Software firms can benefit from key tax deduction

Leaders of software companies have a lot to think about. Staying ahead of the competition through constant research and development, capturing market share and retaining top talent are just a few; tax considerations are probably low on the list.

However, one tax deduction, Section 199 of the Internal Revenue Code, could save software companies significant sums, contributing to one of the most important items on the “things to think about” list: the bottom line. Section 199, also known as the Domestic Production Activities Deduction, benefits companies and individuals that manufacture within the United States, contributing to job growth and competitiveness. Many software developers fit this description but don’t know about this potentially valuable deduction.

Benefits of the deduction

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To qualify for the deduction, a company must generally have revenue attributable to the sale or license of property that has been produced or developed in the United States. The deduction amounts to 9 percent of the lesser of taxable income or qualified production activities income, which is equivalent to qualifying revenue less allocable cost of goods sold and other deductions. The deduction is subject to a maximum of 50 percent of the company’s W-2 payroll. Companies operating at a loss won’t qualify for the deduction, and the more a company has in qualified revenue, the more attractive the deduction is.

To ensure they qualify, software developers must track sales revenue to prove their claim to the deduction is valid. They also must separate revenue streams if not all sales qualify.

Qualifying software

In order for the sale or license of software to qualify under Section 199, the software first must be developed within the United States.  Off-the-shelf or “canned” software (i.e., available on a disc) as well as downloadable software can qualify. If the software only is available online (i.e., cloud-based), it may still qualify if:

• The company derives, on a regular and ongoing basis, gross receipts from the same software (with only minor differences) that is available on a tangible medium or via download (the “alternative delivery” test).

• An unrelated person, on a regular and ongoing basis, derives gross receipts from substantially identical software that is provided to customers on a tangible medium or via download (the “substantially identical software” test). 

“Substantially identical” is determined based on the functionality of the software applications under consideration. According to the Section 199 rules, “substantially identical software” means software that from a customer’s perspective has the same functional result as the online software and overlaps significantly with the online software’s features or purpose. In addition, the regulations provide a safe harbor for all computer games as substantially identical to each other.

In certain situations, apps also may qualify; however, they must generate qualifying revenue and be either on a tangible medium or downloadable.

Successful implementation

Companies that develop software in the United States should investigate the Section 199 deduction with their tax provider as follows:

1. Determine if the company and its products qualify.

2. Perform the proper allocation of revenue and expenses. Certain small taxpayers may be eligible for a simplified allocation approach.

3. Document eligibility for the deduction (e.g., a description of the company, eligible products, qualifying activities, methodologies used to compute DPAD, etc.). The goal here is to have substantiation for the deduction ready should the IRS want to review it.

4. Claim the benefit on the applicable tax return.

Section 199 is commonly overlooked by software companies, but technology executives should mention it to their tax providers if the deduction is not already being claimed.  While getting the benefit from Section 199 may require some initial administrative work, the benefit will most likely be well worth the additional work.

Michael DePrima and Lawrence Knutson are partners with EKS&H LLLP. They can be reached at 303-846-1340 or MDePrima@eksh.com, or Lawrence Knutson at 303-224-4625 or LKnutson@eksh.com.