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Love Is Complex and So Is the Accounting Related to Software Development Costs

Bonnie Mann Falk, Partner, Berdon LLP
Partner, Citrin Cooperman Advisors LLC / Berdon Advisors LLC

02.15.22 | Assurance Chat

New Tax Rules

Starting in 2022, for tax purposes, all new software development costs (aka, specified research and experimental expenditures or R&D) are required to be capitalized and amortized over 5 years for domestic costs (15 years for foreign costs), beginning with the midpoint of the year in which the R&D expenditures are paid or incurred. This new rule represents a big change from the days of the options to deduct software development costs in full in the year paid or incurred or to capitalize over 3 or 5 years. Furthermore, there is no deduction for these new costs once software is retired, abandoned, or disposed of; amortization must run its course.

There are different financial reporting implications of this new tax rule for tax basis vs. GAAP (generally accepted accounting principles) basis financial statements. The change for tax basis financial reporting is fairly straightforward. The considerations for GAAP basis financial reporting are more complicated.

Tax Basis

If you prepare financial statements on the tax basis, you will only be recording software development costs as assets which are then capitalized and amortized over 5 or 15 years, as applicable, using the midpoint of the year in which the costs are paid or incurred as the in-service date. For pre-2022 software development costs, just continue what you are doing; old rules apply. In addition, you will need to disclose the change in accounting principle and note the policy difference between tax basis and GAAP basis.

GAAP Basis

If you prepare GAAP basis financial statements, you continue to follow the guidance under the appropriate standard depending on the software development phase and purpose. The real complexity arises with the manifestation of temporary differences in recognizing expenses in the GAAP financial statements versus the actual tax return resulting in deferred tax assets. Some factors to consider when identifying and assessing these temporary differences include:

Factors for ConsiderationGAAP Basis Financial StatementsTax Basis Financial Statements
Distinction between software purchased or developedSoftware purchased for internal use is capitalized, with some related costs being expensed. Costs related to the development of internal-use software or the customization of purchased software are expensed or capitalized depending on the phase of development of the software and whether it will subsequently be sold in the marketplace, no matter if the software is developed internally or externally.

Computer software and program formats purchased as part of a business combination that are protected or copyrighted are generally considered intangible assets and are accounted for as described above. Software under development may still be considered an asset in the acquisition, with new costs treated as described above.
For tax purposes, there is a greater distinction between purchased and developed software.

Purchased internal-use software is amortized over 3 years or is eligible for bonus depreciation which is recognized in the year purchased.

Purchased software that is not publicly available that is included in the purchase of a business is amortized 15 years from the date of acquisition.

If you pay someone else to develop the software, the tax treatment (purchased vs. developed) depends on who bears the risk of operability or functionality.

Treatment of costs related to the customization of purchased software depends on certain factors as well.
Expense vs. capitalizeWhether a particular software development cost is expensed or capitalized is determined by the phase in the development process and the purpose of the software.Since all software development costs are specified research and experimental expenditures, all such costs are capitalized.
Term of amortizationThere is no specific number of years stated in the guidance. Typically, 3-5 years is used with no distinction between purchased vs. developed or foreign vs. domestic costs.Software development costs: 5 years for domestic costs; 15 years for foreign costs.

Purchased software: 3 years; 15 years if part of a business acquisition.
Recognition beginsCosts are either expensed or capitalized when incurred.Begin capitalizing at the midpoint in the taxable year.

Software not publicly available purchased through a business acquisition begins amortization at the date of acquisition.
Project gets retired, abandoned, or disposed ofCease amortization and apply the guidance for impairment.Continue amortizing over the initially determined life of the project.

Current Events

Stay tuned! Part of the now broken-up Build Back Better Act includes the reversing of the TCJA amendments to the tax code relating to specified research and experimental expenditures originally proposed in the 117th Congress in the House in February 2021 by Rep. John Larson under H.R. 1304, the American Innovation and R&D Competitiveness Act of 2021, and in the Senate in March 2021 by Sen. Margaret Wood Hassan under S.749, American Innovation and Jobs Act. Currently, H.R. 1304 has bipartisan support, with co-sponsorship by over 20% of the representatives, and sits with the House Ways and Means Committee1, and S.749 has bipartisan support, with co-sponsorship by 25% of the senators, and sits with the Committee on Finance2.

Questions? I can be reached at 516.806.1193 | BMannFalk@BERDON.COM or reach out to your Berdon advisor.

Bonnie Mann Falk is a Partner in the Quality Control (QC) Department of Berdon with nearly 30 years of experience in public accounting and expertise in a variety of areas including quality management, compliance, and risk management. As a QC Partner, Bonnie advises the Firm on policies and procedures to enhance quality, increase efficiency, and elevate communication.

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1 https://www.congress.gov/bill/117th-congress/house-bill/1304?s=1&r=96
2 https://www.congress.gov/bill/117th-congress/senate-bill/749?s=1&r=49