Further development of capitalized software from the tax accounting perspective? Should cost be amortized or expensed?

[verdeth]

Founders of a small company I work for assigned their IP to the company recently. The IP consists of trademarks and software. The software is marketed by the company in the form of several software products.

The software is being improved to keep it up-to-date and relevant. Improvements include bug fixes as well as new features.

I understand that the assigned IP needs to be capitalized and amortized. But what about the further development of the software? Should these costs be also capitalized and amorized, or could be expensed when incurred, since they are similar to research and experimental expenditures?

Thank you for your help!

[Carl]

YOu can do either. However, I recommend capitalization unless you have the business income to deduct it from in the year you want to expense it. I'm sure you're already aware of the limits on expensing a high cost IP asset, so won't get into that. But if you have the income to deduct the expense from, expensing it is usually better.

[Carl]

 Just realized something. Did you mean to say amotize instead of capitalize? I think amortize is what you meant.

[verdeth]

Yes, amortize is what I've meant. Will correct the question! Thanks.

[verdeth]

Thank you for your answer! The software does generate income, and expensing further development would be our preferred way to go. Would such treatment follow section 174? (As a side note -- we have decided to treat the assigned software as section 197 intangible. Does this in any way affect the treatment of the further development cost?)

I am not aware of the limits on expensing a high cost IP asset. Could you please refer me to an article covering this?

[Carl]

Since intangibles are almost always considered a flat out deduction (as opposed to depreciation) when you have the choice of expensing it or amortizing it over time, the cost of each "improvement" (for lack of a better word) is treated on it's own merits as it's own stand alone entity, but only to a degree.

For example, if you amortized the base product (I use the word "product" because I can't think of any other way to describe an intangible asset at this time) then it's generally expected any future additions, enhancements or upgrades to that produce will also be amortized.  Now I've not looked at the detail in the IRS pubs myself. But I would think the IRS would have issues with you amortizing some aspects of the base asset, while expensing other parts.  So if you start out expensing, I would suggest you keep improvements the same.

To decide which is best for the long term (and I reiterate "long term") you have to look at the current, as well as the impact on the current and projected impact on the future projected tax liability.  Some discussion on this follows.

If the business has the taxable income from which to expense it, then expense it. But don't just take that comment at face value.  While expensing it the first year can get your taxable business income to zero with any excess carried over to the next year, if the excess carried over won't lower your tax bracket that next year, then amortization "may" be the better way to go over the long term.

If the business does not have the taxable income from which to expense it, then amortize it and deduct it over 5 or 7 years (Can't recall the schedule for software).

Another consideration too, is that if amortizing it over a number of years has the potential to bump you into a lower tax bracket for one or more of those years (excluding the first year) then by all means, amortize.

You may need to work this through the program to give you more accurate data to work with for your future predictions of tax liability down the road, so you can make a more educated decision on what you believe is best at this time.