Long ago, the Internal Revenue Service established rules for deducting business computer and software expenses. Two years ago, the rules for deducting computer costs were updated to reflect a tremendous expenditure on Y2K "fixes."
Unfortunately, far too few electrical contractors understand the tax treatment of even basic computer and software costs, let alone the fact that Y2K-related "glitch fixes" may be tax deductible.
Today, the cost of all assets an electrical contractor acquires as part of the purchase of a business are amortizable as "intangible assets," especially computer software. Previously, the IRS required that you capitalize intangible assets and you could not claim them as a tax deduction unless they had a readily determinable life.
If computer software has been obtained as part of the purchase of an ongoing business, the electrical contractor must write it off as a "Section 197" intangible asset, an asset with a 15-year write-off period. The costs of developing software (for the contractor's own use or for sale or lease to others), however, may either be deducted as an immediate expense or amortized over a five-year period (or shorter if appropriate). Remember that the costs must be treated consistently.
For computer software purchases, specifically those costs that are not amortizable over 15 years as a Section 197 intangible asset, costs are depreciated using the straight-line method over three years beginning in the month it is placed in service.
Computer software received with a computer as part of its cost (i.e., the cost was not separately stated), is depreciated under our basic depreciation system, the Modified Asset Cost Recovery System (MACRS), along with the computer, over a five-year recovery period. If the cost of the software is separately stated, the software cost must be amortized over five years using the straight-line method.
Naturally, computer software with a useful life of less than one year is currently deductible.
Another tax deduction is allowed for renting software used in a trade or business.
Y2K-related Software Costs
Several years ago, the IRS published the guidelines that it will follow when examining the income tax returns of electrical contractors who incur some computer software costs as a result of their software's inability to recognize dates beginning in the year 2000. According to Revenue Procedure 97-50, the IRS will not question any business's treatment of costs associated with enabling computer software to recognize the years 2000 and beyond.
Unfortunately, the IRS did not stop there. The IRS will only ignore Y2K-related fix expenses if the electrical contractor's Y2K-related computer software expenses are treated in the same manner as the contracting operation's developed, purchased, and leased software.
Any change in the treatment of year 2000 costs in order to conform to this revenue procedure will be considered a change in the electrical contractor's accounting.
Accordingly, contractors who wish to change their method of accounting for those costs to conform to those rules must adhere to the automatic change of accounting method rules.
Interpretations of the tax rules as they apply to computer software differ but, generally, an electrical contractor has the option of immediately deducting or "expensing" the cost of developed software. Alternatively, if it is to the electrical contracting operation's advantage, the firm can amortize the development cost over a five-year period.
Amortization is defined as "the systematic write-off of costs incurred to acquire an intangible asset such as patents, copyrights, goodwill, and computer software." (Dictionary of Business Terms, 2nd edition, Jack P. Friedman (Barron's, 1994). Depreciation, on the other hand, is a tax deduction allowed every business as a reasonable allowance for the wear and tear or exhaustion of property or assets used in a trade or business or for the production of income.
When it comes to software purchased by the electrical contractor, the IRS has already said on record that they will not object to the contractor's treatment of such costs - if that treatment is followed consistently. Thus, where purchased software costs are included in the hardware (that is, the computer) costs, without being separately stated, they may be treated as part of the cost of the hardware that is capitalized and depreciated.
Where those purchased software costs are separately stated, and the electrical contractor treats them as an intangible asset with a five-year recovery period, the IRS will not question it so long as all software costs are treated similarly.
In today's fast-changing, technology-oriented world, computers and software quickly become outdated. New versions or updates of computer programs are routinely released. Computer systems, however, can only be upgraded so far before the contractor's software or hardware become obsolete. Then the firm must buy a new computer, new software, or both.
If that new computer - or computer system - is acquired before the old equipment has been fully depreciated or written off, chances are it has a book value. The value the replaced computer equipment is carried at on the electrical contracting operation's books can be treated as an abandonment loss.
If that old equipment is traded in, the fair market value often acts as a down payment as the firm acquires a newer, more modern computer. With a trade-in or down payment, the new equipment assumes the book value of the old computer. Any additional payment is added to the new equipment's book value.
Our income tax rules play a major role as firms acquire computer software - and the computers themselves. Regardless of whether the software is leased, purchased off the shelf or developed specifically for the electrical contractor, tax deductions can help reduce the out-of-pocket cost to the electrical contractor - even for the costs of one-time Y2K "fixes."
BATTERSBY is a freelance financial writer, based in Ardmore, Pa. He can be reached by telephoning (215) 747-6684 or by e-mail at Mbattersby@MCIMail.com.