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Video Game Tax Incentives Part I: The 100% Deduction

This part I of a three part series on major tax incentives for video game and general software development. In this part I focus on the 100% deduction and compare the 100% deduction with standard 3-year amortization.


There are some great tax deductions and tax credits out there for video game developers. Electronic Arts made the front page of the New York Times a few years back based on reporting that its use of a combination of tax credits and deductions resulted in paying $98 million in taxes worldwide on global profits of $1.2 billion for 2006-2011. However, these tax incentives are not just for behemoths such as EA, and they can be powerful tools to maximize up-front after-tax profits for independent and/or startup video game developers.

In the following three articles, I am going to cover the three main deductions and credits for software developers: (1) the 100% deduction under section 174; (2) the 20% Research & Experimentation Tax Credit under section 41; and (3) the 9% domestic production tax deduction under section 199.  But first, I want to explain the tax accounting rules in the absence of a deduction or credit. Then, in this first article, I will cover the 100% deduction under section 174.

What Happens Without the Special Credits & Deductions

Let’s say that you’re a software developer in a world without IRC’s 41, 174, or 199. You spend $300,000 to develop your game, and, for the sake of simplicity, all of that is spent on salary and other capitalized expenses.

Like most people you probably assume that you’d be able to deduct that entire $300,000 in the first year. Unfortunately, that’s not the case. Instead, that $300,000 is capitalized and you have a capital asset which is the intellectual property consisting of the game that you’ve developed. You would then amortize that $300,000 capital asset over a 36 month period starting with the date that you offered the game for sale underIRC section 167(f)(1).

In simpler terms, you’d be entitled to a $100,000 deduction per year for 3 years.

Let’s make this example a little more interesting. Let’s say that you have the same capital expenses in year 1 as described above, and that you have no other expenses. Let’s also say that you have $500,000 of sales proceeds in year 1, 2, and 3, and all of these sales are standard non-exclusive licenses. Of course, in a real software development situation you’d probably see most of your income in the first year, and you’d have to file amended returns in the later years to get a tax return from the IRS back, but the overall net effect would still be similar and disadvantaged after calculating for the time value of money. Let’s also assume that you have a tax rate of 35%.  For future value calculations, we will use the current IRS discount rate of 1.4% (pdf). However, in more “normal” economic times a more “typical” discount rate is 5%, and I’ll also provide future value calculations with that more normal figure.

  Amount Calculation
Year 1
Gross Income $500,000.00 Total sales proceeds for the year
Gross Expense $300,000.00 Total software development costs
Net Profit Before Tax $200,000.00 Gross Income – Gross Expense
Depreciation Deduction $100,000.00 1/3 of Gross Expense
Taxable Income $400,000.00 Gross Income – Depreciation Deduction
Federal Tax $140,000.00 $400,000 * 0.35
Net After Tax Profit $60,000.00 Net Profit Before Tax – Federal Tax
Future Value of Profits in Year 3 $61,691.76 60,000 * 1.0142
     
Year 2    
Gross Income $500,000.00 Total sales proceeds for the year
Gross Expense $0.00  
Net Profit Before Tax $500,000.00 Gross Income – Gross Expense
Depreciation Deduction $100,000.00 1/3 of Gross Expense
Taxable Income $400,000.00 Gross Income – Depreciation Deduction
Federal Tax $140,000.00 $400,000 * 0.35
Net After Tax Profit $360,000.00 Net Profit Before Tax – Federal Tax
Future Value of Profits in Year 3 $365,040.00 360,000 * 1.014
     
Year 3    
Gross Income $500,000.00 Total sales proceeds for the year
Gross Expense $0.00  
Net Profit Before Tax $500,000.00 Gross Income – Gross Expense
Depreciation Deduction $100,000.00 1/3 of Gross Expense
Taxable Income $400,000.00 Gross Income – Depreciation Deduction
Federal Tax $140,000.00 $400,000 * 0.35
Net After Tax Profit $360,000.00 Net Profit Before Tax – Federal Tax
Future Value of Profits in Year 3 $360,000.00  
     
Total Net After Tax Profit $780,000.00  
Total Future Value of Profits in Year 3 $786,731.76 Total of Future Values
Total Future Value of Profits in Year 3 at 5% Discount Rate $804,150.00 60k * 1.05^2 + 360k * 1.05 + 360k

This isn’t a bad result. And it is the result that most companies that develop games and software for others on a royalty basis are subject to. But it’s not the best result. It’s even less great in normal economic times. And for a software developer that needs as much money as possible as soon as possible to start funding its next game, $60,000 in year one is not very much.

Fortunately there are a few tax deductions and credits that can give you the best result.

The 100% Deduction Under Section 174

For the startup and independent developer, the 100% deduction under section 174 works to put the most amount of money in your pocket as soon as possible. In Rev. Proc. 2000-50 the IRS decided that the process of software development was so similar to research and experimentation that all software development costs qualify under the 100% deduction in section 174. This section allows a software developer to deduct 100% of its expenses in the year that they were incurred. The table below demonstrates that the big difference in the future value of the profits in year 3 means that the 100% deduction can afford you a more immediate and greater economic return.

  Amount Calculation
Year 1
Gross Income $500,000.00 Total sales proceeds for the year
Gross Expense $300,000.00 Total software development costs
Net Profit Before Tax $200,000.00 Gross Income – Gross Expense
174 Deduction $300,000.00  
Taxable Income $200,000.00 Gross Income – Depreciation Deduction
Federal Tax $70,000.00 $200,000 * 0.35
Net After Tax Profit $130,000.00 Net Profit Before Tax – Federal Tax
Present Value of Profits in Year 3 $133,665.48 0,000 * 1.0142
     
Year 2    
Gross Income $500,000.00 Total sales proceeds for the year
Gross Expense $0.00  
Net Profit Before Tax $500,000.00 Gross Income – Gross Expense
Tax Deductions $0.00  
Taxable Income $500,000.00 Gross Income – Depreciation Deduction
Federal Tax $175,000.00 $500,000 * 0.35
Net After Tax Profit $325,000.00 Net Profit Before Tax – Federal Tax
Present Value of Profits in Year 3 $329,550.00 325,000 * 1.014
     
Year 3    
Gross Income $500,000.00 Total sales proceeds for the year
Gross Expense $0.00  
Net Profit Before Tax $500,000.00 Gross Income – Gross Expense
Deductions $0.00  
Taxable Income $500,000.00 Gross Income – Depreciation Deduction
Federal Tax $175,000.00 $500,000 * 0.35
Net After Tax Profit $325,000.00 Net Profit Before Tax – Federal Tax
Present Value of Profits in Year 3 $325,000.00  
     
Total Net After Tax Profit $780,000.00  
Total Present Value of Profits in Year 3 $788,215.48 Total of Present Values
Total Present Value of Profits in Year 3 at 5% Discount Rate $809,575.00 130k * 1.05^2 + 325k * 1.05 + 325k

Okay, I see what you’re thinking: “that’s only about $5,000 more than in the base example–how is that so much better?” The discount rate is a great value to use for finance company projections, but it’s not necessarily the best value to use for software developers. If you wanted to begin developing your next game as soon as possible, then the extra $70k that you have in your pockets in year one in the second example is going to go a lot further towards developing your next project. And that’s where the value in the deduction lies: getting more money in your pocket sooner so that you can more economically deploy your capital sooner.

There is one catch, though. The software that’s developed must be used in a trade or business. What this means is that if you develop the software and you want to take advantage of this deduction, then you must market and sell the software yourself. As held in a recent, unpublished case in the 9th Circuit, Saykally v. Commissioner, 247 F.Appx. 914, a software developer who develops software for a third party who then markets the software is not engaging in a trade or business and is ineligible for the deduction. This ignores the current reality of the software development business, and some tax policy commentators are pushing for an amendment to the law or regulations that allows developers receiving royalties to benefit from this deduction.

Tomorrow

Check in for more info about the Research & Experimentation Tax Credit which is more popularly known as the R&D tax credit.

William Lewis is a tax and business attorney based in the Silicon Valley. He advises domestic and foreign clients on a range of business, tax, and estate planning matters. You can reach him by email at lewistaxlaw[at]gmail[dot]com.

Virus photo credit: .hj barraza via cc

Originally published at the Global Law & Business Perspective.

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