What expense category is Perpetual Software License?

In an era dominated by subscriptions, some businesses still choose to purchase software outright with a perpetual license. This model, where a company pays a single, large upfront fee for the right to use the software indefinitely, has a significantly different tax treatment compared to a recurring monthly subscription.

Unlike a subscription fee, which is a currently deductible expense, the cost of a perpetual software license is considered a capital expenditure by the IRS. This means the cost must be capitalized and recovered over time. This guide will explain the specific IRS rules for these assets to ensure you handle them correctly.

Perpetual Software License Category

The cost of purchasing off-the-shelf computer software is a capital expenditure. It is treated as an intangible asset. The IRS has specific rules for recovering this cost.

According to IRS Publication 946, the cost of computer software that is readily available for purchase by the general public, is not acquired as part of a larger business purchase, and has not been substantially modified, must be depreciated over a 36-month period using the straight-line method.

Important Considerations When Classifying Software Licenses

The key to correct tax treatment is distinguishing between a purchased asset and a service subscription.

Purchased (Perpetual) vs. Subscription (SaaS) Software

• Purchased License (Capitalize): A one-time payment for a perpetual license that you own. The cost must be capitalized and depreciated over a 36-month period.
• Subscription Fee (Deduct Now): A recurring monthly or annual fee for software access (Software as a Service). As detailed in IRS Publication 535, these are treated as rent or subscription expenses and are deductible in the year they are paid or incurred.

Bundled Software

IRS Publication 535 provides a special rule for software that comes bundled with computer hardware and is not stated as a separate cost. In this case, the software is treated as part of the hardware and is depreciated along with the hardware, typically over a 5-year period under MACRS.

Software Acquired as Part of a Business Purchase

If you acquire software as part of buying another business, it is typically treated as a Section 197 Intangible. Publication 535 requires these assets to be amortized over 15 years, not the 36-month period for off-the-shelf software.

Tax Implications and Reporting

The tax treatment for purchased software licenses requires capitalization and depreciation.

Depreciation Over 36 Months

As stated in Publication 946, you must depreciate the cost of purchased off-the-shelf software on a straight-line basis (in equal amounts) over a 36-month period, commencing with the month the software is placed in service.

Section 179 Deduction

As an alternative to depreciation, IRS Publication 946 and Publication 334 explain that off-the-shelf computer software is eligible for the Section 179 deduction. This allows you to elect to deduct the full cost of the software in the year it is placed in service, subject to annual limits.

How to Report the Deduction

The annual depreciation deduction or the Section 179 deduction for software is calculated and reported on Form 4562. The total from this form is then carried to your main business tax return (e.g., Schedule C, Line 13).

What Records to Keep

You must keep records to substantiate the cost and purchase date of the software. This includes:

• The license agreement.
• The purchase invoice from the software vendor.
• Proof of payment.

How Fyle Can Automate Tracking for Software Purchases

Fyle helps you accurately capture and categorize major software purchases, providing your accountant with the clean data needed to handle capitalization and depreciation.

• Capture Purchase Invoices: Instantly capture the invoice for the software license by forwarding the vendor email directly to Fyle.
• Centralized License Agreements: Attach the perpetual license agreement and terms of service directly to the expense record in Fyle.
• Categorize for Capitalization: Code the purchase as a fixed or intangible asset, separating it from recurring subscription expenses.
• Automate Your Accounting: Fyle syncs the capitalized cost to the correct asset account in QuickBooks, Xero, NetSuite, or Sage Intacct, ready for depreciation.