The tax treatment of computer software can be a confusing area. Computer software is an intangible product itself, but it can be acquired in a variety of ways. It may be bundled with a computer processor (hardware), sold on a disc as computer software, downloaded over the Internet, accessed (but not downloaded) over the Internet, or developed by the taxpayer. It may be acquired by itself, or as part of a business. Thus, the treatment of computer software can vary, depending on the circumstances. In view of these variations, it is important to get proper advice as to the tax treatment of computer software.
Computer software is treated as an intangible under Code Sec. 197 if it is acquired as part of the acquisition of the assets of a trade or business. In this situation, the software must be amortized over 15 years, a fairly long period. However, if the software is stated and sold separately, not as part of a business acquisition, it can be amortized on a straight-line basis over 36 months. Off-the-shelf computer software can also qualify for Code Sec. 179 small business expensing if it is placed in service in a tax year beginning in 2012. (Code Sec. 179 expensing generally is reserved for tangible personal property.)
Bundled software that is included in computer hardware must be capitalized and depreciated over the life of the hardware, generally five years for computers. If the software is leased or licensed, it may be deducted under Code Sec. 162. If the taxpayer prepays for several years use of the software, the payments must be deducted ratably over the period of use.
Software that is developed by the taxpayer is treated like other research expenditures. It may be deductible over Code Sec. 174(a) as expenses are paid. The taxpayer may instead elect to capitalize the cost of the software under Code Sec. 174(b) and to amortize the costs over 60 months, beginning at the time the software is completed. Finally, the taxpayer could amortize the software over 36 months, beginning after the software is placed in service.
Finally, there also are rules for enterprise research planning (ERP) software. ERP software is a shell that integrates different software modules for financial accounting, inventory control, sales and distribution, production, and human resources. Until the IRS issues regulations on ERP software, taxpayers have relied on a 2002 IRS letter ruling, providing that:
- The cost of purchased ERP software is amortized ratably over 36 months under Code Sec. 167(f);
- Training and related costs under a consulting contract are deductible as current expenses;
- Separately stated computer hardware costs are depreciated as five-year MACRS property (“qualified technological equipment”);
- The costs of writing machine-readable code software are treated as developed software and may be deducted currently, like research and development expenditures; and
- The costs of option selection, implementation of ERP templates, and costs of software modeling and design are treated as installation/modification costs and are amortized over 36 months as part of the purchased ERP software.
The domestic production activities deduction under Code Sec. 199 is an additional nine percent deduction from income that is based on the amount of the taxpayer’s qualified production activities income (QPAI). QPAI includes receipts for the lease, license, sale or disposition of an item, including computer software that is sold through a disc or download. However, QPAI generally does not include income from the provision of online services for the use of computer software, because there is no disposition of a product.
Please contact our office at (908) 725-4414 if you have any questions about deducting computer software and development costs.