Purchasing, leasing and developing software.

Depending on how software is acquired or developed, expenditures for it may be currently deducted or amortized under various rules, and possibly eligible for the research and development (R&D) credit. Part II of this two-part article summarizes and illustrates the potential R&D deductions, the R&D credit and Sec. 197 amortization.

EXECUTIVE SUMMARY

* R&D software expenditures may be currently deducted or amortized ratably over 60 months (or more), beginning in the month benefits are first derived from using the software.

* Taxpayers developing software for internal use, either through employees or third parties, may qualify for the R&D credit under Sec. 41.

* With the exception of off-the-shelf software, software acquired as part of a business acquisition is a Sec. 197 intangible.

Taxpayers can acquire software in many ways. This two-part article discusses the important tax rules that apply when a taxpayer buys, leases or develops its own software for internal use. Part I, in the July 2003 issue, described and illustrated the deductions for purchased, leased and modified software. Part II, below, summarizes and illustrates expensing and amortization of research and development (R&D) expenditures, the research tax credit for internal-use software and the amortization of software that is an acquired Sec. 197 intangible.

R&D Deductions

Some taxpayers require software specifically geared to their own operations. If such software is not readily available in the marketplace, they must develop it through their employees or third parties. The related software expenditures may qualify as R&D under Sec. 174. Even expenditures associated with developing purchased software may qualify for R&D deductions. (13) Taxpayers may be able to deduct R&D costs currently or amortize them ratably over 60 months (or more), beginning in the month when they first derive benefits from using the software. (14)

If a taxpayer elects to amortize R&D costs under Sec. 174(b) and abandons a research project before it deducts all related capitalized costs, it can deduct the remaining costs under Sec. 165 when it abandons the project.

Noncorporate taxpayers that deduct R&D costs under Sec. 174(a) may have an adjustment item for alternative minimum tax purposes. Sec. 56(b)(2)(A) provides that such expenses must be amortized over a 10-year period in computing alternative minimum taxable income. However, under Sec. 56(b)(2)(D), this adjustment is not required of taxpayers who materially participate in the activity (as defined in Sec. 469) for which the R&D costs are incurred.

Software development costs are deductible under Sec. 174(a) and (e) only if the taxpayer incurs them in connection with a trade or business and the costs are reasonable in amount. Under Regs. Sec. 1.174-2(a)(1), the deductible amount includes all costs incidental to software development, including the costs of obtaining a patent. In addition, Sec. 174 applies to amounts the taxpayer pays to employees as well as third parties, according to Regs. Sec. 1.174-2(a)(8) and (9).

R&D includes direct and indirect (e.g., overhead) costs. There is little guidance on indirect costs in the Sec. 174 context. In Kilroy, (15) the court allowed the taxpayer to deduct under Sec. 174 a percentage of indirect costs (office expenditures) related to the taxpayer's inventing activities. Example 1 on p. 487 identifies some indirect costs and reasonable allocation methods.

Example 1: A produces widgets; A's information technology (IT) department developed new software that improves the production process. A rented a building with 100 rooms, with two rooms devoted to software development. Exhibit 1 below shows the direct and indirect R&D costs associated with the new software project. The project took all of 2003, and A began using the new software in January 2004.

Exhibit 1 indicates that for indirect costs, only 2% of the rooms are devoted to software development; thus, A would allocate 2% of rent and utilities to software development. As for insurance, in 2003, A paid a $240,000 insurance premium, and believes its risk exposure from the IT department is 0.5% of its total risk exposure. A allocates general and administrative expenses among departments on the basis of relative salaries. Thus, A's total R&D costs are $1,784,600. If A elects to currently deduct these costs under Sec. 174(a), it could deduct $1,784,600 in 2003. If A elected to amortize them over 60 months, it could deduct $356,920 (($1,784,600/60 months)) x 12 months in 2004) in 2004. The amortization begins in 2004, because this is when A first derives benefits from the software. (In addition to the deduction, a taxpayer may be eligible for the R&D credit, as described below and as illustrated in Examples 2-4.)

R&D Credit

Taxpayers developing software for their own use, either through employees or third parties, may qualify for the R&D credit under Sec. 41. They are eligible for the credit if their software development activities satisfy not only the Code's requirements for R&D activities in general, but also regulatory requirements relating to "internal-use software" in particular. Such software is not developed to be sold, licensed, leased or otherwise marketed for a fee to third parties.

Under Sec. 41(d)(1), software development costs generally qualify for the credit if:

* They qualify for deductibility under Sec. 174;

* The research is for purposes of discovering information that (among other things) (1) is technological in nature and (2) will result in developing a new or improved business component for the taxpayer; and

* The research relates to a new or improved function, performance or reliability of quality.

However, the following activities (among others) do not qualify for the credit, under Sec. 41 (d)(4):

* Research after commercial production;

* Routine or ordinary testing or inspection for quality control;

* Funded research; and

* Any research conducted outside of the U.S., Puerto Rico or a U.S. possession.

According to Prop. Regs. Sec. 1.41-4(c) (6)(ii), internal-use software development costs qualify for the R&D credit, provided:

1. The taxpayer develops software for use in an activity that constitutes qualified research (other than the development of internal-use software);

2. The taxpayer develops software for use in a production process;

3. The taxpayer develops software to be used in providing computer services to its customers; (16) or

4. The software satisfies a "high threshold of innovation" test.

Prop. Regs. Sec. 1.41-4(c) (vi) states that the "high threshold of innovation test" is met if the software:

* Is intended to be unique or novel and to differ in a significant and inventive way from prior software;

* Development involves significant economic risk to the taxpayer; and

* Is not commercially available.

As the R&D tax credit is allowable only for increases in research expenditures, it is often called the "incremental" R&D, credit. (17) Specifically, under Sec. 41(a)(1), it is 20% of the excess of R&D costs for the year over a base amount. The R&D credit applies to amounts taxpayers pay to employees, as well as to third parties. If taxpayers contract out R&D to third parties, only 65% of the amount paid qualifies for the credit, under Sec. 41(b)(3)(A).

Software development costs can qualify for both the Sec. 174 deduction and the Sec. 41 credit, but there must be an adjustment so as not to allow double benefits. Under Sec. 280C(c), taxpayers have two choices: to use (1) the full credit and reduce the deduction by 100% of the credit; or (2) the full deduction and reduce the credit by 35% of the credit.

Example 2: The facts are the same as in Example 1. A incurs $1,784,600 of software development costs to improve its production process, satisfying the Sec. 41(d)(1) requirements. A's base amount is $500,000. The software will be used only by A, and it will not be sold or otherwise marketed to third parties. The software is presumed to be internal-use software.

The $1,784,600 qualifies for the R&D credit, because it satisfies the Code and regulation requirements. A can take an R&D credit of $256,920, as calculated in Exhibit 2 at left, assuming the base amount is $500,000.

Example 3: The facts are the same as in Example 2, except that A pays $1,784,600 to a third party to develop the software. A's R&D credit is $131,998, as shown in the second calculation in Exhibit 2.

Example 4: In Example 1, A is entitled to a Sec. 174(a) deduction of $1,784,600, and in Example 2, A is entitled to a Sec. 41 credit of $256,920. Exhibit 3 on p. 489 shows the two choices available to A in 2003.

Amortization of Sec. 197 Intangibles

With one exception, if a taxpayer acquired software in connection with a business acquisition (or the acquisition of substantial assets of a business), the software is a Sec. 197 intangible asset. The taxpayer deducts the cost of such software ratably over 180 months, beginning in the month it acquired the software.

Regs. Sec. 1.197-2(c) (4)(i) provides that "off-the-shelf" software is not a Sec. 197 intangible asset unless it has been substantially modified. A modification is substantial if modification costs exceed the greater of 25% of the price of unmodified software or $2,000. If the taxpayer acquired the software as part of acquiring a business, and it is not a Sec. 197 intangible asset, the taxpayer deducts the cost ratably over 36 months.

Example 5: On June 1, 2003, A bought off-the-shelf software for $54,000. B buys all of A's assets, including the software, on Sept. 1, 2003. Under Sec. 1060, $36,000 of the selling price/purchase price is allocated to the software (an applicable asset acquisition).

In Example 5, the software is not a Sec. 197 intangible because, even though B acquired it as part of a business, it was not substantially modified. Consequently, B's 2003 depreciation deduction for the software is $4,000, calculated as: $36,000/36 (total months of recovery period) x 4 (months in 2003).

Example 6: The facts are the same as in Example 5, except that, after purchasing the software for $54,000, B spent $15,000 to customize it to suit its purposes.

In Example 6, the software is a Sec. 197 intangible, because the $15,000 modification costs exceed the greater of (1) $13,500 (25% x $54,000) or (2) $2,000. In this case, B's 2003 software depreciation deduction is $800, calculated as: $36,000/180 (total months of recovery period) x 4 (months in 2003).

Conclusion

The tax consequences associated with acquiring software depend on whether a taxpayer buys it, leases it, develops it or acquires it in connection with a business acquisition. Depending on the circumstances, taxpayers can either deduct the cost of software currently, or ratably over 36 months, depreciate it as part of the cost of hardware (as shown in Part I in the July 2003 issue), treat it as an R&D cost or amortize it over 180 months.

Exhibit 1: Allocation of R&D expenditures

Direct costs:
Programmers' salaries                   $ 600,000
Project materials                          20,000
Depreciation of programmers' computers     50,000
Attorney's fees (copyright, etc.)          75,000
Total direct costs                                      $  745,000

Indirect costs:
Rent                                       36,000 (1)
Utilities                                   2,400 (2)
Insurance                                   1,200 (3)
General & administrative (G&A)          1,000,000 (4)
Total indirect costs                                     1,039,600

Total R&D costs                                         $1,784,600

(1) $1,800,000 (annual building rent) x 2% (2/100 rooms)

(2) $120,000 (annual utilities) x 2%

(3) $240,000 (ins. premium) x 0.5%
(degree to which IT department generates risk)

(4) $10,000,000 (total G&A) x 10% (proportion
of IT department salaries to all salaries)

Exhibit 2: A's R&D credit calculations

1. A develops software:

            $1,784,600   Software R&D costs
          -    500,000   Base amount

             1,284,600   Subtotal
          x        20%   R&D credit percentage

            $  256,920   R&D credit

2. A pays third party to develop software:

            $1,784,600   Payment to third party for software R&D
          x        65%   Applicable percentage

             1,159,990   Eligible for R&D credit
          -    500,000   Base amount

               659,990   Subtotal
          x        20%   R&D credit percentage

            $  131,998   R&D credit

Exhibit 3: Offset of Sec. 41 credit and Sec. 174(a) deduction

Choice                    Credit       Deduction

1. Full credit         $256,920
   Reduced deduction                  $1,527,680 *

2. Reduced credit      $166,998 **
   Full deduction                     $1,784,600

* $1,784,600-$256,920

** $256,920-($256,920 x 35%)

(13) See Witner and Krumwiede, "Purchasing, Leasing and Developing Software (Part I)," 34 The Tax Adviser 404 (July 2003), for a discussion of modification versus development expenditures in the context of enterprise resource planning software installation.

(14) See, e.g., Rev. Proc. 2000-50, IRB 2000-52, 601.

(15) Oliver B. Kilroy, TC Memo 1980-489; see also Eugene Magee, TC Memo 1973-271.

(16) Internal-use software requirements do not apply to the development of a combined software and hardware product to be used by the taxpayer in providing services to its customers; eligibility is determined by examining it as a single product; see Prop. Regs. Sec. 1.41-4(c) (6)(iii).

(17) The basic research credit in Sec. 41(a)(2) does not apply in the circumstances discussed and is beyond the scope of this article.

Larry Witner, LL.M., CPA 

Associate Professor

Bryant College

Smithfield, RI

Tim Krumwiede, Ph.D., CPA

Associate Professor

Bryant College

Smithfield, RI