Tax Deduction for Software - The Guide To Writing Off Software Costs

7 Min Read

Scope of Work

Taxes

Contractor

Tom Smery

Tom Smery is a certified CPA for over a decade. In his free time, he writes articles to pass on his expert knowledge on taxes and accounting. Thomas has a wide range of deep knowledge on 1099 taxes, and finance topics. You can find him fishing when he is not preparing taxes for his clients or writing about accounting.

Yes, you may be able to deduct taxes that are software-oriented. Treatment of software is considered as a miscellaneous deduction, and you may use the IRS Code Section 179 - Net Operating Loss Deduction. You may claim these expenses at the end of the tax year when you are filing for the other deductions of your business.

Bear in mind that for you to deduct computer software expenses, certain conditions need to apply. These conditions include:

Your deductions are itemized
Your deductions make up more than 2% of your AGI

As long as the conditions are met, you are eligible for a tax write-off.

Note: If you want to maximize all of your tax deductions at the push of a button, try Bonsai Tax. Our receipt scanner can discover potential tax write-offs from your credit card/bank statements. Users typically save an average of $5,600 with our software. Claim your 14-day free trial here.

What Is Section 179?

Section 179 is part of the IRS tax code that allows business owners to deduct treatment of software and other miscellaneous qualifying equipment. The Section 179 deduction allows you to get a tax write-off for software pieces that were either purchased or leased for your company.

Section 179 has been around for a while, and the chances are high that every business owner may have deducted some costs through it. Items within the code continue to change, as well as the requirements.

For the 2021 tax year, Section 179 has the following specifications for software equipment:

100% bonus depreciation
$2,620,000 spending cap
$1,050,000 deduction limit

The purpose of this deduction is to help small businesses with average income make purchases encouraging business growth. An organization can deduct purchases in the year that they become qualified for it, helping them increase their income.

Types of Software You Can Write Off

Depending on the nature of your business, you can deduct several types of software. Categorization depends on their use and development, and once you familiarize yourself with the tax rules of Section 179 for computer software, you should be able to calculate your tax deduction.

Without further ado, here is what the IRS allows you to deduct at tax time.

Purchased Software

Some software costs fall into the category of "purchased software," meaning that they will have a specific deduction method according to the IRS. For computer software to be considered "purchased," it needs to follow at least one of the rules below:

It is a piece of computer software that received no customized treatment and is available to the general public and without an exclusive license to the buyer
It needs to be bought from a contractor who is at risk for an economic downfall, should the software fail to perform.

For software to be considered a deductible expense, it cannot have a code that is specifically related to your business. For software to be deductible purchase, it needs to meet the following criteria:

Business owners use it in more than half their tasks, being an important part of income generation.
The life of the purchased software product, whether it includes hardware or not, should be at least half a year.
The software needs to be given a "determinable useful life," during which the buyer can expect to use the product without any issues.

The full cost of the computer software may be deducted through section 179, as long as it is filed in the year that it has been placed into service. In other words, you'll need to write it off immediately, by the end of the current tax year - and not after it had led a long and "useful life."

There are some cases in which you may not be immediately deductible - for example, when you do not meet the deduction requirements. You may want to keep a record of your purchases so that the IRS can determine whether you are eligible or not.

That being said, if these costs are not immediately deductible, they may be amortized over a three-year tax period. The calculations will start from the month you purchased the computer software for your business or property and put it into service.

Sometimes, software can be bought as part of a hardware purchase - in which case, you may not have a separately stated cost for the computer software. In this scenario, you'll have to treat the cost as if it is part of the hardware.

In other words, when you depreciate the costs of the hardware over the years, the same thing should apply to the cost of software. Moreover, if the software you bought is part of a substantial purchase for your business, then the costs of the software ought to be amortized over the next 15 years.

Leased Software

Even if you just lease software rather than purchase it, it still means that you'll have paid quite a lot for it. In many cases, software subscriptions are not cheap. As a result, the general public may have issues keeping up with the yearly costs.

Thankfully, the IRS allows for tax deduction when you decide to lease rather than purchase a piece of software. For example, if your company needs a subscription for a Cloud service or a paid online service, the costs for it are considered deductible.

The deduction needs to be filed for in the same year that you paid for it. This applies if you're a cash-type taxpayer, in which case you'll have to pay by the end of the tax year.

However, if you are an accrual-type taxpayer, then it needs to be paid by the end of the tax year when the leased items are accrued. You might want to check with the IRS page about the deadlines and other aspects, as the code often goes through different changes.

Bear in mind that leased software may not be deductible in the years before the computer software being allocable. Moreover, if the leased product has rental costs that go past $250,000, the IRS may apply a series of special rules. You may want to further investigate with them for lease-related aspects if this applies.

Note: a tax software for self-employed folks that will help maximize tax deductions for the year...could also be written off. Bonsai Tax will scan your receipts from your bank/credit card statements and help you save thousands during tax time. In fact, users save on average of $5,600 by using our software. Try a 14-day free trial today.

Company-Developed Software

Even if you do not purchase or get software on a lease, it doesn't mean that you do not suffer any costs. In many circumstances, software development costs can become an even bigger expense.

Software is categorized as "developed" when its development took place within the business. In other words, the company did not purchase it but instead created it.

If the software does not perform well on the market, then the contractor will not be at economic risk. It is their property, so the market is not that important.

For the following tax year, the bonus depreciation applies for software development costs, should it meet the condition. If the bonus depreciation is not applicable, then the tax payer can choose to deduct the development costs through other means. Amortization periods throughout multiple years are often used in order to cover related costs.

How Much Can You Deduct for Software?

While you can still deduct the costs for the computer software, keep in mind that they are part of the "MISC Deductions" category. As a result, you can only deduct what is over 2% of your AGI. That is the minimum deduction you can go for.

With that in mind, if you meet all of the requirements, you may deduct up to $1,050,000 of that purchase from the gross income of your company. If the software purchase goes past this price, then you can get the 100% bonus deduction for it instead.

Check with the IRS to see how much you can get. In most cases, it will depend on the income of the taxpayers, the costs inquired, and whether the piece receives custom treatment or not. This section will also come with more details.

Check out our full list of 1099 write-offs to see what other deductions you may qualify for as a freelancer.

The Bottom Line

Taxpayers who wish to run a business can generally have all their expenditures written off. The condition is that they meet the requirements asked in Section 179. With their taxes deducted, they can now focus on making a profit for their business.

What Defines a Verbal Contract?

A verbal contract (formally called an oral contract) refers to an agreement between two parties that's made —you guessed it— verbally.

Formal contracts, like those between an employee and an employer, are typically written down. However, some professional transactions take place based on verbally agreed terms.

Freelancers are a good example of this. Often, freelancers will take on projects having agreed on the terms and payment via the phone, or an email. Unfortunately, sometimes clients don't pull through on their agreements, and hardworking freelancers can find themselves out of pocket and wondering whether a legal battle is worth all the hassle.

The main differences between written and oral contracts are that the former is signed and documented, whereas the latter is solely attributed to verbal communication.

Verbal contracts are a bit of a gray area for most people unfamiliar with contract law —which is most of us, right?— due to the fact that there's no physical evidence to support the claims made by the implemented parties.

When is a Verbal Agreement Legally Binding?

For any contract (written or verbal) to be binding, there are four major elements which need to be in place. The crucial elements of a contract are as follows:

Offer and acceptance: An offer is made and accepted by another party involved in the agreement;
Consideration: The involved parties must exchange something of value (money, a service, time, etc), this is known as consideration;
Intention and certainty: All parties must fully understand the terms of the contract and intend to make a legally binding agreement freely; and
Capacity: The parties must have the capacity to legally enter into the contract; they're above age and of a stable mindset.

Therefore, an oral agreement has legal validity if all of these elements are present. However, verbal contracts can be difficult to enforce in a court of law. In the next section, we take a look at how oral agreements hold up in court.

How strong is a verbal agreement in court?

Most business professionals are wary of entering into contracts orally because they can difficult to enforce in the face of the law.

If an oral contract is brought in front of a court of law, there is increased risk of one party (or both!) lying about the initial terms of the agreement. This is problematic for the court, as there's no unbiased way to conclude the case; often, this will result in the case being disregarded. Moreover, it can be difficult to outline contract defects if it's not in writing.

That being said, there are plenty of situations where enforceable contracts do not need to be written or spoken, they're simply implied. For instance, when you buy milk from a store, you give something in exchange for something else and enter into an implied contract, in this case - money is exchanged for goods.

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When are verbal agreements not enforceable?

There are some types of contracts which must be in writing.

The Statute of Frauds is a legal statute which states that certain kinds of contracts must be executed in writing and signed by the parties involved. The Statute of Frauds has been adopted in almost all U.S states, and requires a written contract for the following purposes:

The sale of real estate or vehicles
Real estate leases lasting longer than one year.
Property transfer following the death of the owner.
The case of a party agreeing to pay debt for someone else.
Any contract that requires more than a year to fulfil.
A contract involving and exceeding a specified amount of money (which varies by state).

Typically, a court of law won't enforce an oral agreement in any of these circumstances under the statute. Instead, a written document is required to make the contract enforceable.

Contract law is generally doesn't favor contracts agreed upon verbally. A verbal agreement is difficult to prove, and can be used by those intent on committing fraud. For that reason, it's always best to put any agreements in writing and ensure all parties have fully understood and consented to signing.

How are Verbal Contracts Enforced?

Verbal agreements can be proven with actions in the absence of physical documentation. Any oral promise to provide the sale of goods or perform a service that you agreed to counts as a valid contract. So, when facing a court of law, what evidence can you provide to enforce a verbal agreement?

How can you prove an oral contract?

Unfortunately, without solid proof, it may be difficult to convince a court of the legality of an oral contract. Without witnesses to testify to the oral agreement taking place or other forms of evidence, oral contracts won't stand up in court. Instead, it becomes a matter of "he-said-she-said" - which legal professionals definitely don't have time for!

If you were to enter into a verbal contract, it's recommended to follow up with an email or a letter confirming the offer, the terms of the agreement , and payment conditions. The more you can document the elements of a contract, the better your chances of legally enforcing a oral contract.

Another option is to make a recording of the conversation where the agreement is verbalized. This can be used to support your claims in the absence of a written agreement. However, it's always best to gain the permission of the other involved parties before hitting record.

Written vs Verbal Contracts: What's the Verdict?

Fundamentally, most verbal agreements are legally valid as long as they meet all the requirements for a contract. However, if you were to go to court over one party not fulfilling the terms of the contract, proving that the interaction took place can be extremely taxing.

So, ultimately, the question is: written or verbal agreements?

Any good lawyer, contract law firm, or legal professional would advise you to make sure you formalize any professional agreement with a written agreement. Written contracts provide a secure testament to the conditions that were agreed and signed by the two parties involved. If it comes to it, a physical contract is much easier to eviden in legal circumstances.

Freelancers, in particular, should be aware of the extra security that digital contracts may provide. Many people choose to stick to executing contracts verbally because they're not sure how to write a contract, or they think writing out the contract terms is too complicated or requires expensive legal advice. However, this is no longer the case.

"@bonsaiinc is probably my all time favorite freelance tool. hands down. the team is super responsive and accessible when i have questions."

David Urbinati

Motion design / animation

Say hello to digital contracts

Today, we have a world of resources available at our fingertips. The internet is a treasure trove of invaluable information, platforms, and software that simplifies our lives. Creating, signing, and sending contracts has never been easier. What's more, you don't have to rely on a hiring a lawyer to explain all that legal jargon anymore.

There are plenty of tools available online for freelancers to use for guidance when drafting digital contracts. Tools like Bonsai provide a range of customizable, vetted contract templates for all kinds of freelance professionals. No matter what industry you're operating in, Bonsai has a professional template to offer.

Benefits of written contracts

A written contract makes the agreement much easier to prove the terms of the agreement in case something were to go awry. The two parties involved can rest assured that they're legal rights are protected, and the terms of the contract are sufficiently documented. Plus, it provides both parties with peace of mind to focus on the tasks at hand.

Create Professional Contracts with Bonsai

Bonsai's product suite for freelancers allows users to make contracts from scratch, or using professional templates, and sign them using an online signature maker.

With Bonsai, you can streamline and automate all of the boring back-office tasks that come with being a freelancer. From creating proposals that clients can't say no to, to sealing the deal with a professional contract - Bonsai will revolutionize the way you do business as a freelancer.

Why not secure your business today and sign up for a free trial?

Tom Smery

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