliver the product,” he says.
Prior to the 2018 Farm Bill, accrual accounting sometimes benefited growers limited by Section 280E. While farmers still have the accrual option, Hale doesn’t usually recommend it. “If they’re going to be accrual, they have to start counting inventories and receivables and payables [differently],” he explains. Doing so would mean extra work without equivalent benefit for most farmers.
14. Take advantage of depreciation rules.
Depreciation involves expensing over an extended time period the cost of an asset you’ve purchased. The Tax Cuts and Jobs Act increased farming depreciation allowances significantly. The Internal Revenue Code also allows businesses to deduct the cost of certain assets, up to specific levels, as expenses rather than depreciating them over time.
“This new crop requires some specialized equipment adapted for cultivation and harvest,” Hale says. “Any of that equipment is eligible for the same depreciation rules as any other business. With most ag equipment, farmers can either depreciate it over time, or they can elect to write it off the first year up to some really high amounts.”
15. If new to farming, consider leasing equipment
“Agriculture is a very capital-intensive industry. [Existing] farmers already have equipment,” Hale says. “All they have to do is customize a few pieces for hemp and off they go. If you’re coming into farming from scratch, I would suggest maybe looking at renting equipment until you get comfortable with it.”
He says agricultural lenders are very familiar with leasing equipment. “That might be something to consider instead of trying to buy everything,” Hale says. And, under cash accounting, leasing expenses would get deducted the year they’re paid out.
As the newly legal hemp industry matures and more businesses enter the market, Hale expects a bit of the Wild West ahead for farmers. “It’s exciting, but it’s new,” he says. “Anytime there’s something new, there’s going to pitfalls and land mines and kinks that have to be worked out.”
But whether you’re an experienced hemp farmer or new to the field this year, these tax tips can help you improve your bottom line this tax season—and keep you on track for improved operational efficiencies, along with increased profits, for years to come.
Jolene Hansen is a freelance writer and frequent contributor to GIE Media publications. Reach her at email@example.com