If you’re an independent software developer or a self-employed IT professional, having knowledge of key tax issues relevant to your business is critical to your success. Take note of the following tax tips to stay in compliance from our nyc cpa, mitigate unnecessary tax burdens and avoid tax penalties.
Evolve your entity structure with your business. Many independent software developers and self-employed IT professionals start their businesses as flow-through entities such as S-corps or LLCs. However, as a business grows, it may be more beneficial to convert to a C-corp status if you are receiving significant venture capital or foreign investments. These types of entity selection and structure decisions can have significant tax implications, so it is usually wise to consult with a tax professional who can guide you through the advantages and disadvantages of each scenario.
Consider how to tackle tax accounting (really!). Nothing can replace the help of a tax professional or CPA who specializes in the software and IT industries, but it is wise to have at least a basic knowledge of GAAP (Generally Accepted Accounting Principles)—if for no other reason than to take comfort in the fact that you know your accountant is using the most advantageous method for the stage of your business. For example, if you’re a freelance IT professional who is primarily a service provider, it is likely that the cash method of accounting will net you more tax savings. However, if you’re a self-employed software developer with product sales, the accrual method of accounting will offer you benefits such as the ability to defer revenue beyond the receipt of cash.
Claim deductions for start-up costs the right way. While most independent software developers and self-employed IT consultants are well aware that they can deduct the start-up costs of establishing their companies, they often don’t understand that tax rules usually require that these expenses are capitalized and amortized (with the exception of R&D costs). Another caveat: the IRS scrutinizes these type of deductions closely, which means you need to carefully document them and be well-versed when it comes to eligible deductions.
Know the best deduction method for capitalized software development costs. Generally, software development costs can be capitalized for the period from when a product is considered technologically feasible until it is ready for commercial release. These capitalized costs can then be either immediately expensed (to help reduce taxable earnings, if necessary) or amortized over the life of the product—of course, you’ll want to select whichever option will give you a more advantageous tax position.
Classify your team according to IRS rules. If you use contractors to increase your bandwith as an independent software developer or freelance IT consultant, then you need to make sure you treat them right, especially when it comes to their employment status. In addition, you should ensure that any client that you work for as an independent contractor is documenting your employment relationship correctly. Worker classification issues are an area of particular focus for the IRS and complying with the rules is essential for avoiding penalties and fines. If you need help understanding the tax rules related to independent contractors versus employees and how to issue 1099 and W-2 forms, reach out to CPA or tax professional.
Beware of the tax implications of multi-state and international operations. Even if you are an independent software developer or IT professional, when you do business in multiple municipalities, states or countries, you need to be well aware of the geography-based income and sales tax regulations to avoid any potential penalties.
State departments of revenue, in particular, are on the lookout for new revenue opportunities related to business tax revenue. So remember that you will likely be viewed as having a tax nexus with any state in which you have physical contact, even if it is short-term contact such as on-site software installation or client training.
State and local sales tax may be an even bigger issue—and there is little consistency from location to location as to the percentage of revenue that you may be obligated to pay and what transactions are subject to sales tax. The onus is on you to research the sales tax regulations specific to where you do business. Don’t wait when it comes to checking out whether you need to register for sales tax, or you could end up with an unexpected tax bill. Look into it as soon as you begin selling—even if it is a SAS product, sales of which may be taxed in some jursidictions.
If you are doing business abroad, know that U.S.-based companies are subject to the tax of foreign countries on their operating profits only when they have permanent operations in place. IRS tax rules do permit a credit against U.S. tax obligations for those paying taxes to a foreign government. However, these rules have significant limitations, so it is best to check with a tax professional for the most current and accurate interpretation of this area of the IRS tax code.
Don’t forget to claim applicable tax credits. On the flipside of the tax coin, federal and state tax credits are available to many software developers as incentives for things such as research, job creation, training, and angel investor capital.
State tax credits, especially those for R&D, are readily available to businesses working on emerging technologies, including software applications and other IT-related innovations. For example, New York State’s research and development (R&D) tax credits are available to encourage the creation and expansion of emerging technology businesses. In New York, these tax credits include a three-year job creation credit of $1,000 per employee and a capital credit for investments in emerging technologies.
The tips above are just the beginning when it comes to tax-saving opportunities and business considerations for self-employed software developers and freelance IT professionals. Whether you’re just starting out as a freelance IT consultant or you’re running a growing software development company, it pays to be aware of tax issues relevant to the technology industry and to partner with our experienced nyc cpa can ensure that you remain compliant with IRS statutes and your business remains profitable.