Overview of Tax Rules for Software Purchases and Development Costs

We usually get a lot of questions about the proper tax treatment when our clients purchase or develop software.

There are so many questions beacause the type of software varies so greatly.  Software ranges from operating systems and programs that are bundled with computers, to off-the-shelf software available to anyone, to specialized software that is written especially to suit the needs of particular businesses or industries, to software designed to facilitate cloud computing or software developed or extensively adapt available software for their own needs. The tax rules in this rapidly evolving area are complex, and some of them also are murky and dated.

Acquired Computer Software

The tax treatment of acquired, as opposed to developed, software costs depends on whether the costs are separately stated or included in the cost of hardware.

Separately stated costs. The cost of software bought by itself, rather than being bundled into hardware costs, is treated as the cost of acquiring an intangible asset and must be capitalized. The capitalized software cost may be amortized over 36 months, beginning with the month the software is placed in service.

Additionally, the separately stated cost of software may also be eligible for 50% bonus first-year depreciation if acquired before 2013.

Expensing is another alternative. If placed in service in a tax year beginning before 2013, the cost of separately stated computer software is eligible for expensing under Code Sec. 179 if it is readily available for purchase by the general public, is subject to a nonexclusive license and has not been substantially modified.  These limits are quite generous in 2012, based on the total assets purchased.  The limits are set to decrease significantly after 2012, depending on outcome of the political debates set for later this year.

Bundled software. The cost of software included or bundled, without being separately stated, in the cost of the hardware is capitalized and depreciated as a part of the cost of the hardware.

Under MACRS, computers are depreciable over 5 years using 200% declining balance depreciation and, if bought new and placed in service in 2012, are eligible for 50% bonus first-year depreciation. Computers also are eligible for expensing under Code Sec. 179.

Leased or Licensed Software

If a taxpayer leases or licenses computer software for use in its trade or business, the IRS treats it as any other rent and it is deductible as incurred or paid.

Cost of Software Development

The IRS says the costs of developing computer so closely resembles research and experimental expenses that it warrants similar accounting treatment. As a result, a taxpayer may use any of the following three methods for costs paid or incurred in developing software for a particular project, either for the taxpayer’s own use, or to be held by the taxpayer for sale or lease to others:

  1. The costs may be consistently treated as current expenses and deducted in full.
  2. The costs may be consistently treated as capital expenses that are amortized ratably over 60 months from the date of completion of the software development.
  3. The costs may be consistently treated as capital expenses and amortized ratably  over 36 months from the date the software is placed in service.  Under this method, the cost may also be eligible for a bonus first-year depreciation allowance.

Cost of Enterprise Resource Planning (ERP) Software

ERP software is a shell that integrates different software modules for financial accounting, inventory control, production, sales and distribution, and human resources. Consultants often are hired to implement the ERP package by customizing it. This implementation is accomplished by using internal ERP templates and pre-set programs and by writing additional machine readable code.

A later iteration, ERP II, refers to certain software allowing both company employees and suppliers and customers access to the systems via the web.

Guidance dedicated exclusively to developed or otherwise self-created software, including ERP software, should be forthcoming, but such formal guidance has yet to be released. However, PLR 200236028, provides a detailed prescription of how to deal with ERP software. It concerns a fiscal-year, accrual-method Company which acquired ERP software. Company also entered into a consulting agreement with its ERP supplier for additional software development and employee training for the new software, hired another company to act as project manager for the implementation and design modifications of the ERP system, and entered into an agreement with a third company for additional training, software design enhancements, and technical issue resolution.

The PLR concludes that:

  • The costs of the acquired ERP software and sales tax paid on it are amortized ratably over 36 months (as specified in Code Sec. 167(f)(1) and Reg. § 1.167(a)-14(b)(1)) beginning with the month the system is placed in service. Remebr that ERP software that is amortizable over 36 months and bought and placed in service in 2012 generally is eligible for the 50% special depreciation allowance.
  • The functional consulting costs (training, troubleshooting, maintenance, and running reports during the training, but not any reorganization expenditures) and separately incurred maintenance and training expenses are generally deductible as business expenses, even though they may have some future benefit. However, any pre-paid training expenses would be deductible as business expenses in the year in which they are incurred.
  • The project involved technical consulting costs (the modeling and design of additional software, the writing of machine readable code, and the option selection and implementation of existing imbedded ERP templates). Company was solely responsible for adapting and customizing the purchased ERP software. The consultants’ contracts called for them to work on a cost-plus expense, open-end job order, but Company was responsible for the costs of completing the project, including correcting, at its own expense, any problems relating to the software systems’ operability or functionality. The contracts provided no guarantees or warranties, and the consultants were to be paid regardless of their success or failure. The PLR concludes that the technical consulting costs are taxpayer-developed software costs under Rev Proc 2000-50 and are currently deductible.
  • Another portion of Company’s expenses were for technical consulting costs for the option selection and implementation of embedded templates, including any allocable portion for the modeling and design of additional software activity, that is part of enterprise-specific installation/modification costs of the ERP software necessary to make it compatible with Company’s business. Since ERP software cannot be implemented without these steps, IRS ruled that these costs must be capitalized along with the purchased ERP software and amortized ratably over 36 months, beginning with the later of the month the ERP software is put in service or the month the template work is available for use by Company.

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