Are you running an SaaS business? You know, “software as a service”?
And are you taking the Software As A Service Sec. 199 domestic production activities deduction? No? You probably should be. This deduction can save you a bundle in income taxes.
Note: In general, digital goods and digital services firms probably all benefit from the Sec. 199 deduction. Computer software, computer games and sound recordings are specifically called out for favorable tax treatment in the Sec. 199 loophole. In this blog post, though, I’ll focus on how the loophole works for SaaS-type firms.
How the Software As A Service Sec. 199 Deduction Works
The Sec. 199 deduction, also known as the “Domestic Production Activities Deduction,” lets you deduct 9% of your manufacturing income from your taxable income.
This description sounds so simple you’ll think you don’t understand. But the deduction really does work this simply. If your SaaS business makes $1,000,000 a year, you don’t have to pay income taxes on the full $1,000,000. Rather, you can deduct 9%, or $90,000, from the $1,000,000. And then this means you’ll only pay income taxes, at least on a federal level, on $910,000.
Note: Many states with income taxes, though not all, also allow you to take a Sec. 199 deduction on your tax return.
The deduction comes with a couple of other tweaks, too, that you need to know about. First, the general logic of Sec. 199 is that domestic manufacturers get this tax break because they provide manufacturing jobs in the United States. To make sure you’re doing what Congress wants, the law actually limits your deduction to 50% of your business’s wages. To get a $90,000 deduction, in other words, the business needs to pay at least $180,000 of wages.
Note: If you’re currently operating an SaaS business as a partnership with working partners, you may want to explore electing to treat your partnership as an S corporation. This election converts partners into shareholder-employees with wages. And more wages may result in a larger DPAD deduction.
And then, second, you get to deduct the lessor of 9% of your overall taxable income or 9% of your manufacturing income. If your business makes $1,000,000 manufacturing stuff but loses $500,000 selling services, your taxable income equals $500,000. And in this case, you get to deduct 9% of the $500,000 you make overall and not 9% of the $1,000,000 you make manufacturing.
Special Requirements for SaaS Businesses
SaaS businesses have another wrinkle they need to consider if they want to take the Sec. 199 deduction. The firm either needs to sell a non-SaaS version of the software—this version can be either downloaded to a user’s computer or distributed on something like a CD or DVD. Or the firm needs to have competitors who sell “substantially identical software” that’s downloaded or distributed on something like a CD or DVD. (The Treasury Regulations that provide the gritty details about how this all works appear here: 1.199-3(i)(6)(iii) Exceptions)
Note: We’ve also got an extended discussion of the Sec. 199 DPAD deduction here. And note that an eclectic set of businesses qualify for the the Sec. 199 DPAD deduction, including mining companies, traditional manufacturers, architectural and engineering firms, and many digital goods and digital services firms.
Complicating Factors for the Sec. 199 DPAD Deduction
In the situation where you’re talking about a software as a service firm, of course, the business typically involves more than just “leasing” software. A firm may provide training, technical support and storage of data. Accordingly, let me share a handful of additional comments about how the loophole works for an SaaS business.
Revenue From Technical Support, Training, Data Storage or Database Access Doesn’t Count: In general, only the revenues earned from leasing or renting or actually selling computer software counts as manufacturing revenue and produces manufacturing income. Revenue from other stuff (like training or technical support or database access or data storage) doesn’t count as manufacturing revenue. But the accounting gets murky, so you need to be careful. You can ignore de minimis amounts of revenue from this other stuff for example… And you can often ignore technical support and maybe even training if these items are embedded in the software as a service “product.”
Unicap Matters: You’re supposed to comply with the uniform capitalization rules if you want to use the Sec. 199 deduction. The uniform capitalization rules, also known as unicap, say you’re supposed to do your cost accounting like a manufacturer does his or her cost accounting. This means you capitalize the direct and indirect costs of manufacturing some item and only later expense those costs when you sell the item.
Note: With software development companies, including SaaS companies, the Unicap accounting may be simpler because you can probably use the Sec. 174 Research and Experimental Expenditures deduction to deduct many of the costs of manufacturing your software product.
Accrual Accounting: If your business is a manufacturer—and if you’re saying you want to take the Sec. 199 DPAD deduction you’re also saying you’re a manufacturer—you more quickly trip over the revenue threshold which triggers a requirement for you to use accrual basis accounting. Most small businesses (including sole proprietorships, S corporations, and partnerships) can use cash basis accounting if they’re a service business and revenues equal $10,000,000 or less as per Rev. Proc. 2002-28. But if you run an SaaS business and want to say you’re a manufacturer so you can use the Sec. 199 DPAD loophole, you’re probably supposed to use accrual accounting unless your revenues equal $1,000,000 or less. To use the Sec. 199 deduction, therefore, you may need to change your accounting method from cash to accrual accounting.
Checking to See If You’re Already Taking DPAD
Interested in whether you’re already taking the DPAD deduction? You may be doing this without realizing it if somewhere along the way, your bookkeeper or accountant was alert to the opportunity. And determining whether or not you’re taking the deduction is easy in most cases.
If you own a sole proprietorship or an interest in an S corporation or partnership, look at line 35 on the face of your 1040. That line should show a deduction equal to roughly 9% of your manufacturing business’s profit or your share of the profit.
If you own a regular C corporation, look at line 25 on the page 1 of your 1120 corporation return. That line should show a deduction equal to that roughly 9% figure we’ve been talking about in the earlier paragraphs.
Note: The actual deduction amount gets calculated on an 8903 Form which is a page in your 1040 or 1120 tax return if you’re getting the DPAD deduction.
If you’re not getting a deduction, talk with your tax adviser about the steps you may be able to take in order to start claiming the deduction. And be sure to ask about the possibility of filing amended returns for open years to add the deduction to any recent years’ returns.