CPA & Business Advisory Blog

software and manufacturing

Is a Software Developer a Manufacturer?

When you think of a software developer, you typically don’t think of that company as a manufacturer. However, under the Internal Revenue Code Section 199, Domestic Production Activity Deduction (DPAD), a computer software developer may meet this definition.

In general, a taxpayer may take a deduction against gross income equal to 9% of its qualified production activity income (QPAI). QPAI is determined by taking production gross receipts less cost of goods sold and other deductions allocated to this income. Production gross receipts means the taxpayer manufactured, produced, grew or extracted the product.

These produced gross receipts include those that are from the lease, rental, license, sale or exchange of computer software that was produced in the U.S. by the taxpayer. This is true even if the software sale is provided over the Internet.

To meet the definition of produced or manufactured, under the safe harbor test the labor and overhead costs incurred by the taxpayer should be greater than or equal to 20% of the total cost of the product. The use of computer software online by a customer is a service and not a lease, rental, license, sale or exchange of software. Therefore, income from these services does not qualify for DPAD unless one of the two exceptions is met:

  1. Gross receipts from providing computer software online can qualify if that taxpayer also derives gross receipts from the software by selling the same computer software affixed to a tangible medium or downloaded from the internet.
  2. Substantially identical software is available on the market by an unrelated person.

This could be a significant permanent tax deduction for software developers

If you would like to have a discussion about how your software development business can benefit from a Section 199 deduction, or for more information on Skoda Minotti’s Tax Planning & Preparation Services, please contact Marie Lenarduzzi at 440-449-6800 or mlenarduzzi@skodaminotti.com.

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