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 (DPAD), benefits companies and individuals that manufacture within the US, contributing to job growth and competitiveness. Many software developers fit this description, yet don’t know about this potentially valuable deduction.
Benefits of the Deduction
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 US. The deduction amounts to 9% of the lesser of (1) taxable income, or (2) 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% 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 must also separate revenue streams if not all sales qualify.
In order for the sale or license of software to qualify under Section 199, the software must first be developed within the US. Off-the-shelf or “canned” software (i.e., available on a disc) as well as downloadable software can qualify. If the software is only available online (i.e., cloud-based), it may still qualify if:
1. 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),
2. 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 computers games as substantially identical to each other.
To highlight these rules, consider the following examples:
Ex. 1. X produces tax preparation computer software within the US. X derives, on a regular and ongoing basis, gross receipts from sales of X's computer software which has been affixed to a CD, as well as from of X's computer software which customers have downloaded from the internet. X also derives gross receipts from providing customers access to its computer software for the customers' direct use while connected to the internet. The computer software sold on the CD or by download has only minor or immaterial differences from the online software. X's gross receipts derived from providing access to the online software therefore qualify under Section 199, as do the receipts from the sale of the software affixed to the CD and downloaded.
Ex. 2. Q domestically produces and sells payroll management computer software to customers via a connection to the internet. This is Q's sole method of providing access to its product. One of Q's competitors, R, derives, on a regular and ongoing basis, sales from substantially identical payroll management software that has been affixed to a CD as well as downloaded from the internet. Q's gross receipts derived from providing access to its payroll management online software will therefore qualify under Section 199.
In certain situations, apps may also qualify; however, they must generate qualifying revenue and be either on a tangible medium or downloadable. In one instance, a bank wanted to claim the Section 199 deduction for a free app that simply allowed users to access online services that bank customers were already receiving. The IRS rejected the deduction claim for three reasons:
1. The app was fundamentally an Internet connection-dependent access point to banking services, and did not offer additional functionality,
2. The bank collected no gross receipts from the download or use of its app, and
3. The app failed to meet the “substantially identical” requirement for online software.
As the examples above illustrate, determining whether a company’s software qualifies under Section 199 is not always straightforward. Therefore, it is necessary to perform a thorough analysis with an industry-experienced tax provider before claiming the deduction.
Tips for Successful Implementation
Companies that develop software in the US 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.
This article was originally published in the June 26, 2015 Edition of BizWest magazine.
EKS&H employs highly technical tax practitioners who have helped hundreds of technology and manufacturing companies minimize their tax obligation. Our commitment to these businesses includes membership in and support of the Colorado Technology Association (CTA), Boulder and Denver Software Clubs, and other industry organizations. To learn more about Section 199/DPAD, please contact Michael De Prima at 303-846-1340 or MDePrima@eksh.com, or Lawrence Knutson at 303-224-4625 or LKnutson@eksh.com.