IRS Further Clarifies Software Cost Capitalization

In the last few years, the Service has issued several pronouncements on how to characterize website development and Y2K conversion software costs. Under Rev. Proc. 2000-50, it provided automatic accounting-method-change rules to allow taxpayers to comply.

Recently, Letter Ruling 200236028 described which enterprise resource planning (ERP) software taxpayers can deduct under Secs. 162 and 174, and which they have to capitalize under Sec. 167(f)(1).

ERP software combines different software packages (e.g., human re-sources, inventory control and financial accounting) into one cohesive unit. A company that purchases ERP software usually engages consultants who fine tune the software for proper integration with the company's other software.

In the ruling, a company purchased ERP software, along with some hardware, and engaged the supplier to implement the ERP system, make some system modifications and provide ERP training. It also hired a second consultant to oversee the necessary installation and design modifications and, later, a third consultant, to address certain technical issues, provide additional training and further enhance the design. The Service ruled on how to treat the costs of the separate ERP system components.

Hardware. Separately stated hardware costs are depreciable over five years, as provided in Sec. 168 (see Rev. Proc. 87-56).

Software. The cost of the initial ERP package (including sales tax) is amortizable over 36 months, under Sec. 167(f)(1). This includes initial costs for consultations on system installation and necessary integration modifications. The rationale for this treatment is that the software cannot be implemented without these steps.

Training. The training expenses and any separately stated maintenance are currently deductible under Sec. 162, except to the extent they represent prepaid training under Sec. 461.

Design. For design-enhancement costs, the agreement between the taxpayer and its consultants specified that the taxpayer bore the economic risk of development work. The consultants provided no warranties or guarantees and were paid on a cost-plus-expenses basis, regardless of the project's success. The Service found that, under Rev. Proc. 2000-50, Section 5.01(1), these expenditures were user-developed software, deductible under Sec. 174(a).

Other. Consulting expenses not identified as related to (1) writing software code or (2) training are includible in the initial software cost, to be amortized over 36 months under Sec. 167(f)(1).

From R. Milton Howell, III, CPA, Davenport, Marvin, Joyce & Co., LLP, Greensboro, NC