As technology companies invest in research and development (R&D), including software development for internal or external use, they face an array of accounting and tax rules that govern cost classification and the way they are expensed or amortized over time. Affected businesses should first understand how to classify software development expenditures for Generally Accepted Accounting Principles (GAAP) purposes.
Determining whether the software will be sold, leased, or licensed to customers, or if it will be used within the business, will impact how the expenses are treated for GAAP. Then, the business needs to review accounts and activities to identify which expenses to capture for tax purposes, noting that, while there’s some overlap with the GAAP definitions around software development, the tax rules will result in different classifications for some expenses. Properly identifying tax expenses for R&D is important for proper reporting on tax returns and for claiming the potential tax benefits from these investments.
Companies often find it challenging to keep the differing GAAP and tax rules straight. To sort through the various treatments, businesses first need to understand the primary resources that govern tax and GAAP reporting treatment of software related expenditures:
- Accounting Standards Codification (ASC) 985-20 — Software to be sold, leased, or marketed (“External use”)
- ASC 350-40 — Internal Use Software
- Internal Revenue Code Section 174 — Amortization of research and experimental expenditures
- Internal Revenue Code Section 41 — Credit for increasing research activities
GAAP software development costs
For companies with substantial software development budgets, determining whether to expense these costs as regular business expenses or to capitalize them as assets can significantly impact the bottom line. Under GAAP, this determination isn’t a choice; it’s based on the type of expense and when it’s incurred. Costs related to external use software are expensed before technological feasibility is established, and then capitalized until the software is available for general release. Costs related to internal use software are expensed until the preliminary project stage is complete, and then capitalized until the software is ready for its intended use. Once these criteria are met, the costs begin to be amortized over the software’s useful life. This approach aligns expenses with their period of benefit, ensuring that costs are matched with the time frame in which the software provides value to the company.
IRC Section 174 and restoration of full expensing of domestic expenditures
Section 174, as amended by the Tax Cuts and Jobs Act (TCJA) of 2017, requires taxpayers to capitalize and amortize all R&D expenditures, including all costs for software development, over a period of five years for domestic costs and 15 years for foreign costs. In and of itself, this was a significant change for taxpayers who could previously deduct R&D in the year incurred. To further complicate things, taxpayers currently expensing software development costs for GAAP are unable to immediately deduct the same expenses for tax purposes. Similarly, there’s often a difference between when capitalized costs are amortized for GAAP versus when they’re amortized for tax. These timing differences can cause taxpayers to find themselves with unexpected taxable income, even when they’re reporting a loss for book purposes.
The One, Big, Beautiful Bill (OBBB) restores the expensing of domestic Section 174 R&E costs starting in 2025. Foreign costs are excluded from the OBBB changes and will continue to be amortized over 15 years.
What about unamortized domestic R&D costs capitalized in 2022, 2023, and 2024? Taxpayers may continue to amortize such costs over the remainder of their five-year periods. However, the OBBB provides two additional accounting method change elections. First, all taxpayers may elect to deduct the remaining unamortized costs immediately in 2025 or deduct such costs ratably over 2025 and 2026. Certain taxpayers meeting the small business taxpayer definition in 2025 will have a third option to amend their returns from 2022 through 2024 to remove the capitalization of domestic R&D in such years. For this purpose, a small business taxpayer is defined by Section 448(c) to include those with gross receipts under $31 million for the prior three years and those not considered a tax shelter.
For many technology companies, the amount of unamortized R&D costs is substantial. Modeling should be performed to determine the optimal timing for deducting prior year costs, including interplay with various other tax provisions and planning around potential tax losses that might be generated.
IRC Section 41 research and development tax credit
The Section 41 Credit for Increasing Research Activities (R&D tax credit) is a federal incentive designed to encourage investment in U.S.-based R&D activities, including software development. While the GAAP and Section 174 rules discussed above tell us when software development can be expensed, Section 41 focuses on a subset of the Section 174 costs and provides an additional incentive, in the form of a dollar-for-dollar tax credit. To qualify for the R&D tax credit, expenses must first be treated as Section 174 expenditures. Then, Section 41 looks to the activities performed by the taxpayer, and only those efforts aimed at developing or improving products, processes, or software are eligible. Eligible expenses incurred related to these activities can include wages, supplies, rental lease cost of computer (or, in more plain language, cloud computing costs), and contract research. More information regarding the calculation of the R&D tax credit and other requirements can be found here.
A comparison of the GAAP accounting and tax rules for Section 174 and Section 41 R&D expenses is summarized in the following table.
Comparison of accounting and tax rules for R&D expenses
Common challenges and potential considerations
To avoid pitfalls, affected businesses should learn how the definitions apply to their GAAP reporting and tax recordkeeping functions and develop a process to identify and categorize each expense for financial statements and tax preparation. The identification and categorization process should include:
- Analyzing the types of activities undertaken (i.e., development vs. maintenance).
- Determining if technological feasibility has been met.
- Identifying where the work is being performed (domestic vs. foreign).
- Identifying the resources working on software development during the year, both internal employees and outside contractors/vendors.
- Determining the appropriate cost for each resource; fully burdened wages, taxable wages, or third-party contractors.
- Establishing a tracking mechanism to document the analyses and outcomes and to ensure consistency year over year.
If you’re unsure about how to treat software development costs, you’re not alone. The rules are complex, and there are many subtle distinctions — particularly on the tax side — that govern what costs do and don’t need to be capitalized. The answer for every company will vary based on the specific facts and circumstances of its costs and business processes. Reach out to our audit and tax advisors with questions on specific scenarios.
