There seems to be no quick answer to the tax treatment of software developments costs, especially among tax compliance officers in Texas. Local IRS Officers would prefer to call software development cost “start-up costs” and insist on capitalization and then begin a five year amortization in the year that the business began operations. Or the auditor would lean toward the “matching concept” and not allow write-off of expenses until there is income.
More likely than not, since there is generally no income in the year of the software development costs, the auditor would attempt to say that “ there is lack of motive” and disallow the costs entirely.
In fact, software development costs are not start-up costs, but are more closely related to research and development costs.
In summary, software means any program designed to cause a computer to perform a desired function. There are costs to acquire software and costs to develop software.
Costs to acquire software are capitalized and amortized using a straight line method and a useful life of 3 years.
There are two tax treatments of developed software costs. The Current Expense Method and the Capital Expenditures Method. If the tax payer consistently uses one method the IRS will not disturb a taxpayer’s treatments of costs paid or incurred in developing software of a particular project. Under the current expense method, software development costs, for a cash basis taxpayer , isexpensed in the year costs are paid. Following the example of R&D costs, software development costs would be costs incident to the development or improvement of an experimental or pilot model which meets basic design specifications.
You can also include the cost of documentation required to describe and maintain the program or routine. Under the capital expenditures method, all the costs properly attributable to the development of software by the taxpayer are consistently treated as capital expenditures that are recoverable through deductions for ratable amortization over a period of 60 months from the date of completion of the development or over 36 months from the date the software is placed in service.
Consistency is important. If a taxpayer wants to change from one method to another, a Form 3115, Change of Accounting Method, may be required. For an R&D Credit, it appears that software development costs generally are eligible if the software is limited to new or significantly improved software.
Hopefully this is enough information to overcome an IRS auditor’s assertion that software development costs are start-up costs, that the taxpayer does not have a profit motive or that the taxpayer cannot deduct these costs until there are sales of the product.
See Rev. Proc. 2000-50, Sections 167, 197. Private Letter Rulings (PLR) 9345012, 93310057, 9331061 and 2002236028. For R&D see sections 1.174-3 and 1.174-4 and Rev. Rul. 70-637.