For expenses associated with software, the tax accounting — whether the expenses can be deducted currently or must be capitalized and depreciated or amortized — can be handled in many different ways depending on how the software costs are incurred. For instance, software can be purchased or it can be internally developed. Purchased software can be acquired off the shelf, bundled with hardware, acquired as part of an acquisition of assets, or licensed from a third party. For internally developed software, there are several ways to deduct these costs.
Purchased software
- Off-the-shelf: Software purchased off the shelf is typically amortized over 36 months. Off-the-shelf software is eligible for bonus depreciation, however, if its original use begins with taxpayer in question. It is also currently eligible for IRC §179 expensing as long as the software is readily available for purchase by the general public, has not been substantially modified, and is not subject to an exclusive agreement or license.
- Bundled: Software that is bundled with a hardware purchase is treated as part of the hardware cost unless the cost of the software is separately stated. If it is not separately stated, then it is depreciated as part of the computer over five years (and otherwise eligible for bonus depreciation or IRC §179 expensing). If the software cost is separately stated then it is treated as off-the-shelf software.
- Acquired as Part of an Asset Acquisition: Software is treated as an IRC §197 intangible asset if it is acquired as part of the acquisition of assets constituting a trade or business. Section 197 intangibles are generally amortized over 15 years; however, if the acquired software is readily available for purchase by the general public, has not been substantially modified, and is not subject to an exclusive agreement or license, then it is treated as off-the-shelf software. Most internally developed and specialty software programs will fall under the IRC §197 intangible rules when they are acquired as part of an acquisition of a trade or business.
- Licensed: Software that is licensed from a third party vendor is treated similarly to a leasing arrangement. The cost of software licensing is amortized over the term of the licensing agreement.
Internally-developed software
Internally developed software may qualify for special software development treatment, which is similar to research and experimental expenses under IRC §174. Software development expenses can be deducted in one of three ways:
- Consistently treated as current expenses and deducted in full;
- Consistently treated as capital expenses and amortized ratably over 60 months from the date of completion of the software development; or
- Consistently treated as capital expenses and amortized ratably over 36 months from the date the software is placed in service (under this option the costs are eligible for bonus depreciation and §179 expensing).
"Software development" has not been specifically defined by the IRS. Generally, costs incurred under a contract to develop software are "software development" costs if the taxpayer is economically at risk for the functionality of the software. When an outside consultant or contractor bears the risk for the functionality of the software, the costs are treated as purchased software and subject to off-the-shelf treatment.
Two areas where the costs need to be analyzed closely are ERP system implementations and website development. The costs of these systems need to be subdivided into their various components and treated separately. For ERP implementations, the costs involved commonly would include purchased software, software development and various currently deductible expenses (e.g., training, technical support). Website development costs may include some hardware costs in addition to purchased software, software development and various currently deductible expenses (e.g., advertising, marketing, content).
A taxpayer's treatment of software costs is an accounting method. If a taxpayer has adopted a method of accounting for either purchased software or for software development costs, an automatic method change (number 18) is available if one of the other tax accounting methods is preferable. Your local CBIZ tax professional can assist you in analyzing your software costs and maximizing the tax benefits available.
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