By Kenneth H. Bridges, CPA, PFS July 2015
While many of the accounting and tax issues faced by software companies are common in other industries as well, there are certain areas in which software companies must be well-versed in order to establish and maintain credibility with investors and lenders and minimize exposure to taxes. These areas (arranged roughly chronologically over the life cycle of the typical software company) include:
Choice of entity type – Software companies often start out as a flow-through entity (S-corp or LLC) in order to enjoy the flow-through of tax losses and credits, avoid the potential for double taxation, and provide maximum flexibility in an exit transaction, but later find it more advantageous to convert to C-corp status (perhaps to accommodate a significant venture capital or foreign investor). Other times, software companies find it advantageous to move in the opposite direction (from C-corp status to flow-through status). Great care must be taken in the initial choice of entity type, as well as any subsequent change (since significant adverse tax consequences can result).
Debt and equity transactions – Rapidly growing software companies often have various types of owners, including founders, key employees, angel investors, and institutional venture capital funds, and multiple types of debt and equity, including senior debt, convertible debt, common stock, and potentially multiple series of preferred stock with differing rights and preferences. In general, amounts associated with debt (other than principal repayment) will result in a tax deduction, while any amounts associated with equity (including costs incurred to raise the equity) do not result in a tax deduction.
Stock-based compensation – Software companies often use restricted stock, stock options and other forms of equity-based compensation to attract and retain key talent. It is important to understand the financial accounting and tax ramifications of such, both from the perspective of the company and the employee. The company will generally want to try to minimize any charge to financial statement earnings, while enjoying an income tax deduction for any amount included in income by the employee. From the employee’s perspective, it is important to avoid having a W-2 income inclusion at a time when there may be no cash involved with which to pay the resulting tax, and to try to structure for long-term capital gains treatment (rather than having ordinary income).
Start-up costs – Tax rules generally require the capitalization of “start-up costs”. If the company properly identifies these costs, it can make an election to amortize such over a period of 15 years.
If not, the deduction is lost. Certain types of expenses (e.g. interest and R&D) are generally not subject to these rules, and determining the date on which business begins for purposes of these rules is critically important. Careful navigation of these rules can maximize a company’s tax deductions and minimize the risk of an unpleasant surprise in an IRS examination.
Capitalization of software development costs – GAAP (generally accepted accounting principles) provides for software development costs to be capitalized from the point in time in which technological feasibility is established up until the point the product is ready for general release, with the capitalized costs to subsequently be amortized over the life of the product. Tax rules generally permit these costs to either be immediately expensed or capitalized and amortized, at the election of the taxpayer.
Revenue recognition – Because software sales often have a very high margin and a company may have infrequent but substantial sales transactions and continuing obligations after initial delivery, complex rules govern the timing of recognition of revenue from software sales. These rules typically operate to defer recognition of revenue. While this may be undesirable from a GAAP perspective, such may be beneficial from the perspective of minimizing the company’s cash outlay for income taxes.
Tax accounting methods – While GAAP requires the use of the accrual method (and frequently the deferral of revenue from software sales), tax rules generally provide a great deal of flexibility in the selection of accounting methods. Software companies many times start out primarily as service providers (with the cash method often producing the most desirable tax result), and then evolve into product companies (with the accrual method often producing a more desirable tax result, based on the potential to defer revenue beyond the receipt of the cash). Careful selection of an initial method, and the optimal timing of a subsequent election to change methods, can result in substantial tax benefits.
Qualified retirement plans – In order to attract and retain talent, most software companies will need a qualified retirement plan. Such plans permit the company an immediate tax deduction, while providing the employee with a potentially very long-term tax deferral.
Non-qualified deferred compensation – In addition to qualified retirement plans, software companies also often offer various forms of non-qualified deferred compensation. GAAP generally requires the accrual of a liability with respect to such plans as the related services are provided, while tax rules generally require deferral of the company’s deduction and provide potentially draconian results to the employee if the plan is not properly structured and maintained.
Worker classification issues – Software companies often make significant use of outside contractors in order to attract talent needed on a temporary basis. Knowledge of the rules in this area can help a company minimize the likelihood of trouble with the IRS, state departments of revenue, and Federal and state departments of labor.
Tax credits – Most software companies are eligible for the Federal research tax credit, and states frequently offer their own research credit, as well as credits for job creation, training, angel investor capital, and other behavior the state wishes to encourage and reward.
Multi-state income tax – Software companies almost always have a national (or international) focus, rather than a local focus. With state departments of revenue being increasingly hungry for revenue (and increasingly aggressive in pursuing out-of-state companies), it is imperative for a software company’s management to be well-versed in multi-state income taxation. Typically, a company will have “nexus” with any state with which it has physical contact (even temporary contact like on-site installation and training).
Multi-state sales tax – Potentially even more significant than state income tax is state and local sales tax. While a company that is not profitable may not have significant exposure to income tax, its exposure to sales tax (which is a percentage of gross sales) can be enormous. States are all over the board in terms of what types of software transactions are subject to its sales tax, and the method of delivery and language used on invoices can often be determinative as to whether or not the transaction is subject to sales tax.
Doing business abroad – U.S.-based software companies often quickly expand their sales effort outside of the U.S. The U.S. has a tax treaty with most of its trading partners, and such treaties generally define which country has the right to tax the income from a transaction (to minimize the likelihood of duplicate taxation). As a general rule, a U.S.-based company will be subject to the tax of a foreign country on its operating profits only if it has a “permanent establishment” in such foreign country, but exceptions exist. U.S. rules (with significant limitations) generally permit a credit against U.S. tax for tax properly paid to a foreign government. Also, U.S. tax law provides certain incentives to encourage exporting.
Limitations on the use of loss and credit carryforwards – Tax rules place potentially severe limitations on the use of a company’s loss and tax credit carryfowards following a change in ownership. It is important to understand these rules in order to avoid an unintentional triggering of a limitation that could result in the wasting of a valuable tax asset.
Mergers and acquisitions – Most software companies are built to be sold; and, along the way to an exit, they often grow by the acquisition of other companies. From the seller’s perspective, depending on the structure of the deal the tax result can range from totally nontaxable to double taxation. And from the acquirer’s perspective, the result can range from a purchase price that is tax deductible (over some period of time) to one in which the purchase price is permanently nondeductible.
Software companies often move rapidly through the life cycle from inception to exit. A CPA firm which understands the life cycle of a software company and can address both the immediate issues facing the company today, while also seeing the bigger picture of the long-term, can be a valuable business partner.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.