Right now, there are no formal tax rules on how to treat web expenses. But there are ways you can benefit.
Did you know that there is nothing in our tax laws about how to treat website development and maintenance costs? That’s right, the IRS has not issued any guidelines in this area.
As a tennis facility or retail shop owner, you’re pretty much left on your own as to how to handle these expenses. Would your business be better off with an immediate tax deduction, or with deductions spread over a number of years, offsetting what, hopefully, will be higher income in those later years?
Informal IRS guidance suggests that one approach to web expenses is to treat them like an item of software and depreciate those amounts over three years. In reality, many taxpayers who pay large amounts to develop sophisticated websites have been allocating their costs to items such as software development (currently deductible as Section 174), research and development costs, or currently deductible advertising expenses.
In the absence of formal IRS guidelines, the strategies utilized by many businesses will vary, often depending on the financial status of the operation.
Software is usually an “intangible” business asset. Thus, software used to create a website usually is treated as either “purchased” or “self-created.” Although the tax rules for purchased software are straightforward, self-created software deductions are more questionable.
Today, the expense of developing software (whether for your business’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. Purchased software, other than an intangible asset acquired as part of a business acquisition, is usually depreciated using the straight-line method over three years beginning in the month that it is placed in service.
Are those web-related expenditures really for software? After all, how can any operator differentiate between whether a cost is for software, whether it relates to graphics or whether it relates to content? It might even be considered an advertising expenditure.
Advertising expenses are deductible if they are reasonable in amount and bear a reasonable relation to your business. 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.
Many facility and business owners — as well as their tax professionals — consider the costs of developing and maintaining a website to be similar to advertising costs and, thus, deductible as an expense. A ruling by the U.S. Tax Court supports this: Packaging design costs were treated as a deductible advertising expense even though the design provided the company with “significant future benefits.”
Research & Experimentation
Our tax rules allow a credit for amounts spent on research and experimentation. Extremely regulated and very narrow in scope, the R&E tax credit is available, in some instances, for “internal-use software.” However, only costs of research in the laboratory or for experimental purposes qualify — whether carried out by the business or on behalf of that business by a third party.
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.
Some website software clearly does not qualify as internal-use software, such as an online tax preparation program or an online game, both of which are intended primarily for customer use. Other web programs, such as an application devoted to network management or pure order-processing software, are likely to be considered to be for internal use.
A tax “credit” is a direct reduction of your business’s tax bill as opposed to a reduction in its taxable income. Unfortunately, until it expired at the end of 2005, it existed for the incremental increase in research expenditures.
As an alternative, you can elect to capitalize research and experimental costs, amortizing 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 be amortized or depreciated over its useful life.
Be aware that the IRS wants to tighten the rules for claiming the R&E tax credit. In fact, some say IRS field agents are already taking the position that nothing qualifies for this credit.
Today, the capitalized cost of goodwill and most other intangible assets are ratably amortized, or written-off over a 15-year period generally beginning in the month of acquisition. A unique 15-year safe harbor exists for self-created intangibles. You can amortize certain created intangibles that do not have readily ascertainable useful lives over a 15-year period using the straight-line depreciation method and no salvage value. Anyone may use the 15-year amortization period for intangible assets other than one acquired from another person. But is a 15-year write-off period for the cost of developing and maintaining your website beneficial?
Web-related costs aside, the cost of developing software (whether for your business’s own use or for sale or lease to others) may be deducted currently or it may be amortized over five years (or shorter if established as appropriate), so long as such costs are treated consistently. For today’s software purchases, computer software that is not amortizable over 15 years as a Section 197 intangible asset is depreciated using the straight-line method over three years. The cost of 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. Computer software with a useful life of less than one year is currently deductible. A deduction is allowed for rental payments made for software licensed for use in a trade or business.
Obviously, immediately deductible expenses, whether for software or web costs, are far more beneficial in reducing out-of-pocket costs than a depreciation deduction that spreads those costs over a number of years. And while the IRS hasn’t yet outlined specific tax treatment for web development costs, it has provided clues that can produce substantial tax savings for your business — if handled properly.
See all articles by Mark E. Battersby
About the Author
Mark E. Battersby is a tax advisor and author in Ardmore, Pa.