Unlike computer software, the US tax code has no built-in error messages. That can lead to user confusion, such as when you’re trying to figure out how to deduct the cost of software. For example, the software you purchase to complete your individual income tax return is considered a tax preparation fee. When you itemize, you can include the cost on Schedule A and deduct it, subject to a 2% haircut.
For businesses, the tax treatment of software is murkier. Off-the-shelf software—the business-use equivalent of your tax program—can be fully deductible under code section 179 or depreciable over a three year term. To qualify for immediate expensing, the software must be readily available for purchase, subject to a nonexclusive license, and used as-is. (Note that eligibility for section 179 is part of the annual “extender” tax rules and has expired for 2015, but may be retroactively reinstated before the end of the year.)
Other software used by businesses is generally considered intangible property and the tax treatment depends on whether the software is purchased or leased. Software that a company develops is treated in a manner similar to research costs, and may be expensed or capitalized and amortized.
Costs related to software, such as the computer itself (hardware), as well as maintenance, trouble shooting, and training employees, may be depreciated or expensed currently.
In Private Letter Ruling 200236028, released in 2002 and still effective today, the IRS considered the question of the tax treatment for a specialized software known as Enterprise Resource Planning (ERP). This software integrates different modules for financial accounting, inventory control, production, sales and distribution, and human resources. Usually consultants are hired to implement the package by customizing the software programs and routines to fit specific needs. This implementation is accomplished by using templates and pre-set programs and by writing additional machine readable code. The software is not usable until the implementation is completed.
The taxpayer bought computer hardware and ERP software and entered into a consulting agreement for additional software development and employee training. In addition, the taxpayer entered into an agreement for the consultant to act as project manager for the implementation and design modifications. The taxpayer entered into an agreement with a second company for additional training, software design enhancements, and technical issue resolution.
The actual cost for the software and the consulting combined, excluding the computer hardware, was almost four times higher than budgeted. Under the consulting contracts, the taxpayer 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 of the operability of the systems whose development the consultants were aiding. The consultants were to be paid regardless of their success or failure.
The taxpayer wanted to know how to deduct the cost of the purchased software, the developed software, the employee training costs, and the computer hardware.
Here’s the relevant tax law.
From Internal Revenue Code Section 162: Provides, in part, that there shall be allowed as a deduction all ordinary and necessary expenses paid or occurred during the taxable year in carrying on any trade or business.
From Internal Revenue Code Section 167(a): Provides, in part, that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear, or obsolescence of property used in a trade or business. For purposes of section 167, the term “computer software” is defined in section 167(f)(1)(B) as having the meaning given to such term by section 197(e)(3)(B), except that such term shall not include any computer software that is an amortizable section 197 intangible.
From Internal Revenue Code Section 167(f)(1)(A): If a depreciation deduction is allowable under section 167(a) for computer software, such depreciation deduction shall be computed by using the straight line method and a useful life of 36 months.
From Internal Revenue Code Section 197(c): Except as otherwise provided in section 197, section 197(c) defines the term “amortizable section 197 intangible” as meaning, in general, any section 197 intangible that is acquired by the taxpayer after August 10, 1993, and that is held in connection with the conduct of a trade or business or an activity described in section 212. Section 197(e)(3)(A) provides, in part, that the term “section 197 intangible” shall not include computer software that is not acquired in a transaction (or series of related transactions) involving the acquisition of assets constituting a trade or business or substantial portion thereof.
From Internal Revenue Code Section 197(e)(3)(B): Provides that the term “computer software” means any program designed to cause a computer to perform a desired function. Such term shall not include any data base or similar item unless the data base or item is in the public domain and is incidental to the operation of otherwise qualifying computer software.
From Internal Revenue Code Section 263(a): Provides, in part, that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.
From Treasury Regulation 1.263-(a)-1(b): In general, capital expenditures include amounts paid or incurred (1) to add value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or (2) to adapt property to a new or different use. However, amounts paid or incurred for incidental repairs and maintenance of property are not capital expenditures.
From Revenue Procedure 2000-50: Provides guidelines on the treatment of the costs of computer software. Section 2 of this revenue procedure defines computer software as any program or routine (that is, any sequence of machine readable code) that is designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine. Section 5.01 provides, in part, that the cost of developing computer software in many respects so closely resemble the kind of research and experimental expenditures that fall within the purview of section 174 as to warrant similar accounting treatment.
How would you treat the following costs?
ERP software fee and sales tax
Functional consulting costs—Maintenance, training, trouble shooting
Technical consulting costs—Write machine readable code
Technical consulting costs—Option/implement existing embedded templates
This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.
The separately stated computer hardware cost is to be capitalized under section 263(a) and depreciated under section 168 over a 5-year recovery period.
The cost of the purchased ERP software (including the sales tax) is to be capitalized under section 263(a) and amortized ratably over 36 months, beginning with the month the software is placed in service by taxpayer.
The employee training and related costs are deductible as current expenses under section 162.
If the taxpayer is solely responsible for the creation and performance of the software project covered by the consulting contracts, the costs of writing machine readable code software under the consulting contracts are self-developed computer software and are allowed to be deductible as current expenses pursuant to section 5.01(1) of Revenue Procedure 2000-50.
The costs of option selection and implementation of templates under the consulting contracts are installation/modification costs that are to be capitalized and amortized as part of the purchased ERP software ratably over 36 months, beginning with the later of the month the purchased software is placed in service by the taxpayer or the month the template work is available for use by the taxpayer.