What expense category is Software Development Costs?

For any technology-driven business, the costs of developing software—whether for internal use or sale to customers—represent a major investment. These expenditures, which encompass everything from developer salaries to contractor fees, are crucial for driving innovation and growth.

However, a critical change in U.S. tax law has significantly altered how businesses must account for these costs. As of 2022, software development expenses can no longer be deducted in the year they are incurred. This guide explains the new mandatory IRS rules for capitalizing and amortizing these costs, ensuring your business remains compliant with the regulations.

Software Development Costs Category

The costs you incur to develop software are now treated as specified research or experimental expenditures.

Under a significant tax law change detailed in IRS Publication 535 for tax years beginning after December 31, 2021, all software development costs must be capitalized and amortized (deducted in equal amounts) over a set period. The previous option to deduct these costs as a current expense has been eliminated.

Important Considerations While Classifying Software Development Costs

To handle these costs correctly, accountants and business owners must understand what is included and how the new rules apply.

Mandatory Capitalization and Amortization

The most critical change is that capitalizing software development costs is no longer optional. All businesses must now treat these as capital expenditure and recover the cost over time through amortization.

What Costs Are Included?

Publication 535 clarifies that the costs related to developing software are treated as research and experimental expenditures. This includes a wide range of costs directly associated with the development process, such as:

• Salaries and wages for software developers and their managers.
• Fees paid to third-party contractors for development work.
• Supplies and other direct costs are consumed during the development process.

Distinction from Purchased Software

The rules for developing your own software differ from those for purchasing software from others.

• Developed Software (Amortize over 5 or 15 years): Costs to create your own software fall under the new R&D amortization rules.
• Purchased Off-the-Shelf Software (Depreciate over 3 years): As detailed in IRS Publication 946, the cost of computer software that is readily available for public purchase is depreciated over a much shorter 36-month period.

Tax Implications and Reporting

The tax treatment for software development costs requires a specific amortization schedule and reporting process.

The Amortization Period

According to Publication 535, you must amortize software development costs over the following periods, beginning at the midpoint of the tax year in which the costs were paid or incurred:

• 5-year period for development activities performed in the United States.
• A 15-year period for any development activities performed outside the United States.

How to Report the Deduction

The annual amortization deduction for your software development costs is calculated and reported on Form 4562, Part VI. The total from this form is then carried to your main business tax return.

The R&D Tax Credit

It is essential to note that, although the costs must be amortized, your business may still be eligible to claim the Research and Development (R&D) Tax Credit. This is a separate tax benefit calculated on Form 6765.

What Records to Keep

You must maintain meticulous records to substantiate all software development costs. This includes:

• Detailed payroll records for all employees involved in development.
• Invoices and contracts from any third-party developers or consultants.
• Project management records and timesheets that document the development activities.

How Fyle Can Automate Tracking for Software Development Costs

Fyle is essential for capturing and organizing the various costs of a software development project, providing a clean record for your accountant to handle the mandatory amortization.

• Track by Development Project: Code all expenses—from developer salaries to contractor payments—to a specific software project.
• Centralize All Invoices: Forward your development contractors and software tool vendors' email invoices directly to Fyle for automatic capture and processing.
• Create a Clear Audit Trail: Fyle maintains a complete, unalterable record of all project costs, which is crucial for substantiating your capitalized basis.
• Automate Your Accounting: Sync capitalized development costs to the correct asset account in QuickBooks, Xero, NetSuite, or Sage Intacct.