{"id":33446,"date":"2024-06-03T12:58:56","date_gmt":"2024-06-03T19:58:56","guid":{"rendered":"https:\/\/evergreensmallbusiness.com\/?p=33446"},"modified":"2024-05-22T12:41:53","modified_gmt":"2024-05-22T19:41:53","slug":"section-174-software-development-accounting-primer","status":"publish","type":"post","link":"https:\/\/evergreensmallbusiness.com\/section-174-software-development-accounting-primer\/","title":{"rendered":"Section 174 Software Development Accounting Primer"},"content":{"rendered":"

\"Section<\/a>Okay. So, yeah, Section 174 software development accounting.\u00a0 A bit of mess, right?<\/p>\n

I hear you. We had more than a few client questions last tax season about how to handle this complexity. Thus a quick overview.<\/p>\n

But one clarification: This discussion of Section 174 and software development cost capitalization rests on the new \u00a7 174 statute, which appeared in late 2017. And then on IRS Notice 2023-63, which was published in September 2023.<\/p>\n

However, taxpayers and tax accountants really all need updated Treasury Regulations to plan ahead. And to get the bookkeeping right for 2024.<\/p>\n

That qualification made? We can dig into the details.<\/p>\n

Section 174 in a Nutshell<\/h2>\n

Section 174 changed in the 2017 Tax Cuts and Jobs Act, as noted. The old law said you could just currently deduct these expenditures.<\/p>\n

The (sort of) “new” law says you need to capitalize “specified research or experimental” (aka “SRE”) expenditures. And then you amortize the capitalized amounts.<\/p>\n

If you do the research in the US, you amortize the expenditures over five years. If you do the research outside the US, you amortize over fifteen years.<\/p>\n

The law includes another big change. Tax law now wants to treat software development costs as a SRE expenditure. Quoting the statute, Section 174(c)(3)<\/a>, says this:<\/p>\n

For purposes of this section, any<\/strong> amount<\/strong> paid or incurred in connection with the development of any<\/strong> software<\/strong> shall be treated as a research or experimental expenditure.<\/p><\/blockquote>\n

I added the boldfacing to the statutory language. But you see this is big. Apparently, nearly every software development cost a developer pays or incurs should be capitalized and amortized.<\/p>\n

To put this into perspective, if you spend $1,000,000 developing a piece of software? You might think you get to deduct the $1,000,000 when you spend the money. But you don’t. You deduct $200,000 a year over five years. Or you deduct $66,666 a year over fifteen years.<\/p>\n

Example of Section 174 Software Development Accounting<\/h2>\n

Notice 2023-63<\/a> provides a good example of precisely how a taxpayer handles the accounting. Tax advisors and company accountants want to read those pages carefully or their updated replacement in the regulations.<\/p>\n

But essentially, you or your accountants add up all the direct and indirect costs of your software development activities. Pull that cost out of your profit and loss statement. Temporarily<\/em> hold those dollars on your balance sheet. And then, as noted earlier,\u00a0amortize this cost over either five or fifteen years.<\/p>\n

One thing to note: You use a mid-year starting point for the first year. For example, if\u00a0a taxpayer incurred $1,000,000 of direct and indirect costs of software development in year 1, this results in a $200,000 amortization expense each full<\/em> year. (Because $1,000,000 divided by five years equals $200,000.) But the first year? A taxpayer only\u00a0amortizes a half-year.<\/p>\n

For year 1 in this example, then, the taxpayer deducts $100,000 of software development costs.\u00a0The next four full years, he or she deducts a full $200,000.\u00a0The last “half year?” The taxpayer deducts $100,000 of remaining software development costs.<\/p>\n

Two Weird Accounting Aspects of Section 174<\/h2>\n

Two weird things to note about the Section 174 statute’s accounting.<\/p>\n

First, the amortization starts in the year the costs are paid or incurred. Not the year the software developed is finished and placed into service. A two year software development project that costs $1,000,000 a year? You amortize each year’s $1,000,000 separately. And starting the middle of each year.<\/p>\n

A second point: If you sell or retire or abandon the software you develop before the full five years runs? Like, say, in year 3? You ignore the sale, retirement or abandonment. And you keep on amortizing. You do not, in other words, start amortizing and then just “write off” the remaining unamortized bit.<\/p>\n

Many Research and Experimentation Costs Don\u2019t Need to Be Capitalized<\/h2>\n

After a bit of fiddling, I got ChatGPT 4o to summarize in a table the general SRE costs Notice 2023-63 says you should and shouldn’t capitalize. A crude replica of that table, lightly edited, follows:<\/p>\n

 <\/p>\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n
Category<\/th>\nDeductible as Section 162 Expenses<\/th>\nCapitalized and Amortized as SRE Expenditures<\/th>\n<\/tr>\n
Labor Costs<\/td>\nNA except for a reasonable allocation of other costs for directly supporting SRE activities<\/td>\nLabor costs of employees and contractors performing, supervising, or supporting SRE activities<\/td>\n<\/tr>\n
Materials and Supplies<\/td>\nN\/A<\/td>\nCosts of materials and supplies used in SRE activities<\/td>\n<\/tr>\n
Depreciation<\/td>\nN\/A<\/td>\nDepreciation on property used in SRE activities<\/td>\n<\/tr>\n
Patent Costs<\/td>\nNA<\/td>\nCosts of obtaining a patent<\/td>\n<\/tr>\n
Operational Costs<\/td>\nNA<\/td>\nRent, utilities, insurance, taxes, repairs, and maintenance costs for SRE facilities<\/td>\n<\/tr>\n
Travel Costs<\/td>\nNA<\/td>\nTravel costs for SRE activities<\/td>\n<\/tr>\n
General Administrative Costs<\/td>\nCosts indirectly supporting SRE activities such as human resources, accounting and general administration<\/td>\nNA<\/td>\n<\/tr>\n
Interest on Debt<\/td>\nInterest on debt to finance SRE activities<\/td>\nNA<\/td>\n<\/tr>\n
Website and Hosting Costs<\/td>\nCosts to input content into a website, website hosting<\/td>\nNA<\/td>\n<\/tr>\n
Domain and Trademark<\/td>\nCosts to register an Internet domain name or trademark<\/td>\nNA<\/td>\n<\/tr>\n
Non-SRE Activities<\/td>\nCosts for activities such as quality control testing, efficiency surveys, management studies, consumer surveys, advertising, promotions, acquisition of another\u2019s product, and research in connection with literary or historical projects<\/td>\nNA<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

Not All Software Development Costs Need to be Capitalized<\/h2>\n

And then the following computer-y costs (again I\u2019m mostly quoting directly from Notice 2023-63) also don\u2019t need to be capitalized:<\/p>\n

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