So, you’ve 
got an idea for a piece of software that will change the world? How do you best monetize your product so that you can get the well-deserved reward for your efforts? Fortunately, we’re here to layout a few options and explain what their tax treatment looks like.
There will be a lot of differences in tax treatment depending on if you are an LLC or a Corporation. To better understand these differences, you should check out our blog regarding Choice of Entity.
Software Income Types
The basic ways to monetize a piece of software are these:
- Sell the Software;
- Subscriptions (users pay an ongoing feed);
- Advertisements;
- Sell the Company around the Software;
- License the Software;
- Sell the Data the Software Creates or Receives;
- Pay for Premium Features;
- Seek Donations.
Tax Types
There are only a few ways income can be taxed. These are:
- Ordinary Income;
- Passive Income; and
- Capital Gains.
Preference
Generally, the preference you want your income to be taxed is in this order: (1) Capital Gains, (2) Passive Income, and (3) Ordinary Income. The IRS, however, would prefer the tax goes in the other direction, so you have to be able to prove your classification.
Ordinary Income
The most common type of income you see on a day-to-day basis is the Ordinary Income. This is income generated from all sources that you worked for that doesn’t involve the selling of assets. Ordinary income includes wages from a company as W-2 or 1099. This Ordinary Income is what you receive if you have subscriptions, advertisements, licenses, sell the data, have premium features or seek donations, in most cases. We’ll discuss the uncommon cases a little later. Ordinary Income is the worst type of tax treatment because you have to pay income tax and the FICA taxes. The FICA taxes alone are a 15.3% tax after the individual and company portions.
Capital Gains
Capital Gains is what you get when you sell an asset for a profit. The simple example would be that you bought a tractor for $20,000 and sold it for $30,000. $10,000 would be taxed as Capital Gains and $20,000 of the sale would be what is called “Return on Capital” which is a 0% tax because you’re not showing a profit. This example is very simple because depreciation and improvements need to be taken into account.
In the world of software, your blank screen on your IDE is worth $0. Then you add libraries you’ve licensed or paid for, build a framework, and then fill in all the code. After that, you add in graphics and spruce up the GUI, making your product look good as well as work well. Through each of these steps, you’re making the product worth more. When you sell it or the company, any money you put into it is considered Return on Capital and the gain is Capital Gains. Capital Gains is going to be taxed between 15% and 40% depending on a lot of circumstances.
Passive Income
Passive Income happens when you are no longer working on something, yet still receive payments for it. This can include royalties and license fees if you’re not out there brokering these deals. You also cannot be involved in the management of the company to receive the Unearned Income tax treatment. The best example of this is a silent partner in a company. This person put money or time in and that stepped away. She still earns a portion of the profit based on ownership or some other previous agreement, and this money received outside of work is considered Passive Income.
In the software world, Passive Income can come up with license fees and royalties after you’ve stopped providing support and maintenance on a product. Passive Income is taxed at different rates, depending on what it is. Royalties and licenses are taxed as Ordinary Income without the FICA taxes as long as there is no ongoing effort or management by the taxpayer.
Conclusion
Knowing all of this, now it is time to structure the company’s revenue in a way that makes the most sense from a tax and business standpoint. If it doesn’t make sense to make grow the company and sell it, then don’t rely on that strategy just because of the preferential tax treatment. You can also combine strategies. There’s nothing that says you cannot have a subscription model with advertising that sells the data you generate with the goal of ultimately selling the software to a third party. When you do this, just make sure you have a CPA or tax attorney helping ensure you choose the most beneficial strategy for your income.