Computer software and taxes. What could be simpler? After all, every hearing care professional may deduct what the tax law calls a reasonable allowance for the exhaustion, wear, and tear of all property used in their practice and/or for the production of income. Unfortunately, as with many areas of our tax law, theres far more to computer software deductions than a simple depreciation write-off.
The deductions available for computer software can, in fact, confuse even the most astute hearing care practice owneras well as his/her tax adviser. One reason for much of that confusion? Theres more than one type of computer software expenditure. Thus, the first step every hearing care professional should take is to decide whether the expense is for off-the-shelf software programs, developing or modifying software for use in the hearing health practice, or for developing or maintaining the practices Web site.
Further clouding the issue is the hearing practices financial picture, both today and in the years ahead. After all, many of those software-related deductions offer the professional and their business/practice a variety of options, such as whether to claim a tax deduction now or spread those software costs over a number of years. Would the hearing practice be better off with a small, current tax deduction to offset low or non-existent income in a start-up or slow year? Would additional write-offs in later years benefit the practice as its financial picture improves? Would an immediate tax deduction for those expenses this year help keep the tax bill manageable? Or, perhaps, this years exceptional income would benefit from a supersized tax write-off or even a tax credit?
Booting Up Computer Software Write-Offs: The Basics
Generally, the purchase of computer software can best be compared to the purchase of any business asset. If computer software has an expected useful life 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, at least for the time being, be expensed and immediately deducted as Code Section 179 property. Depreciable off-the-shelf computer software placed in service in 2002 through 2007 may be expensed and immediately written-off under Code Section 179 of the Internal Revenue Code, our basic tax law. Again, this applies to software that is readily available for purchase by the general public, is subject to a nonexclusive license, and has not been substantially modified and which is usually depreciable over three years.
Under Code Section 179, the maximum deduction, as adjusted for inflation, was $102,000 in 2004 ($100,000 in 2003). Beginning in 2008 and thereafter, the maximum deduction will be reduced to $25,000 per year and not adjusted for inflation.
Whats more, that maximum Code Section 179 deduction must also be reduced, dollar-for-dollar, by the cost of qualifying property placed in service during the tax year in excess of, as adjusted for inflation, to $410,000 in 2004 ($400,000 in 2003). After 2008, this investment limit, like the deduction limitation, will be reduced to $200,000 per year and not adjusted for inflation.
Authors Note: The Code Section 179 expense deduction is treated as depreciation for recapture purposes. This means that if Code Section 179 property is disposed of, any gain that results from the disposition is generally treated as ordinary income to the extent of the Code Section 179 expense allowance plus any depreciation claimed.
Specialized Computer Software
Although most dispensing offices and businesses rely on standard packaged software, it is not uncommon for some larger practices to develop their own software programs to suit their own unique business and dispensing needs. The costs of developing computer software for a hearing care 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. Accordingly, the IRS has announced that they will not disturb any taxpayers treatment of costs paid or incurred in developing software for any particular project, either for the taxpayers 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 where the hearing care practice consistently treats those costs as either current expenses or capital expenditures. That means that the costs of developing computer software should always be deducted either currently, or it should be consistently treated as a capital expense and deducted (prorated) over a period of 36 months (3 years) from the date the software is placed in service. Thus, no switching back and forth as the practices general economic health rises or falls would be permitted.
Any hearing care professional can choose to deduct certain current research and experimental costs. However, only the costs of research in the laboratory or for experimental purposeswhether carried on by the clinician and his/her staff on behalf of the practice by a third partyare deductible. Market research and product testing costs are not research expenditures under the rules.
As an alternative, a hearing professional can choose to capitalize the costs and amortize them ratably over a period of at least 60 months (5 years) beginning with the month in which benefits are first realized from them, assuming that the property created does not have a determinable useful life at that time. Costs associated with property that have a determinable useful life must be amortized or depreciated over the useful life of the item.
Relative to deducting software expenses, the research tax creditwhich is a direct reduction of the hearing health care offices tax bill, as opposed to a deduction from the income upon which that tax is computer relatedis quite controversial. Generally, software is not eligible for the research credit when it is used internally, such as in general and administrative functions like payroll, bookkeeping, or personnel management, or in providing non-computer services such as in accounting, consulting, or banking services.
Acquiring SoftwareAnd Section 197 Intangibles
The tax rules contain a unique provision designed primarily to permit the deduction of intangible assets which usually dont have an ascertainable useful life. Under Code Section 197, the capitalized cost of goodwill and most other intangible assets acquired after August 10, 1993, and used in a trade or business or for the production of income, are ratably amortized over a 15-year period generally beginning in the month of acquisition. Intangibles amortizable under this provision are referred to as Section 197 intangibles.
It should be noted that computer software which is not acquired in connection with the purchase of a business or which is readily available for purchase by the general publicsubject to a non-exclusive license and that has not been substantially modifiedis specifically excluded from the definition of a Code Section 197 intangible. However, certain depreciable computer software generally acquired after August 10, 1993 that is not an amortizable Code Section 197 intangible asset may be depreciated using the straight-line method over 36 months. And, as mentioned above, off-the-shelf computer software may be expensed under Code Section 179.
When it comes to the cost of acquired computer software, the IRS will not disturb any hearing professionals treatment of costs that are included, without being separately stated, in the cost of the hardware (computer) if the costs are consistently treated as part of the cost of the hardware that is capitalized and depreciated. Similarly, the IRS will not recharacterize or disturb the costs of acquired computer software that are separately stated if those costs are treated as a capital expenditure for an intangible asset, the cost of which is to be recovered by amortization deductions ratably over a period of 36 months, beginning the month the software is placed in service.
Today, computer software that is not amortizable over 15 years as a Code Section 197 intangible asset is usually depreciated using the straight-line method over three years beginning in the month it is placed in service. The cost of computer software that is included as part of the cost of computer hardware, and is not separately stated, is treated as part of the cost of the hardware.
Web Site Development Costs
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) using the Code Section 179 first-year expensing election and even as currently deductible advertising expenses.
Computer software is usually subject to an allowance for depreciation. Depreciation, in this case, means using the straight-line method with a useful life of 36 months. An immediate expensing deduction is available as Code Section 179 property for that computer software, thus providing an option for many hearing professionals and their practices. Remember, however, the IRS will usually maintain a hands-off policy in cases where the deductions for the costs of computer software are treated consistently, year-after-year. w
Editors Note: As with any tax advice, be sure to check with a tax accountant or attorney to verify that the tax breaks discussed here pertain to your own particular business situation.
|Mark E. Battersby is a tax and financial freelance writer, advisor formerly enrolled to practice before the IRS, and the author of four books. His office is located in the suburban Philadelphia community of Ardmore, Pa.|
Correspondence can be addressed to HR or Mark E. Battersby, PO Box 527, Ardmore, PA 19003-0527; email: [email protected].