Where do we want to spend our money today? Or rather, where do we need to spend our money? That question is at the core of most business decisions. Would you rather use your finite resources for paying taxes or contributing to the development of your business? The good news is there are ways, with proper planning, the capital you invest in future technology or your people can in turn reduce the tax liability your company will incur, whether it’s now or in the future. Here are five key planning items technology companies can use to maximize the value of the capital in their businesses.
1. FDII Deduction
FDII, or foreign-derived intangible income, is a relatively new category of income created by the Tax Cuts and Jobs Act of 2017 and defined in the new Section 250 of the Internal Revenue Code. It’s an important category of income because C corporations who have FDII can apply a 37.5% deduction to it, reducing the effective tax rate on that income to 13.125% from the standard corporate income tax rate of 21%.
The deduction was created to encourage corporations to incorporate in the U.S., rather than overseas, by making U.S. tax laws more competitive with other tax regimes. The deduction was set at 37.5% for tax years 2018 through 2025, but will shrink to 21.87% (resulting in a 16.41% effective tax rate) for all years after.
While it can be complex from a calculation and compliance standpoint, the FDII deduction can be lucrative for entities treated as C corporations that generate income from the sale or lease of property to non-U.S. persons or that provide services to overseas persons or with respect to overseas property. As you might guess, a lot of SaaS businesses fall into this category. If your business sells or licenses software overseas, you owe it to yourself to seek out a tax advisor with experience in this field and find out if the FDII deduction might save your company this year on its tax return.
2. R&D Credits and Deductions
Whether you’re providing SaaS, hardware, semiconductors or some other cutting-edge technology, investing heavily in research and development (R&D) is key to market adoption and growth. Fortunately, the federal government and many states offer some major tax breaks in the name of encouraging innovation and stimulating the economy. Chief among those is the ability to offset certain R&D-related expenses against your company’s tax liability through the R&D tax credit.
In general, money spent on labor, supplies and consultants related to an R&D project qualifies for the federal tax credit. Activities and capital investments that do not qualify include travel, meals, leases, land and real estate capital improvements. To be considered an R&D project it must pass a four-part test established by the Internal Revenue Service. This test consists of:
- Elimination of uncertainty: The project is undertaken to resolve technical uncertainty about a proposed product or process.
- Process of experimentation: To eliminate uncertainty, the company follows a process of experimentation. A process of experimentation will include things like modeling, simulation, statistical analysis, or just old-fashioned trial and error.
- Technological in nature: The project relies primarily on the hard sciences, e.g., physics, chemistry, biology or computer science.
- Qualified purpose: The purpose of the project must be to serve a business need or opportunity — namely, a new product or process that results in better performance, function, reliability or quality.
If you haven’t made use of this credit in the past, but just completed a qualified R&D project or are currently in the middle of one, don’t anguish. Notably, unlike many tax incentives, the R&D credit can be applied to current or prior tax years. This is just another reason why the R&D credit is considered one of the most valuable tax planning tools in your toolbox, and why businesses should make use of it accordingly.
3. 100% Bonus Depreciation
Growing tech companies, especially those in their early stages, incur a lot of related costs – from computers and furniture for employees to major equipment purchases. Bonus depreciation is a tax incentive that allows companies to immediately deduct many of the costs associated with these purchases from their taxable income.
Like the R&D deduction, bonus depreciation is designed to incentivize investment in service of growing the economy. That’s why the Tax Cuts and Jobs Act of 2017 increased first-year bonus depreciation from 50% to 100%. One benefit of this to businesses is increased cash flow. Consequently, most tech companies will want to elect to take this immediate write-off for large asset purchases where the law allows.
Although there are some notable exceptions, namely most buildings and building improvements, 100% bonus depreciation currently applies to most tangible personal property put into service during the taxable year. Some types of computer software are also eligible.
Businesses should note 100% bonus depreciation won’t be around forever. Starting in tax year 2023, the percentage of bonus depreciation will decrease by 20% each year, until it reaches zero and depreciation reverts back to standard rules. The upshot is tech companies planning any major capital investments subject to bonus depreciation in the near-to-mid future should include this tax incentive in their business planning and financial justifications.
4. Business travel
When a company reimburses an employee for businesses-related travel expenses, the company can then deduct some of those expenses from its taxes. When you include travel-related expenses like transportation, accommodations and food, this can add up to no small impact on your taxes.
To ensure you don’t pay more taxes than necessary, make sure employees and businesses are educated with regard to travel for work. Many companies and individuals, for instance, are unaware distances traveled in their personal vehicles outside of their normal commute (what the IRS calls a “tax home”) to events such as, say, a conference or a summit, are not only reimbursable for them, but tax-deductible for the company.
Additionally, companies should implement a system for tracking employee expenses. Between trading receipts and emails and getting approvals, work-related expenses can get complicated quickly. Investing in a quality application now to track and store this information can result in significant tax savings down the line.
5. Stock Options
Startups and more established companies alike often incentivize top talent to join their ranks by offering stock options. That’s a good talent acquisition strategy, but what happens when employees decide exercise those options?
From a tax perspective, it’s important to remember the exercise of a stock option triggers a tax deduction for the company if:
- An employee exercises their non-qual, or non-qualified stock option. The IRS regards the difference between the price at which it’s exercised and the fair market value as a form of compensation. Companies can deduct this amount from their taxable income. Non-quals are more common for private companies, but can be seen at both private and public companies.
- An employee vests their RSUs, or restricted stock units. The IRS treats the vesting as compensation for the employee. Like non-quals, this compensation triggers a tax deduction for the company who issued the RSUs. As soon as they’re fully vested, RSUs are essential akin to restricted shares in a company. They are also primarily a feature of public companies.
Also note that employer does not get to claim a tax deduction upon the exercise of an employee's incentive stock option (ISO), unless the employee fails to meet the holding period requirements and sells early.
Ultimately, the takeaway with regard to stock options is this: If your company’s employees exercised their stock options in 2019, understand there is a certain amount of compliance work and tax planning that you need to do to ensure your business remains in good legal standing and you don’t pay more taxes than you need to.
As always, understand that every situation is different and may have an effect on outcomes. The counsel of an experienced tax professional, like those in BPM’s Corporate Tax Services group, is thus invaluable.
BPM for Technology
BPM is one of the largest California-based public accounting and advisory firms, ranking in the top 50 in the country. Our Technology team is the largest industry group at BPM, consisting of over 100 professionals who serve over 700 technology clients on a range of services such as SEC and private company audit and compliance, information technology audit and compliance, corporate tax service and compliance, international tax and transfer pricing, transaction advisory, systems implementation and more. Our team has extensive expertise in providing accurate and timely services that minimize risks while maximizing growth opportunities for clients in both the private and public sector, in every business phase ranging from raising capital, managing revenue growth and preparing for an IPO and beyond to optimizing your tax footprint and guiding you through mergers and acquisitions. Contact us today or visit www.bpmcpa.com/technology.