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Deductibility of contract development costs under sec. 174.

In Field Service Advice (FSA) 9930016, the IRS concluded that a company's expenditures in developing a computer software product were to acquire another's production or process, and therefore not deductible as research and experimental costs under Sec. 174.

The taxpayer is a developer and marketer of a computer software product. In an amended return and three originally filed returns, it claimed Sec. 174 deductions related to a "standard product agreement" a "standard product license agreement" and a "standard independent contractor agreement" it had entered into when developing the product. Under the standard product agreement, the taxpayer hired a developer to develop computer software on a work-for-hire basis. The taxpayer had the right to request necessary modifications, and paid the developer only when it believed specific milestones had been met. The developer was also required to correct, at its own expense, any "bugs" that the taxpayer detected after accepting the product.

Under the product license agreement, the taxpayer purchased exclusive worldwide computer software rights for existing software. The licensor was obligated to make any reasonable conversions and modifications that the taxpayer requested before the software would be deemed acceptable. The licensor was also required to correct, at its own expense, any hugs that the taxpayer detected after accepting the product.

Under the independent contractor agreement, the taxpayer hired independent contractors to develop nontechnical aspects of the software, such as background or theme music, on a work-for-hire basis. The taxpayer had the right to request any necessary modifications, and paid the independent contractor only when it believed specific milestones had been met.

The developers and independent contractors were responsible for the operability of the software; thus, they (and not the taxpayer) were at risk for its development. Likewise, the licensor was at risk for converting or modifying the software. Because the taxpayer was not at risk for developing the software, the Service held that the contracts were for the purchase of computer software and, therefore, excluded from the definition of research and experimental expenditures under Regs. Sec. 1.174-2(a)(3) (vii), which excludes expenditures incurred in the purchase of another's patent, model, production or process.

Contract research agreements are often structured such that payments are made as the work progresses, at specified "milestones." The mere fact that a taxpayer makes payments to a contractor as it meets specific milestones does not necessarily mean that the payment is for another's patent, model, production or process. The issue continues to be whether the taxpayer is truly at risk for the development activity. Risk can be determined only through an analysis of the contractual rights and obligations of each party involved.

FROM SARA MCCLELLAND AND DAVID HUDSON, WASHINGTON, DC
COPYRIGHT 2000 American Institute of CPA's
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Article Details
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Title Annotation:IRC section 174
Author:Hudson, David
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jan 1, 2000
Words:445
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