Costs to fix computer systems for the year 2000.

As the year 2000 approaches, many companies that process (transactions based on storing two digits for the year of the activity (e.g., "96" for 1996) will have to modify their computer software to account for the year based on storing four digits. The costs can be high, as high as $40 million at large companies and estimated billions of dollars for a worldwide fix, according to some financial analysts. Systems that attempt to process year 2000 transactions with the year "00" may encounter significant processing inaccuracies (and even inoperability). For book purposes, a Financial Accounting Standards Board task force has concluded that the costs incurred to change computer software from two-digit years to four-digit years for the year 2000 are period costs that should be expensed as incurred.

The financial accounting treatment of an item does not dictate its treatment for tax purposes. The substantial costs to correct the year 2000 problem may cause the Service to scrutinize their deductibility. The Supreme Court's decision in INDOPCO, Inc., 503 US 79 (1992), has sparked increased IRS examination activity and challenges to the current deductibility of many different expenditures generally regarded as currently deductible. In INDOPCO, the Court enunciated a "future benefit" test, which states that even though a separate and distinct asset was not created, the presence of a benefit beyond the year in which the expenditure is incurred required capitalization of the costs.

The costs of modifying computer software to accommodate four digits should be deductible currently for tax purposes, for one of two reasons. First, Rev. Proc. 69-21 provided that the costs of developing software, whether or not the particular software is patented or copyrighted, were deductible or amortizable under rules similar to those for research and experimental expenditures under Sec. 174. This treatment applies regardless of whether the costs would actually meet the Sec. 174 standard. Sec. 174(a) allows a taxpayer either to currently deduct research and experimental expenditures or to capitalize them as deferred expenses and amortize them over a period of 60 months or more (beginning with the month in which the taxpayer first realizes benefits from such expenditures).

The Service issued proposed regulations under Sec. 174 in 1983, which would have limited the deduction of software development costs to "new or significantly improved" software. Revised proposed regulations issued in 1989 focused on whether the software had met "its basic design specifications related to function and performance level. . . ." Both proposed regulations have been withdrawn, however, and the final Sec. 174 regulations issued in 1994 did not address software development costs. Hence, the only official guidance from the IRS relating to software development costs remains Rev. Proc. 69-21. The Service indicated after the INDOPCO decision (in the preamble to final Sec. 263A and 174 regulations) that it has no current plans to change the treatment of software development costs under Rev. Proc. 69-21. Thus, if year 2000 costs are considered "development" costs, they are within the scope of Rev. Proc. 69-21, and currently deductible.

Alternatively, the year 2000 costs could be viewed as costs in the nature of ordinary and necessary "repairs," because they are necessary to prevent a problem that would otherwise surface on Jan. 1, 2000. Under this view, the costs would be currently deductible because they do not make the software any more valuable, but only allow it to continue to function in the same way it did prior to the year 2000; see Rev. Rul. 94-38.

The costs of modifying computer software should be currently deductible or amortizable over a period of 60 months or more, depending on the method of accounting adopted by a taxpayer. If a taxpayer is currently capitalizing and amortizing other software development costs and wishes to change its treatment, it must request IRS consent by filing Form 3115, Application for Change in Accounting Method, with the IRS National Office. Form 3115 must generally be filed within 180 days from the beginning of the tax year.

From Carol Conjura, CPA. J.D., Jay Kalis, CPA, and Pauline Mak, CPA, Washington, D.C.