Software, hard taxes
By Mark E. Battersby

Computer software and taxes. What could be clearer? After all, you may deduct what the tax laws call a “reasonable allowance” for the exhaustion, wear, and tear of all property used in your practice — or for the production of income.

But deductions for software are anything but clear. One reason for much of that confusion is because Uncle Sam allows more than one type of computer software expenditure — for off-the-shelf programs, developing or modifying software for use in the practice, developing or maintaining a Web site, and research.

• Off-the-shelf software. Generally, the purchase of off-the-shelf software can best be compared to the purchase of any other business asset. If computer software has an expected use of longer than one year, its cost is usually written-off or deducted over a 36-month period.

Alternatively, although treated as a capital asset, most off-the-shelf software can be expensed and immediately deducted as Code Section 179 property.

• Software development. The costs of developing computer software for the chiropractic practice, in many respects, closely resembles the kind of research and experimental expenditures that fall within the purview of Section 174, Research Expenses, so as to warrant similar accounting treatment.

The Internal Revenue Service has announced that it will not disturb any taxpayer’s treatment of costs paid or incurred in developing software for any particular project, either for the taxpayer’s own use or to be held by the taxpayer for sale or lease to others.

Naturally, this is not a blanket license issued by the IRS. In fact, the IRS will not question the tax treatment of software development costs only when the chiropractic practice consistently treats those costs as either current expenses or capital expenditures. That means that the costs of developing computer software must always be deducted currently or consistently treated as a capital expense and deducted over a period of 36-months from the date it is placed in service.

• Web-site development. The IRS has yet to issue formal guidance on the treatment of Web-site development costs. However, informal internal guidance suggests that one appropriate approach is to treat those costs like an item of software and depreciate them over three years.

It is clear, however, that taxpayers who pay large amounts to develop sophisticated sites have been allocating their costs to items such as software development (currently deductible, like research and development costs), utilizing the Section 179 first-year expensing election and even as currently deductible advertising expenses.

• Research. The research tax credit, a direct reduction of the chiropractic operation’s tax bill rather than a deduction from the income, is quite controversial.

Generally, software is not eligible for the research credit when it is used internally, such as in general and administrative functions (such as payroll, bookkeeping, or personnel management, or in providing noncomputer services (in accounting, consulting, or banking services).

If you engage in research, you can choose to deduct certain research and experimental costs. Note, however, that only the costs of research in a laboratory or for experimental purposes, whether carried on by you or on your behalf by a third party, are deductible.

Market research and product testing costs are not research expenditures under the rules.

Mark E. Battersby is a tax and financial advisor, freelance writer, lecturer, and author with offices in suburban Philadelphia. He can be contacted at 610-789-2480.

Disclaimer: The author is not engaged in rendering tax, legal or accounting advice. Please consult your professional advisor about issues related to your practice.