Tax Matters

When Are ERP Costs Deductible?
The IRS normally takes the position that businesses must capitalize the cost of enterprise-resource-planning software (ERP) and amortize it over 36 months. ERP software incorporates financial accounting, inventory control, production, sales and distribution and human resources modules. In a recent letter ruling, the IRS explained the circumstances under which companies may be able to currently deduct some ERP software costs. Because the IRS had not previously issued any taxpayer guidance on the treatment of ERP costs, this letter ruling offers CPAs critical insights into its evolving position.

In LTR 200236028, a taxpayer in the business of marketing and distributing music industry-related products purchased ERP software and entered into consulting agreements to customize the software to fit the company’s needs. In addition to the hardware and the software license fee, the company incurred costs for

Functional consulting.
Maintenance.
Outside training.
Technical consulting.

While the letter ruling did not include exact amounts, the total cost of ERP systems could range from $2 million to $200 million depending on the company’s size.

The IRS allowed the company to currently deduct the functional consulting, maintenance and training costs. Two observations are crucial here. First, in revenue ruling 96-62 (1996-2 CB 9) the IRS said the Indopco decision (503 US 79) would not cause training costs to be capitalized. Therefore, training is deductible only if a company categorizes it as such. Second, the costs at issue in this ruling did not include any “reorganization expenditures.” This is another way of saying the company did not undertake any business process reengineering. The IRS requires businesses to capitalize reengineering costs (see TAM 9544001 on reengineering in a conversion to just-in-time manufacturing). When a company engages in reengineering and capitalizes the expense of doing so, it ends up including a good deal of training costs because the essence of reengineering is training employees to accomplish a task in a different way. Taxpayers should isolate as many training costs as possible in the spreadsheets they use to track ERP costs.

Technical consulting costs include modeling and designing additional software, writing machine-readable code and implementing existing imbedded ERP software templates. Taxpayers can deduct these costs only if they can categorize them as software development costs under section 5 of revenue procedure 2000-50. The IRS allowed companies to deduct self-developed software for many years but insisted costs included in this category resemble research and development expenditures. Thus, implementing purchased software templates is definitely not internal software development. On the other hand, writing machine-readable code clearly qualifies.

What about modeling and design costs? Recent signals from the IRS indicate that only the costs of writing code would qualify. This letter ruling, however, contains a hopeful sign that at least a portion of design costs may be eligible for a current deduction as software development. The Office of Associate Chief Counsel, at least here, took the position the taxpayer should allocate modeling and design costs to “the activities of writing machine-readable code and the option selection and implementation of existing embedded software templates.” The portion allocated to code writing is deductible, however the company should capitalize the remaining expenses.

The deductibility of technical consulting costs depends not only on the nature of the work but also on who is responsible for development. Who is at risk for the software’s functional utility? In LTR 200236028, the taxpayer was solely responsible for adapting and customizing the ERP software. The consultants performed their technical activities under a time-plus-expense contract. The taxpayer had to correct any problems relating to the system’s functionality. The consultant contracts provided no guarantees or warranties. Thus, if the taxpayer is the responsible party, it may deduct the consulting costs for writing code and related modeling and design as software development under revenue procedure 2000-50.

Planning for an ERP deduction. CPAs may want to consider the following suggestions in light of LTR 200236028 as they seek to justify a current deduction for ERP costs for a client or employer.

Carefully isolate deductible training and maintenance costs regardless of whether software development is taking place.

Document and isolate any reengineering costs. Conceptually, these are costs of adapting the company to the software rather than adapting the software to the company. Without the proper recordkeeping, IRS agents may assume, by default, that the costs of consultants who are not programmers fall into capitalizable reengineering.

Leave a trail for all the time consultants spend on modeling and design and source code writing. Remember source code writing is directly deductible (assuming the taxpayer is functionally at risk on the project) and part of the time spent on modeling and design should be allocated to code writing.

—Larry Maples, CPA, DBA, COBAF Professor of Accounting at Tennessee Technological University, Cookeville.