Soft tax rules for Web write-offs
By Mark E. Battersby

Would your chiropractic practice be better off taking an immediate tax deduction for Web-related expenses to offset taxable income, or with deductions spread over a number of years, offsetting what might prove to be higher income in those later years?

Don’t ask the Internal Revenue Service — at least for formal guidelines. The agency has not yet issued any.

However, informal internal IRS guidance suggests that one appropriate approach is to treat those costs like an item of software and depreciate those amounts over three years.

DEDUCTING EXPENSES

Software is usually an “intangible” business asset. Thus, software used to create a Web site is usually treated as either “purchased” or “self created.” The tax rules for purchased software are straightforward. Self-created software deductions are more questionable.

Today, the expense of developing software (whether for a chiropractor’s own use or for sale to others) may either be deducted currently or amortized over a five-year period — so long as such costs are treated consistently.

But — are those Web-related expenditures really for software? Or should those expenses actually be allocated to advertising?

Advertising expenses are deductible, if they are reasonable in amount and bear a reasonable relation to the chiropractic practice. The expenses may be for the purpose of developing goodwill as well as gaining immediate sales. The cost of advertising is tax deductible even though the advertising program extends over several years or is expected to result in benefits extending over a period of years.

It is easy to understand why many chiropractors as well as their tax professionals consider the costs of developing and maintaining a Web site to be similar to advertising costs and deduct them as an expense on the annual tax return. This position is further supported by another ruling by the Tax Court; in which packaging design costs were treated as a deductible advertising expense even though the design provided the company with “significant future benefits.”

CREDITS AND AMORTIZATIONS

The tax rules give credit for amounts spent on research and experimentation, but with regard to software, these rules are extremely regulated and very narrow in scope and allow deductions only for so-called “internal use software.”

A tax credit, such as that for research and development expenditures, is a direct reduction of your practice’s tax bill, as opposed to a reduction in its taxable income. Unfortunately, until it expired on December 31, 2005, it existed for the incremental increase in research expenditures. Whether the research tax credit will be given a new and retroactive life by Congress remains up in the air.

However, only costs of research in the laboratory or experimental purposes sense qualify. This is true whether carried on by your practice or on behalf of that practice by a third party. They are tax deductible.

Market research and normal product testing costs are not legitimate research expenditures, although many taxpayers routinely label Web development costs as research and development to reap an immediate tax write-off. Remember, once made, the R&D election applies to all research costs incurred in the project for both the current and all subsequent years.

As an alternative to taking deductions or credits, you can elect to capitalize research and experimental costs, amortizing (write-off or deduct) them ratably using a period of at least 60 months, beginning in the month when the benefits are first realized from them.

This assumes, of course, that the property created does not have a determinable useful life at the time of the deduction or write-off. Costs associated with property that has a determinable useful life must, of course, be amortized or depreciated over its useful life.

The IRS recently proposed regulations that would, in the view of many experts, thwart Congressional intent and make it impossible for anyone to claim the tax credit for R&E. Some say that IRS field agents are already taking the position that nothing qualifies for the credit.

Although the IRS has not, yet, outlined a specific tax treatment for Web development costs, clues exist elsewhere. Those areas where the IRS — or our lawmakers — have provided examples of the proper tax treatment of Web development “related” costs can produce substantial tax savings for your chiropractic practice — if handled properly.

SIDEBAR
What about other software expenses?

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.