Section 174d: Amortizing Your Software Development Costs

Changes to the tax treatment of research and experimental (R&E) expenditures, including software development, took effect for tax years beginning after December 31, 2021. Originating from the Tax Cuts and Jobs Act of 2017 (TCJA), these changes amended Section 174 of the Internal Revenue Code. This section now mandates that all specified R&E expenditures, including any amount paid or incurred for software development, must be capitalized and amortized over several years, eliminating the option for immediate deduction.

Defining Software Development Under New Tax Rules

For tax purposes, the definition of “software development” is broad and covers most activities related to creating or significantly enhancing computer software. IRS guidance, particularly Notice 2023-63, provides a framework for determining which activities fall under this definition. The rules apply to new software and to upgrades and enhancements of existing software that add functionality or improve efficiency.

Included Activities

Activities considered software development include planning and design, such as creating specifications and architectural plans for a new program. The direct act of generating source code, whether by human programmers or automated systems, is a core covered activity. The process of testing the software, including debugging and quality assurance performed before the software is placed in service or ready for sale, also falls within the scope of development costs that must be capitalized.

Excluded Activities

Certain activities are explicitly carved out from the definition of software development. The purchase of off-the-shelf software for general business operations, like a standard accounting program, is not considered a development cost. Similarly, routine data conversion, data entry, and minor maintenance activities that only fix bugs without adding new capabilities are not subject to capitalization. After software is placed in service, only costs for substantial upgrades and enhancements are treated as development costs.

The Amortization Requirement for Development Costs

The amortization period for capitalized software development costs depends on where the activities take place. For costs associated with development conducted within the United States, the amortization period is five years. If the development work is performed outside of the United States, the amortization period extends to 15 years.

A specific accounting rule, the mid-year convention, must be used for this type of amortization. This convention dictates that amortization begins from the midpoint of the tax year in which the costs are paid or incurred, not from the date the software is completed. For the first year, a business can only deduct half of a full year’s amortization amount. For example, a $1 million domestic software development project would yield a $100,000 deduction in the first year ($1,000,000 / 5 years 0.5).

Identifying and Tracking Covered Expenditures

To comply with the capitalization requirement, businesses must identify and track all direct and indirect costs associated with their software development projects. This allows for an accurate calculation of the total amount that must be amortized.

Covered expenditures include:

• Salaries and wages of employees directly involved in the development process, including developers, project managers, and quality assurance testers.
• Payments to third-party contractors for their work on designing, coding, or testing the software.
• Materials and supplies consumed during development, such as the cost of computer hardware used specifically for the project.
• Charges for using cloud computing platforms for developing, hosting, and testing the software.

Procedural Compliance and Reporting

Businesses report these capitalized expenses on Form 4562, Depreciation and Amortization, which is used to calculate and claim the annual amortization deduction. For the first tax year a business is subject to these new rules, it must adopt this accounting method on its tax return.

If a business needs to change its method of accounting in a subsequent year to comply, it may be required to file Form 3115, Application for Change in Accounting Method. This form ensures the transition to the new accounting treatment is properly documented.

Even if a company sells or abandons the software before the amortization period is complete, it must continue to amortize the remaining capitalized costs over the original 5- or 15-year schedule. The unamortized balance cannot be written off in the year of disposal.