Treatment of software costs clarified and slightly modified by proposed intangibles regulations.

The treatment of software costs varies, depending on whether the costs were incurred for software that a company itself developed (self-developed software) or in purchasing completed software (acquired software). The acquired software discussed below relates to software that will be used by the taxpayer in the operation of its business.

Self-Developed Software

A company with self-developed software costs may choose among three alternative tax treatments for these costs.

* First alternative: The company can currently deduct these development costs. The IRS has taken position that self-developed software costs are currently deductible; under Rev. Proc. 69-21, the costs are similar to research and experimentation costs that are currently deductible under Sec. 174(a). The Service had previously reiterated its support of Rev. Proc. 69-21 as it applies to self-developed software, and again did so in Prop. Regs. Sec. 1.167(a)-14(b)(2).

* Second alternative: A company may voluntarily choose to capitalize the self-developed software costs and treat them as deferred expenses (Prop. Regs. Sec. 1.167-14(b)). It is under this alternative that the IRS has modified the provisions of Rev. Proc. 69-21 before incorporating them in the proposed regulations. The proposed regulations provide that the recovery period for costs treated as deferred expenses is three years -- the same as the recovery period for acquired software under Sec. 167(f)(1). This period is a modification of the period in Rev. Proc. 69-21 (which provided for amortization over five years -- the same period as under Sec. 174(b)).

* Third alternative: A business may voluntarily capitalize the software development costs, and recover them over the software's actual useful life (Regs. Sec. 1.167(a)-3).

Acquired Software

The facts underlying a software acquisition can change its tax treatment dramatically. For example, acquisition costs of certain customized software alone may be amortizable over three years, but acquisition of the same software with a customer list that relates to the software could cause the software to be amortized over 15 years, if the IRS concludes that an entire trade or business was acquired. Businesses must consider the specific factual setting of the acquired software. Three-year amortization under Sec. 167(f)(1): In order to determine the tax treatment of acquired computer software and whether it qualifies for amortization over three years, the first question is whether the software was acquired in connection with the acquisition of a trade or business, or a substantial portion of a trade or business. If the software was not acquired in connection with the acquisition of a trade or business (or a substantial portion), the software is generally amortizable over three years under Sec. 167(f)(1).

Note: If the software was acquired in conjunction with computer hardware, but not in connection with the acquisition of a trade or business or substantial portion, it must be considered whether the software costs were "bundled." This issue arises when a company buys a computer with software from a commercial vendor. "Bundled software" means that the cost of the hardware and software is stated as a lump sum. In this situation, Prop. Regs. Sec. 1.167(a)-13(b)(2) provides that the entire cost must be depreciated over the five-year recovery period that applies to the hardware under the modified accelerated cost recovery system (MACRS). This treatment for "bundled" software is in contrast to the treatment if the computer hardware/software purchase is not bundled, with the hardware and software costs each separately stated. For unbundled computer purchases (software and hardware costs itemized separately), the software would be amortized over three years, and the hardware would be depreciated over five years under MACRS.

In a trade or business acquisition, software must be "off the shelf" to qualify for three-year amortization: If software is acquired in connection with the acquisition of a trade or business or a substantial portion, the software is amortized over (1) three years under Sec. 167(f)(1) or (2) 15 years under Sec. 197. Whether the three-year period or the 15-year period will apply depends on whether the software is "off the shelf." If the software is "off the shelf," it is amortized over the three-year period; if it is not, it is amortized over 15 years.

"Off the shelf" computer software is defined by Sec. 197(e)(3)(A)(i), which contains a three-part test. Computer software is "off the shelf" if it (1) is readily available for purchase by the general public, (2) is subject to a nonexclusive license and (3) has not been substantially modified.

Prop. Regs. Sec. 1.197-2(c)(4)(v) provides that software will be treated as "readily available for purchase by the general public" if the software may be obtained on substantially the same terms by a significant number of persons who would reasonably be expected to use the software. It is not necessary that the software be available through a system of retail distribution in order to be considered "readily available for purchase by the general public."

Prop. Regs. Sec. 1.197-2(c)(4)(i) provides that a company will be able to meet the requirement that software is "not substantially modified" if its total cost does not exceed the greater of 125% of the price at which the unmodified version of the software is readily available to the general public or $2,000.

Example 1: Company X purchases a general ledger software program to maintain its financial records. X requested, and the seller performed, modifications to the software program in order to customize it to X's requirements. The cost of the software without modifications was $500,000; the cost of the program, including the modifications, was $600,000. The software meets the "not substantially modified" test because the cost of the modifications ($100,000) was only 20% of the cost of the unmodified software.

In this example, the total cost of the modified software could have been up to $625,000 ($500,000 X 125%) and the software would still qualify as "not substantially modified."

Prop. Regs. Sec. 1.197-2(c)(4)(iv) also provides that for purposes of determining whether software has been substantially modified, integrated programs acquired in a package from a single source are treated as a single computer program; any costs incurred to install the computer software are not treated as a cost of the software.

The regulation clarifies that a trademark or trade name, ancillary to the ownership or use of a specific software program in the taxpayer's business and not acquired for the purpose of marketing the computer software, is included in the definition of computer software and is not included in the definition of a trade name or trademark that would be required to be amortized over 15 years under Sec. 197.

Example 2: X purchases all of the assets of an existing business from Y. One of the assets is all of Y's rights in certain software previously used by Y under the terms of a nonexclusive license from the software developer. The software was developed for use by manufacturers to maintain a comprehensive accounting system. The software was not substantially modified for use by Y within the meaning of Prop. Regs. Sec. 1.197-2(c)(4)(i) and was acquired directly by Y from the developer. The developer does not maintain wholesale or retail outlets, but markets the software directly to ultimate users. Y's license of the software is limited to an entity that is actively engaged in business as a manufacturer.

Prop. Pegs. Sec. 1.197-2(k), Example (1), provides that this software is considered to be readily available to the general public, and thus is not a Sec. 197 intangible. Thus, X may amortize the software over three years.

From Vicki Howe, J.D., Washington, D.C.