By Maples, Larry; Earles, Melanie James
The CPA Journal , Vol. 72, No. 4
Muddled Rules for Software costs
Applying Treasury Department and IRS regulations on the deductibility of software costs requires patience. Two Treasury attempts at writing regulations for the deduction of costs under IRC section 174 met with so much criticism that they were abandoned. In the absence of Treasury regulations, the IRS's hard-line temporary regulations on the IRC section 41 credit on deducting internal software development costs are being applied even though their adoption has been delayed indefinitely. The IRS's Industry Specialization Program has issued useful guidance that the IRS has been following consistently, a good indication of the shape the final regulations will take.
Businesses can recover software costs in several different ways. Certain internally developed software costs may be expensed immediately, while other software costs are subject to various amortization periods (three, five, and 15 years). Software development may also qualify for the IRC section 41 research credit.
The IRS recently issued guidance on handling software costs. Revenue Procedure 2000-50 clears up some ambiguities in previous guidance but does not clarify what constitutes internally developed software. The rules for acquired software are now clear, but remain muddled for developed software. Recent court decisions and a regulations project have addressed the standards that must be met for internal-use software to qualify for the research credit.
Software costs included in the cost of hardware are capitalized and depreciated as part of the cost of the hardware. Thus, non-separately stated software is depreciated over five years using 200% declining balance depreciation under the modified accelerated cost recovery system (MACRS).
Separately stated acquired software can be treated as a capital expenditure amortizable over 36 months starting with the month the software is placed in service, consistent with Treasury Regulations section 1.167(a)-14(b). The recent revenue procedure restates this rule in order to clarify that the rules for acquired software in Revenue Procedure 69-21, which called for amortization over five years unless the taxpayer could establish a shorter period, have been superseded.
The new revenue procedure does not apply to IRC section 197 intangibles. Acquired software that is classified as a section 197 intangible must be amortized over the significantly longer period of 15 years. Taxpayers can, however, use two significant exceptions to remove most acquired software from the reach of this 15-year rule.
IRC section 197(e)(3)(A) and Treasury Regulations section 1.1972(c)(4) provide exception for two types of software that will be amortizable over a 36-month period:
* Software that is acquired separately
* Software that is readily available for purchase by the general public, is subject to a nonexclusive license, and has not been substantially modified.
The disparity between amortization periods may create tension between taxpayers and the IRS. For example, taxpayers will be inclined to interpret the definition of computer software as broadly as possible in order to be eligible for one of the exceptions above. IRC section 197 defines computer software as "any program designed to cause a computer to perform a desired function." This broad definition is narrowed to exclude databases or similar items unless they are in the public domain and incidental to operation of the software. According to the 1993 House of Representatives Conference Report [680; and Treasury Regulations section 1.197-2(c)(4)(iv)], under this definition a spell-check feature is computer software, even though it is a database, because it is incidental to the word-processing program. Definitional questions are inevitable, because of the IRS holding that an item which is not computer software must be amortized over 15 years. …