Tax planning – Computer Software

Do you buy or lease computer software for use in your business? Do you develop computer software
for use in your business, or for sale or lease to others? Then you should be aware of the complex rules
that apply to determine the tax treatment of the expenses of buying, leasing or developing computer
software.

Purchased software. Generally, the way to account for the cost of purchased software is to amortize
(ratably deduct) the cost over the three-year period beginning with the month in which you placed the
software in service.

However, software that (1) is readily available for purchase by the public, (2) is subject to a nonexclusive
license and (3) hasn't been substantially modified (non-customized software), and (4) is placed in service
in tax years beginning before 2013 qualifies as “section 179 property,” and is thus eligible for the Code
Sec. 179 elective expensing deduction that is generally available only for machinery and equipment. For
tax years that began in 2010 or 2011, the deduction was limited to $500,000. For tax years beginning in
2012, the deduction is limited to $125,000 ($139,000 as adjusted for inflation). The limits are reduced by
the cost of other section 179 property for which the election is made. Also, the election is phased out for
taxpayers placing more than $2,000,000 of section 179 property into service during tax years beginning
in 2010 or 2011 and $500,000 for tax years beginning in 2012 ($560,000 as adjusted for inflation). Non-
customized software that was acquired and placed in service after Sept. 8, 2010 and before Jan. 1, 2012
is also eligible for a 100%-of-cost depreciation deduction in the year that the software was placed in
service (bonus depreciation). The bonus depreciation is at a 50% rate if the software was acquired or
placed in service before Sept. 9, 2010. The bonus depreciation for an item of software is reduced to
take into account any portion of the item's cost for which a Code Sec. 179 election is made, and regular
depreciation deductions are reduced to take into account both the bonus depreciation and any Code
Sec. 179 election.

There are two other exceptions to the three-year amortization rule.
• One exception requires that, if you buy the software as part of a hardware purchase in which
the price of the software isn't separately stated, you must treat the cost of the software as part
of the cost of the hardware. Thus, you must depreciate the software under the same method
and over the same period of years that you depreciate the hardware.
• The other exception requires that if you buy the software as part of your purchase of all or
a substantial part of a business, the software must be amortized over 15 years (unless the
software is non-customized software).

Leased software. You must deduct the amounts you pay to rent leased software in the tax year in which
paid, if you are a cash-method taxpayer, or the tax year for which the rentals are accrued, if you are an
accrual-method taxpayer. Generally, however, deductions aren't permitted before the years to which
the rentals are allocable. Also, if a lease involves total rentals of more than $250,000, special rules may
apply.

Software you develop. Costs for developing computer software may be accounted for using any of the
following methods:

(1) amortizing the costs over a three-year period beginning with the month that the software was placed in service;

(2) deducting the costs in the tax year in which the costs are paid (if you are a cash-method
taxpayer) or in the tax year in which the costs are accrued (if you are an accrual-method
taxpayer), but only if all of your costs of developing the software are deducted this way;
(3) amortizing the costs over a five-year period beginning with the completion of the development,
but only if all of your costs of developing software are amortized this way;
(4) amortizing the costs over a period longer than five years, but only if the costs are Code Sec.
174 “research or experimental expenditures.”

You should also be aware that if following any of the above rules requires you to change your treatment
of software costs, it will usually be necessary for you to obtain IRS consent to the change by following
prescribed procedures.

Please give us a call if you have any questions. We would be pleased to assist you in applying the tax
rules for treating computer software costs in the way that is most advantageous for you.

Bob
Robert L. Hesch, CPA
Tax Manager
Flagel, Huber, Flagel & Co, CPAs
9135 Governors Way
Cincinnati, OH 45249-2037
513.583.4044 office | 513.774.7250 fax | 513.703.9763 cell