Purchasing, leasing and developing software.

The tax consequences of acquiring software depend on whether the taxpayer buys it, leases it, develops it or acquires it in connection with acquiring another business. Part I of this two-part article describes the deductions for purchased off-the-shelf software, software modification costs and leased software.

Taxpayers can recover software expenditures in different ways, depending on how it is acquired and developed. Basically, six tax rules relate to acquiring software:

1. If off-the-shelf software is purchased, its cost is deducted ratably over 36 months.

2. If software is purchased along with hardware, and the cost is not separately stated, the cost of software is depreciated as part of the cost of hardware.

3. If software is leased, lease payments are deducted currently.

4. If software development constitutes research and development (R&D) under Sec. 174, its cost is deducted currently or amortized over 60 months or more.

5. If software development meets Sec. 41 requirements, its cost is eligible for the R&D credit.

6. If software qualifies as a Sec. 197 intangible asset, its cost is amortized over 180 months.

Part I of this two-part article discusses the purchase of software subject to the first two rules, as well as software modification costs and the current deduction for leased software. Part II, in the August, 2003 issue, will discuss rules 4-6, including software R&D expensing and amortization and the R&D credit for internal-use software.

Definition of Software

Under Regs. Sec. 1.197-2(c)(4)(iv), software is any program or routine (i.e., any sequence of machine-readable code) that is designed to cause a computer to perform a desired function, and the documentation required to describe and maintain that program or routine. It includes operating systems, executive systems, monitors, compilers, translators, assembly routines, utility programs and application programs. (1)

Off-the-Shelf Software Purchases

Under Sec. 167(f)(1), the cost of acquiring "off-the-shelf" software is deducted ratably over 36 months, beginning in the month the software is placed in service. Off-the-shelf refers to software that is readily available to the general public, subject to a nonexclusive license and not substantially modified.

If software is purchased along with hardware (i.e., bundled software), the cost of software would be depreciated as part of the hardware cost if the cost of software is not separately stated. (2)

Example 1: Over the years, T Corp. has grown in size and scope and has outgrown its present accounting software. On June 1, 2003, T spends $154,000 for more sophisticated software that qualifies as "off-the-shelf." Exhibit 1 on p. 405, illustrates three ways T can calculate its 2003 software deduction.

In Exhibit 1, row 1 computes the first-year deduction when the software's cost is deducted ratably over 36 months, beginning in June 2003. Row 2 shows the deduction computation if T elects to apply the maximum Sec. 179 expense election to the software purchase. Row 3 shows the deduction when the maximum Sec. 179 deduction and bonus depreciation are taken into account. Under Sec. 168(k)(4), taxpayers are entitled to a special 50% depreciation deduction for assets (including software) acquired after May 5, 2003 and before 2005.

Example 2: The facts are the same as in Example 1, except T spends $254,000, instead of $154,000. Of the $254,000, the itemized bill reveals that $100,000 is for hardware and $154,000 is for software. Because the software cost is separately stated, the $154,000 is deducted in the same way as in Exhibit 1. Under the modified accelerated cost recovery system (MACRS), hardware is five-year recovery property and depreciated accordingly; see Example 3.

Example 3: The facts are the same as in Example 2, except the cost of software is not separately stated. Under these facts, this cost is depreciated as part of the cost of hardware. Exhibit 2 on p. 406 illustrates three ways, among others, T can calculate its 2003 depreciation deduction.

Exhibit 2 shows how to compute the first-year software deduction when the cots are combined with the hardware. The first method shows how to compute the MACRS deduction alone. The second computes the deduction when the taxpayer makes a Sec. 179 election in addition to MACRS. The last method presents the software deduction calculation if T elects to apply the maximum Sec. 179 election and 50% bonus depreciation to the purchase.

Leased Software

Basically, a lease is an agreement under which the owner of property (lessor) conveys to the user of property (lessee) the right to use the property in return for a number of specified payments over an agreed-on period. A lessee can currently deduct the costs of leasing software as a business expense under Sec. 162 and Regs. Sec. 1.162-11(a), provided the costs are:

1. Ordinary (e.g., normal, usual, customary and traditional);

2. Necessary (e.g., helpful and appropriate);

3. Paid or incurred in an existing business; and

4. Not a capital expenditure.

Regs. Sec. 1.263-2(a) generally provides that capital expenditures include costs that result in benefits that extend substantially beyond the end of the tax year. Under Regs. Sec. 1.263(a)-1(b), capital expenditures include costs for permanent improvements or betterments that materially increase value, appreciably prolong useful life or adapt an asset to a new or different use. According to the Supreme Court, (3) capital expenditures result in significant future benefits, whether or not they produce a separate and distinct asset.

To clarify the issue of when to capitalize intangible assets, the IRS issued proposed regulations addressing acquired intangibles. (4) Prop. Regs. Sec. 1.263(a)-4(c) would require capitalization of computer software acquired by purchase or similar transaction. This includes payments for a nonexclusive license for software that is readily available to the general public on similar terms, and which has not been substantially modified.

A true lease is distinguishable from a conditional sale. In a true lease, the benefits and burdens of ownership reside with the lessor; in a conditional sale, they transfer to the "lessee" An alleged lease will be a conditional sale if, among other things: (5)

* The lessee, through periodic payments, acquires an equitable (ownership) interest in the software;

* The lessee acquires title on the payment of a stated amount of rentals;

* Total lease payments exceed the software's fair market value;

* Some portion of periodic payments is designated or recognizable as interest;

* The lessee acquires title to the software on payment of a nominal purchase option; or

* The total periodic payments, plus the purchase option price, approximate the price at which the software could have been acquired when the lease became effective.

This arrangement could be called a "lease-to-own," a "capital lease" or a "conditional sale."

Example 4: P leases off-the-shelf accounting software for $1,000 per month beginning in June 2003. For 2003, P could deduct lease payments of $7,000 ($1,000 per month x 7 months) as a business expense.

Example 5: The facts are the same as in Example 4, except P's lease payments of $1,000 per month cease after 60 months because P becomes the owner of the software. Because P acquires title, the arrangement is a conditional sale, instead of a true lease. Thus, at the inception of the "lease," P records an asset equal to the present value of the future lease payments. The present value of 60 $1,000 payments is $53,968. In its records, P debits an asset account (e.g., "software") for $53,968 and credits a liability account (e.g., lease obligation) for $53,968.

In Example 5, P would make principal payments of $53,968 and interest payments of $6,032 ($60,000-$53,968) over 60 months. In addition, P would calculate depreciation deductions as in Exhibit 1, except that $53,968 would be substituted for $154,000.

Software Implementation Costs

The concept of software implementation will be discussed in the context of enterprise resource planning (ERP) software. (6) An ERP system links customers and suppliers to a company's business processes, which are also linked across company departments and functional areas.

ERP software is all-encompassing and totally integrated. It includes modules for financial accounting, materials management, production planning, sales, distribution, plant maintenance, treasury, human resources, asset management and other areas. (7) Instituting an ERP system requires retraining employees, many of whom take on new responsibilities.

An ERP system has a two-pronged adaptation process--adapting the company to the software (business reengineering) and adapting the software to the company (software modification). Software modification involves fine tuning or customizing the software to suit a taxpayer's needs. (In this article, software implementation incorporates both business reengineering and software modification).

Instituting an ERP system is much more than just purchasing and installing software. The magnitude of the undertaking is illustrated by ABC Inc., which spent $2.5 million on new hardware, $750,000 on ERP software and $5.7 million on software implementation. (8) The total cost was almost $9 million, and the project took more than two years to accomplish. As these numbers indicate, the cost of software implementation can far exceed the cost of hardware and software.

A typical ERP project involves planning, buying hardware, buying, modifying and maintaining software, business reengineering and training. The tax consequences of buying hardware and software were discussed previously and illustrated in Examples 1-5. The tax consequences of modifying and maintaining software and training are discussed below and illustrated in Example 6.

According to the IRS, software installation and modification costs are distinguishable from deductible development expenses. For example, if a taxpayer is responsible for completing an ERP project at its own expense, technical consulting costs paid for writing machine-readable code (and allocable costs of modeling and designing additional software) are currently deductible as R&D expenses. However, the expenses of option selection and implementation of templates are modification costs capitalized as part of the purchase price and deducted ratably over 36 months. (9)

The IRS distinguishes between nonprogramming and programming work; it contends that only the latter can qualify as currently deductible R&D. (10) But software alteration and development is more than just writing source code. Programmers cannot program in a vacuum. To identify and make modifications, they have to consult nonprogrammers, who are essential in helping programmers understand the underlying business processes. Nonprogrammers (e.g., system analysts and consultants and designers and project managers) all play a role in deciding how source code should be written. Thus, the distinction between nonprogramming functions and programming functions is not as clear as the IRS would have practitioners believe.

Historically, training costs have been deducted currently as a business expense. According to the IRS, (11) INDOPCO (12) has not changed this result.

Software maintenance costs (including periodic upgrades) are analogous to incidental repairs and maintenance. As upgrading software does not materially increase its value, appreciably prolong its useful life or adapt it to a new and different use, upgrading should not qualify as a capital expenditure. Upgrading keeps software in efficient operating condition; thus, its costs should be currently deductible under Regs. Sec. 1.162-4.

Example 6: To institute an ERP system, T selected a vendor (e.g., Oracle, PeopleSoft, J.D. Edwards or Microsoft). At the outset, the vendor's team (consultants) and T's team (employees) sat down and planned the undertaking. The plan called for T to spend $6.2 million as follows: $3 million for new hardware, $800,000 for ERP software, $900,000 for software modification ($300,000 for nonprogramming work and $600,000 for programming work) and $1.5 million for training T's employees. The consultants were to be paid regardless of the success of the project. Annually thereafter, T would spend $80,000 ($800,000 x 10%) for software upgrades.

It took six months for the two teams to modify the software to meet T's needs. Some of the software modification time was spent working with templates within the software. For instance, T used straight-line depreciation, so the software needed to be configured to produce this result. Working with templates is nonprogramming work.

Some of the software modification time was spent by programmers who wrote source code. For instance, T needed special reports that could only be generated after additional programming. Such programming is undertaken carefully because altering one area of an all-encompassing, totally integrated system may have adverse effects on other areas.

The new hardware T purchased in Example 6 is five-year property under MACRS, so $3 million is depreciated accordingly. According to the IRS, the costs to modify the ERP software should be capitalized into the cost of the software and deducted ratably over 36 months. The part of the $900,000 that relates to software development should be treated as R&D. While the IRS may concede that some or all of the $600,000 (programming) amounts to R&D, it will claim that the $300,000 (nonprogramming) should be capitalized. R&D deductions will be described in Part II of this article, in the August 2003 issue.

The employee training cost of $1.5 million is deducted currently as a business expense. The annual expenditure of $80,000 for software updates is deducted currently as a business expense, because it is analogous to incidental repairs and maintenance. If, however, the taxpayer paid $200,000 up front to be entitled to upgrades over the life of the ERP software, the $200,000 should be capitalized into the cost of ERP software and deducted ratably over 36 months.

Conclusion

Part I above discussed the rules that generally apply to the purchase and lease of computer software, and the modification costs of fine-tuning or customizing a commercial software package to suit a taxpayer's needs. Some taxpayers' software needs are so particular that commercial software packages are not completely adequate. Part II, in the August 2003 issue, will describe the current expense and amortization deductions available for computer software R&D costs, the amortization of software that is an acquired Sec. 197 intangible and the R&D credit rules for internal-use-software.

Exhibit 1: T's 2003 software deduction-purchased separately

1. Straight-line depreciation: $154,000 / 36 (months in recovery period) x 7 (months in 2003) = $29,944

2. Sec. 179 and straight-line depreciation: $100,000 * (Sec. 179 election) + $10,500 ($154,000 - $100,000 / 36 x 7) = $110,500

3. Sec. 179, 50% bonus depreciation** and straight-line depreciation: $100,000 (Sec. 179 election) + $27,000 ($154,000 - $100,000 x 50%)(bonus depreciation) + $5,250 ($154,000 - $100,000 - $27,000 / 36 x 7) = $132,250

* The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) extended the Sec. 179 expense election so that it applies to the purchase of off-the-shelf software. It also increased the total yearly Sec. 179 expense election from $25,000 to $100,000.

** The JGTRRA also added 50% first-year bonus depreciation, in lieu of the 30% bonus already available under Sec. 168(k).

Exhibit 2: T's 2003 software deduction cost (not separately stated)

1. MACRS: $254,000 x 20% (MACRS 5-year recovery property, 1st year) = $50,800

2. Sec. 179 and MACRS: $100,000 (Sec. 179 election) + $30,800 ($254,000 - $100,000 x 20%) = $130,800

3. Sec. 179, 50% bonus depreciation and MACRS: $100,000 (Sec. 179 election) + $77,000 ($254,000 - $100,000 x 50%) (bonus depreciation) + $15,400 ($254,000 - $100,000 - $77,000 x 20%) = $192,400

EXECUTIVE SUMMARY

* Separately purchased off-the-shelf software should be deducted ratably over 36 months; bundled software is depreciated with the cost of hardware.

* A lessee can currently deduct the costs of leasing software as a business expense.

* Most software updates, training and maintenance costs should be currently deductible as business expenses; many software modification costs must be capitalized and depreciated over 36 months.

(1) See Rev. Proc. 2000-50, IRB 2000-52, 601.

(2) Id.

(3) INDOPCO, Inc., 503 US 79 (1992).

(4) REG-125638-01 (12/19/02).

(5) See Rev. Rul. 55-540, 1955-2 CB 39.

(6) Such software is produced by SAP in Germany, by Baan in the Netherlands, and by Oracle, PeopleSoft, J.D. Edwards, and Microsoft in the U.S.

(7) For further discussion, see Rible, "LMBD Agent Suggests Principles to Distinguish Acquired and Developed Software," 2002 TNT 46-36.

(8) Id.

(9) IRS Letter Ruling 200236028 (9/6/02). Proposed regulations on capitalization of acquired intangibles do not provide rules for distinguishing acquired software from developed software or for the treatment of ERP software. However, the IRS stated that final regulations will treat ERP software in a manner consistent with this letter ruling; see the Preamble to REG-125638-01, note 4 supra.

(10) See Maples, Finegan and Maples, "Deducting the Costs of Implementing a New Information System Despite IRS Objections," 95 J. of Tax'n 267 (November 2001).

(11) Rev. Rul. 96-62, 1996-2 CB 9.

(12) See note 3, supra.

Larry Witner, LL.M., CPA 

Associate Professor

Bryant College

Smithfield, RI

Tim Krumwiede, Ph.D., CPA

Associate Professor

Bryant College

Smithfield, RI