For tax years beginning after Dec. 31, 2021, taxpayers must charge specified research or experimental (R&E) expenditures to a capital account. An amortization deduction is allowed ratably over a five-year period (a 15-year period in the case of such expenditures attributable to research conducted outside the United States, within the meaning of Sec. 41(d) (4)(F)). As of this writing, no technical guidance has been issued regarding the amended statute, and questions have arisen that taxpayers must consider for their 2022 federal income tax returns, absent congressional enactment of legislation retroactively restoring prior law.
Before this amendment to Sec. 174, specified research or experimental costs could be currently deducted. The change to requiring mandatory capitalization was made by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, which also amended Sec. 174 to include software development costs in the scope of R&E expenditures (Sec. 174(c)(3)). The result is that software development costs must now be capitalized and amortized over five (or 15) years as well.
However, there is no current guidance on what “software development” means in this context. For instance, how is software development distinguished from software acquisition, and how is third-party contract research treated? Until such guidance is issued, taxpayers seeking to determine the fundamental characterization of software costs in order to evaluate what expenditures fall within the scope of new Sec. 174 may find other sources helpful, including those that have historically governed this area.
Historical treatment of software costs
Sec. 263(a): Under Sec. 263(a) and Regs. Sec. 1.263(a)-4, amounts paid to create or enhance certain intangible assets, including separate and distinct intangible assets, must be capitalized. However, software development costs do not create separate and distinct intangible assets unless otherwise provided in the Internal Revenue Code, the regulations thereunder, or other published guidance (Regs. Sec. 1.263(a)-4(b)(3)(iv)). In contrast, acquired software is capitalizable under Regs. Sec. 1.263(a)-4(c).
Former Sec. 174: For years beginning before 2022, Sec. 174(a) provided a current deduction of R&E expenditures. Regs. Sec. 1.174-2(a)(1) defines the term “research or experimental expenditures” as those “which represent research and development costs in the experimental or laboratory sense.” The regulations further provide that the term specifically includes all such costs incident to the development or improvement of a product. Furthermore, costs represent research and development costs if they are for activities intended to discover information that would eliminate uncertainty concerning the development, improvement, or design of a “business component” (e.g., a product or manufacturing plant process).
Rev. Proc. 2000-50: Software development costs generally were treated as similar to Sec. 174 expenditures under Rev. Proc. 2000-50 (now obsolete in part due to the inclusion of software development in post-2021 Sec. 174(c)(3)) and its predecessor, Rev. Proc. 69-21. Section 5 of Rev. Proc. 2000-50 provides, “The costs of developing computer software (whether or not the particular software is patented or copyrighted) 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.” As a result, “the Service will not disturb a taxpayer’s treatment of costs paid or incurred in developing software for any particular project, either for the taxpayer’s own use or to be held by the taxpayer for sale or lease to others,” where the taxpayer either treated the costs as currently deductible expenses under former Sec. 174(a) or capitalized and amortized them under former Sec. 174(b) (id.).
Section 2 of Rev. Proc. 2000-50 defines computer software for this purpose as “any program or routine (that is, 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.” Also under the revenue procedure, software development includes all forms and media in which software is contained (e.g., operating systems, executive systems, monitors, compilers and translators, assembly routines and utility programs, and application programs). Software development does not include a data or information base described in Regs. Sec. 1.197-2(b)(4) — e.g., data files, customer lists, or client files — unless the item is in the public domain and is incidental to a computer program (Regs. Sec. 1.197-2(c)(4)(iv)), nor does it include costs or procedures that are external to a computer’s operation.
IRS memos and letter rulings: Several IRS technical advice memorandums (TAMs) and private letter rulings, applying Rev. Proc. 2000-50 and other guidance described above, provide insight into the treatment of third-party contract research and other software development activities.
For software development performed by third parties, the IRS appears to have developed an ownership and risk-based test. In TAM 8614004, the IRS held that the taxpayer’s payments to a software developer that initially bore the risk of developing a new software system constituted the costs of purchased software up to a specific amount stipulated in the contract. The IRS also held in this TAM that any excess payments made when the taxpayer assumed risk are the costs of developing software. Similarly, in TAM 9449003, the IRS held that advance royalty payments made by computer game publishers to independent software developers represented amounts paid to acquire software. These amounts were required to be capitalized as purchased software under Section 4 of Rev. Proc. 69-21 and were not deductible under Sec. 174 because the third party was at risk for the development of the property.
For other software development activities, the IRS has provided insight into their characterization in the context of a taxpayer’s implementation of information systems and enterprise resource planning (ERP) systems. For example, in Letter Ruling 8632053, the IRS concluded that certain payments made to consultants for assisting in the development of an information system qualified as software development costs.
The IRS discussed various phases of the software development life cycle in the facts of the ruling. Software development was broadly defined to include the project definition phase, general design phase, detailed design phase, and a systems implementation phase. The IRS reasoned those costs incurred in these pre-production phases were directly attributable to software development, with the pre-production phase ending when the application had been completed, debugged, and turned over to computer operators. The IRS qualified this determination, indicating that the software development expenditures did not include the costs of purchasing or modifying software packages and did not cover the costs of any procedures external to computer operations.
In Letter Ruling 200236028, the taxpayer purchased a standard ERP software package and hired consultants to customize and implement it. The IRS concluded that:
- Employee training and related costs were deductible under Sec. 162;
- Hardware costs were capitalizable under Sec. 168 and depreciated under Sec. 167 over a five-year recovery period;
- The purchased ERP package was capital in nature, capitalized under Sec. 263(a), and amortized straight line over 36 months pursuant to Sec. 167;
- The costs of option selection and implementation of templates (and their allocable portion of the costs of modeling and design of additional software) under the taxpayer’s consulting contracts were installation/ modification costs that were 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 was placed in service by the taxpayer or the month the template work was available for use by the taxpayer; and
- Where the taxpayer was at risk for the creation and performance of the software project covered by the consulting contracts, the costs of writing machine-readable code software (and its allocable portion of the costs of modeling and design of additional software) under the taxpayer’s consulting contracts were for self-developed computer software and allowed to be deductible as current expenses pursuant to Section 5.01(1) of Rev. Proc. 2000-50.
The IRS reaffirmed this private letter ruling’s conclusions in Chief Counsel Advice 201549024, indicating that software development expenditures under Section 5.01(1) of Rev. Proc. 2000-50 occur when the taxpayer is solely responsible for the creation and performance of the software (i.e., an ownership and risk-based test).
Prior to 2022, software development costs definitionally were not deemed to rise to the level of an R&E cost under Sec. 174, and a separate analysis was required to determine if software development activities were in the nature of Sec. 174 expenditures when relevant for other provisions (e.g., Sec. 41 or Sec. 861). Even though software development costs were afforded the same treatment as Sec. 174 costs, Rev. Proc. 2000-50 did not classify software development costs as Sec. 174 costs. (In fact, Rev. Proc. 2000-50 did not apply if the software was treated as a Sec. 174 expenditure.)
Although software development costs are governed by Sec. 174 after 2021, it remains unclear whether software development activities will be governed by the traditional Sec. 174 definition of R&E expenditures — which looks to whether the costs represent research and development in an experimental or laboratory sense, including costs incident to development or improvement of a product and those intended to discover information to eliminate uncertainty (Regs. Sec. 1.174-2(a)(1)) — or will be defined differently.
Other potentially relevant provisions
Sec. 263(a) remains relevant for software acquisition costs. As noted above, costs to create or enhance separate and distinct intangible assets must be capitalized (Regs. Sec. 1.263(a)-4). The regulations specifically require taxpayers to capitalize costs paid to acquire computer software (Regs. Sec. 1.263(a)-4(c) (1)(xiv)). Software development costs paid to third-party developers at no risk to the taxpayer also may constitute amounts paid to acquire software, as illustrated in TAMs 8614004 and 9449003, discussed above. Acquired software then would be recovered under Sec. 167 or Sec. 197 (if in the context of an acquisition of a trade or business) and not Sec. 174. Post-2021, it will continue to be important to distinguish between costs incurred to acquire software and costs incurred to develop software.
Taxpayers selling copies of software via a tangible medium (e.g., discs or flash media drives) may be required to account for costs to obtain the tangible medium, develop or print instruction manuals or other accompanying materials, and produce packaging of the tangible medium as inventory for purposes of Secs. 471 and 263A (see, e.g., Nemetschek North America, Inc., T.C. Memo. 2001-288). Although it is relatively clear that the aforementioned inventoriable costs would not be treated as software development costs under Sec. 174, it is unclear whether the amortization of software development costs capitalized under Sec. 174 may be subject to further capitalization under Sec. 263A in these instances.
Lastly, Sec. 41 provides an income tax credit for qualified research expenditures paid or incurred in carrying on an active trade or business over a base amount (the base calculation depends on the Sec. 41 credit methodology being used). Sec. 41(d)(1)(A) defines qualified research to mean research with respect to which expenditures may be treated as specified R&E expenditures under Sec. 174. Additional requirements are necessary to consider with respect to software development (e.g., whether the “high threshold of innovation test” described in Regs. Sec. 1.41-4(c)(6)(vii) is met, where costs are incurred, etc.). To the extent taxpayers can claim the Sec. 41 tax credit, care still must be taken with respect to appropriately classifying software development between qualified and nonqualified activities.
Treatment of software development costs post-2021
In determining the impact of the mandatory capitalization of software development costs under new Sec. 174, the scope of software development under Rev. Proc. 2000-50 and the associated holdings in related TAMs and private letter rulings may be helpful until substantive guidance is issued. Taxpayers also should be cognizant of other provisions affecting software costs, including the treatment of acquired software under Secs. 263(a), 167, and 197 and the treatment of software that is embodied in a tangible medium under Secs. 471 and 263A. In addition, taxpayers may want to consider whether software costs are eligible for a research credit under Sec. 41.