The recent pandemic forced many businesses to move from traditional brick-and-mortar storefronts to online, subscription-based services or software models. It’s also led many to prepare for an inevitable transaction — an acquisition, merger or round of funding. With these shifts in priority, many finance leaders and founders now face the challenge of having to quickly understand the differences in how software businesses are taxed.
Most frequently, companies in the software sector overlook three key tax areas that can affect their value during a transaction.
Because software companies sell services that are nowhere and everywhere, many tax directors and/or finance departments often ignore sales tax responsibilities until they are notified by a jurisdiction. Sometimes, this approach is prudent because customers’ physical whereabouts can be difficult to determine, and not all jurisdictions have the same sales tax rules. For example, California doesn’t tax software companies, while others do.
So, where do you start? Companies should complete a nexus analysis, which will highlight current and prior periods’ sales tax exposures and liabilities. This typically includes reviewing the company’s activities and financials for physical presence (e.g., existence of a warehouse, office, employee or travel to the state).
The analysis also includes an economic/Wayfair nexus, which confirms whether state thresholds for revenue or transactions were exceeded. Once you have the results of the nexus analysis, you can work with an experienced advisor to strategize how to reduce your overall sales tax exposure.
Software businesses often face significantly historic net operating losses (NOLs) - and we often look for ways to offset those losses. Sometimes, you can use R&D tax credits to offset payroll taxes — which is cash back to your company. However, there are some limitations for this election, including:
Owners/founders of software businesses should also be aware of qualified small business stock (QSBS) early in their company’s lifecycle. The earlier attention is paid to QSBS and its potential business tax implications, the sooner the benefits can be reaped. For a person holding QSBS, they may be able to exclude between 50% and 100% of the gain on the sale of their QSBS from U.S. federal, and most state, income taxes. The amount of the exclusion depends on when the holder acquired the QSBS:
| Date QSBS Acquired | Possible Exclusion |
|---|---|
| Before February 18, 2009 | 50% |
| After February 17, 2009, but before September 28, 2010 | 75% |
| After September 27, 2010 | 100% |
No matter when you acquired the QSBS, the amount of the exclusion is limited to the greater of $10 million or 10 times the holder’s adjusted tax basis in the year that the QSBS is sold.
For example, if you acquired QSBS after September 27, 2010, and have an adjusted tax basis of near $0 in that QSBS (as would be the case if you acquired your QSBS at formation for a nominal amount) then you sell that QSBS for $25 million, you would only pay capital gains tax on $15 million of gain, rather than the full $25 million.
Software business models have been, and will be, here to stay. For many, there’s no going back. While the items outlined above are some of the top issues facing companies today, there are many other tax strategies available to companies looking to reduce their overall tax liability.
As you continue your growth path post pandemic, it becomes even more important to work with a tax advisor who is well-versed in the complexities of your industry and your unique tax situation.
To learn more about these top tax areas, contact our software tax experts.
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