Computers have proliferated to the point that our lives seem to revolve around them. In many chiropractic practices, administrative and marketing activities center on using computers and software for scheduling, billing, contact management (mailing lists), web promotion, e-mail, inventory and maintaining patient records.
The information that follows highlights some of the tax rules that apply to computers and software used in a professional practice and how to use them to your advantage. The discussion hits only on the high points, so be sure to consult with a qualified tax advisor about these matters. Also, be aware that the state tax rules for your state may be different than the federal rules for depreciation.
Basic Depreciation Rules
Computers used exclusively in a trade or business are depreciable using the Modified Accelerated Cost Recovery System (MACRS) over a five-year life. An accelerated depreciation schedule is used for the first three years, converting to straight-line for the last three years. Depreciation is usually computed using a half-year convention, so you compute depreciation for a half year in year one and a half year in year six.
A mid-quarter convention will apply, resulting in a different depreciation schedule, if more than 40% of the aggregate bases of depreciable property is placed in service during the last three months of the taxable year. The depreciation schedule can also be different when a taxpayer has a short taxable year, such as when a new business is opened.
The tax rules for computers have developed over the many years that they have been used for business in our society (from the 1950s), and have not changed very much to reflect rapid obsolescence that we now experience. For example, the guideline lives for computers were first published in a Revenue Procedure published in 1962, and the Asset Depreciation Range system that our current Modified Accelerated Cost Recovery System (MACRS) is based on was published in 1971. So we have a “dictated” life of five years for computers and peripherals, when the actual useful life is probably closer to two to three years.
The Expense Election
In many cases, the cost of a computer may be totally deducted in the year it’s purchased. A taxpayer may elect to expense the cost of certain depreciable property in the taxable year it is purchased. The maximum amount that may be deducted is gradually increasing from $19,000 for 1999, $20,000 for 2000, $24,000 for 2001 and 2002, to $25,000 for 2003.
The limit is reduced one dollar for each dollar the cost of qualifying assets acquired in a taxable year exceeds $200,000. When a group of corporations is more than 50% controlled by the same persons, the expensing limit is allocated among the members, and the $200,000 investment limit is computed for the group. The expensing limit applies at both the company level and the owner level for S corporations and partnerships.
The expense deduction is also limited to the amount of the taxpayer’s taxable income derived from all trades or businesses during a taxable year. Any unused amount from this limit is carried over to the next taxable year.
Some computers are subject to special documentation requirements as “listed property.” Computers and related peripheral equipment that are used only at a regular business establishment and owned or leased by the person operating the establishment are not listed property and are not subject to the documentation requirements.
A home office qualifies as a regular business establishment, provided it is exclusively used on a regular basis: 1) as the principal place of business for any trade or business of the taxpayer; 2) as a place of business that is used by patients, clients or customers in meeting or dealing with the taxpayer in the normal course of his trade or business, or 3) in the case of a separate structure that is not attached to the dwelling unit, in connection with the taxpayer’s trade or business.
Other computers are listed property and subject to documentation requirements. Some examples include a laptop that you take back and forth between your home and office or a Palm Pilot.
Believe it or not, in order to claim a tax deduction for computers that are listed property, you are supposed to keep a log book to track the hours the computer is used for business and the hours it’s used for personal purposes (such as tracking your personal expenses and investments using Quicken.) Only the business percentage is deductible. If the computer isn’t used more than 50% for business, depreciation may only be figured using the straight-line method.
In order to understand why Congress made personal computers subject to the listed property rules, recall that when IBM personal computers were introduced, the investment started at about $6,000. Not very many applications were available. To become familiar with their new machines, many people were playing computer games. The IRS and Congress were concerned about subsidizing the entertainment of taxpayers. Since that time, the prices of computer equipment has dropped dramatically and most people with businesses don’t have a lot of extra time to play computer games. Now we have a howitzer to deal with an ant.
In addition to complying with the listed property rules, employees may only claim depreciation for a personal computer employees have the computer for the convenience of their employers and having a computer is required as a condition of their employment. The computer use is for the convenience of the employer if the employer has a substantial non-compensatory business reason for the use. The computer is required as a condition of employment if the employee is not able to properly perform his or her duties without it.
What About Software?
When software is included as part of a “package deal” with a computer, and the price isn’t separately stated, it is depreciated or expensed with the computer.
“Canned” Software: Computer software that is readily available for purchase by the general public on similar terms, is subject to a non-exclusive license, and has not been substantially modified by the user, is generally depreciated over a 36-month period, using the straight-line method.
Internally Developed Software: Software that is internally developed is accounted for under the rules for research and development. The taxpayer may elect to currently deduct internal development costs or to capitalize them. Capitalized software development costs are depreciated over a 36-month period, using the straight-line method.
“Canned” software purchased with the assets of a business is depreciated on a straight-line basis over a 36-month period. Other software purchased with the assets of a business is accounted for as an intangible asset and is amortized over a 15-year period, beginning with the month of acquisition, regardless of its actual useful life. The rule developed to reduce arguments between the IRS and taxpayers over the allocation of the purchase price for the acquisition of a business and how the purchase price should be deducted.
Computers, Software as Supplies
With the declining prices of computer equipment and software, the accounting rules can sometimes seem like “much ado about nothing.” The expense of accounting for an item could practically exceed its cost. The expense election does provide some relief, but does not apply to software.
When the costs become insignificant, it may be that a taxpayer can justify expensing them as supplies. The tax laws allow taxpayers to currently deduct incidental materials or supplies, for which no record of consumption is kept or physical inventories are taken.
What about computers? Although the investment for a computer could hardly be considered “incidental,” it still seems that the costs are coming down to the “supply” category. Also, the value of computers is decreasing from obsolescence much more rapidly than the depreciation schedule would suggest.
A fellow CPA told me he has been successful in applying for an accounting method to account for computer equipment as inventoriable supplies using the lower of cost or market method. Using this method, the taxpayer does not depreciate computer equipment, but merely writes it down each year to fair market value, and reports it as supplies on the balance sheet. If you have a multiple-office operation, you could realize enough tax savings to justify the extra effort required for this approach.
Today’s booming economy is creating demands on each of us to continually improve our productivity. One of the ways we are able to meet these demands is by automating processes using computer technology. By being aware of these rules and guidelines, you should be able to get the most current tax benefits possible from implementing these technologies in your practice.