John Beesley is a seasoned Certified Public Accountant (CPA) and early adopter of cloud-based professional software. As a small business owner himself, he imparts knowledge to help law firms and small businesses thrive. He spoke with me about how law firms can deduct tech tools for their litigation practice on their taxes. The conversation was edited for clarity and brevity.
What are business deductions, and why are they important for law firms? Business deductions are important for anyone who wants to hold onto their income or money. A valid deduction, first of all, is something allowed for in the tax code, and secondly, is anything ordinary or necessary or reasonable for a business. So there are two levels: it first has to be allowed by law and then it has to be a reasonable, prudent expense.
You might also say that it’s an expense paid with the intent to generate income, whether it be advertising, or anything that enables a business to be more efficient or profitable; the end goal of the expense is to generate more revenue.
Can software solutions be deducted from taxes? If so, what types of software can be deducted by law firms? Certainly they can, and anything that helps the law firm do their business better --- be more efficient, be more profitable --- can be deducted on taxes. When I started my own CPA practice, I thought about using the tax software from my old firm, which either came as a CD in the mail or was downloaded onto a desktop. It was expensive and cumbersome. I had to make sure the software was continuously updated. I found myself doing IT tasks that I didn’t want to do. I just wanted to practice accounting, not be a technology expert.
The next year I searched and found a cloud computing software package, a type of product known as Software as a Service (SaaS). At the time this was likely the only cloud computing pro tax software available. It’s been great! The cloud software took away the cumbersome work I had to do with respect to the other software.
The product was developed by a smaller software company, and there have been some growing pains I rode through with them. At the end of the day, it’s been fabulous, I’ve never switched software, and it has gotten better every year. By paying for cloud-based software, I get to do what I do best and it makes my life more efficient.
I remember going to an office supply store and picking up a box that contained Microsoft Word. Does the software have to be a physical copy of the software license to qualify for the deduction?
Businesses are no longer buying the software license outright, but are going to lease or rent it. Software overall is moving toward a subscription model, and these tools live in the cloud.
For the tax deduction, we must look at it differently because it is different. That’s a good thing!
= Taking the deduction is now more straightforward because the cost of a cloud-based software solution is immediately deductible.
With previous software solutions, businesses had to consider how it is they came to own it: whether it was included as part of computer purchase, obtained by buying a business, or developed specifically for that unique business.
Similarly, software that is purchased usually means the user would have a perpetual license to use the software. The tax code would probably consider it to be an asset that is deductible over three years. SaaS is not this.
Relatedly, is there a difference between a subscription vs. a one-time purchase when it comes to taking the tax deduction?Yes, SaaS is not something that a firm owns, as it’s not something for which a firm has an unlimited license. Usually, SaaS subscriptions are either monthly or up to a 12-month subscription. With the subscription model, a firm would be able to deduct the cost of the software regardless of other circumstances.
In contrast, when off-the-shelf software is purchased, and it’s something the firm owns, then it’s a matter of evaluating the deduction based on ownership. An off-the-shelf computer program may be deducted over three years, or it could qualify for bonus depreciation (currently available through 2022), or if the deduction created a loss to the business then one could consider it as a suspended loss.
To be able to take the tax deduction, does the software have to be of a type that is commonly used in the area of practice by other law firms? There is some discussion about this, but in a different context that raises the question of whether the software was generated with unique licensing. For example, a firm that hires a software developer to build out a solution specific to the firm or its specific client. Oftentimes, the firm would fully own the highly specialized software.
For SaaS, it’s more straightforward: we’re talking about widely used and distributed software.
Does it matter what time of year a law firm buys software? For example, does a business need to wait for a new fiscal year to buy a subscription? No, for a service-based, cloud-based software solution, the timing of the purchase doesn’t matter. As soon as we start using it and paying for it, the tax code recognizes it as a deductible expense. That being said, the tax code allows us to deduct something to be used up typically within a 12 month period. If we pay for something beyond the 12 months, then the cost must be allocated to the period to which it applies.
Is there a limit to how many types of business software can be deducted? No, any SaaS that is ordinary, necessary, and reasonable is allowed to be deducted under the tax code. There could be types of cloud-based solutions that are more directly relevant to a law firm’s work. And there may be other software solutions that are for the enjoyment of their employees. For example, a firm might purchase a music subscription for all their attorneys to keep them happy working long hours in their chair; nonetheless, it would be a business deduction ntended to generate more revenue.
What are some best practices for law firms claiming this deduction? It’s simple: prove that the firm paid for it and demonstrate that it is something currently used in the business. Most folks aren’t holding onto a paper receipt when purchasing software solutions - that’s great! Who wants to shuffle through paper receipts anymore?
Here’s my practice for cloud-based software: I save a PDF copy of my purchase into a cloud-based repository of information. With that, I can show to the IRS, if needed, a bank statement, receipt, or subscription fee for 12 months or less which would allow me to deduct the purchase from my taxes.
Disclaimer: This article is provided for educational purposes only, and to give general information and a general understanding of the topic, not to provide specific tax or legal advice. This article should not be used as a substitute for competent tax or accounting advice from a certified professional accountant or licensed professional attorney in your state.
