How you treat software development costs for tax purposes is changing. It may be time to assess your research and development activities.
Key insights
- For tax years beginning in 2022, certain research and experimental expenditures must be capitalized and amortized rather than expensed.
- This can have particular impact on technology companies and software developers.
- The law may drive organizations to shift the way they think about “onshoring” R&D, in an effort to get the tax deductions three times faster.
Have questions about the new rules?
Certain software development costs may soon have new tax treatment requirements, and now is the time to review how that could impact your operations. For some organizations, that could mean reviewing software development activities and determining whether onshoring research and development (R&D) could help you realize tax savings faster.
For tax years beginning in 2022, research and experimental expenditures in connection with a trade or business must be capitalized and amortized under Internal Revenue Code (IRC) Section 174. Prior to 2022, these expenditures can be expensed.
Under the new rules, expenditures incurred in the United States must be capitalized and amortized over five years, while expenditures incurred outside of the United States must be amortized over 15 years.
What does this mean for software developers?
Under the post-2021 rules, IRC Section 174 states that "any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure." This broad definition leaves little wiggle room for what you can include as software development costs: most would need to be capitalized.
For example, cloud computing services could be swept into the definition. And that means you must analyze the costs associated with these services. Determine which costs are related to software development and which costs should be deemed ordinary and necessary expenses eligible for a current deduction under IRC Section 162. Should maintenance and bug fixes be considered “in connection with” the development process? How about sales teams that provide feedback to the development team?
In the world of software as a service (SaaS), software is no longer “versioned” but is in an ongoing state of development — should all these costs now be capitalized? Again, how should internal use software development be evaluated under this structure?
Historically companies have studied qualified activities to be as inclusive as possible to increase the likelihood of qualifying under IRC Section 41 for the R&D tax credit. But this same analysis may have different consequences under the post-2021 law.
Impacts on decision-making
Some technology companies look to resources outside the United States for R&D talent. In this case, the R&D credit is less important, but the deduction still has value. After 2021, those costs must be capitalized and amortized over 15 years, which could drive organizations to shift their thinking about “onshoring” R&D to get the tax deductions three times faster.
Also, many of these companies currently generate large net operating losses due to the deductibility of these software development costs. These companies may actually end up being taxpayers, which should be factored into the annual burn rate.
As with all tax laws, it is possible that these rules will change before they go into effect. However, you should consider the potential impact on your organization’s operations now.
How we can help
Technology companies must adapt to these new rules. CLA can provide guidance to help you adjust to the impacts of the post-2021 law — and help you determine if onshoring R&D is the right strategy for your organization. Our team stands ready to help, or simply answer any questions.
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