Purchasing, leasing and developing software.

• Author: Witner, Larry
• Position: Part 2

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...