The way the IRS allows your Internet service to take software deductions has changed. Learn which method your ISP business could take to increase your bottom this year—or for years to come.

by Mark E. Battersby [February 21, 2001]

It's been more than 30 years since the Internal Revenue Service updated its guidelines for computer software deductions. Finally, in Revenue Procedure 2000-50, the IRS defined computer software and explained the circumstances under which it would accept an ISPs treatment of the costs in developing, acquiring, leasing or licensing computer software—paid or incurred.

Under its updated procedures, the IRS stated that costs of developing software for the ISPs own use or for sale to others might continue to be treated as an immediately deductible expense. Or, if it is to your business's advantage, ISP operators can continue to treat the costs of developing software as capital expenditures amortizable—written-off in equal installments over 60 months—or, in some cases, depreciated over only 36 months.

So what exactly does the IRS define as "software?"

Deduction defined
According to the IRS, "computer software" is any program or routine—that is, any sequence of machine-readable code—designed to cause a computer to perform a desired function or set of functions and the documentation required to describe and maintain that program or routine.

Software includes all forms and media in which the software is contained, whether it's written, magnetic or otherwise.

Computer programs of all classes, for example, operating systems, executive systems, monitors, compilers and translation, assembly routines and utility programs as well as application programs are included. Computer software could also include incidental and ancillary rights that are necessary to effect the acquisition of:

• the title to,
• the ownership of,
• or the right to use the computer software and
• that are used only in connection with that specific computer software.

Computer software, according to the IRS, does not include any data or information base like data files, customer lists or client files, unless the database or item is in the public domain and is incidental to a computer program. The computer software deduction also does not include any cost of procedures that are external to the computer's operation.

Subtracting software expenses
At its fundamental level, every ISP operator is offered the choice of immediately deducting the costs of developing software—whether for the ISP's own use or for sale to others—or amortizing the expenses over a five-year period.

The key to taking the software tax deduction is consistency—all software costs, year-after-year must be treated in the same manner.

When it comes to acquiring software, the tax rules ask only how you acquired the software. If you obtained the software in an acquisition of another business—or its assets—the software is classified as a so-called "Section 197" intangible and can only be written-off over a 15-year period of time.

As is more often the case, if you acquired the software "off-the-shelf," its cost is depreciated or written-off over a three-year period using the straight-line method of equal deductions each month of a 3-year term.

In those situations where the software is included as part of the cost of computer hardware and if it is not separately stated, the cost is treated as part of the cost of that hardware and depreciated accordingly.

New lease on software deductions
Naturally, computer software with a useful life of less than one year is currently tax-deductible as a business expense. Even better, a deduction is permitted under the tax rules for rental payments made for software leased for use in any trade or business, so licensing fees paid on a per user basis can also be deducted from your ISPs tax bill.

Where an ISP leases or licenses computer software for use in the ISP operation, the IRS will not disturb any deduction that is properly allowable as a rental deduction. Naturally, if lease or license fees do not qualify as a so-called "business expense" and is something that could be charged to a capital account, it is not also deductible under software tax guidelines.

Finally, the IRS has provided guidelines for the treatment of computer software costs. In most cases, the IRS will not disturb the way that your ISP operation treats those software costs.

What better time than now to take a look at how your Internet business is treating software costs?

Something as simple as changing your ISPs accounting methods could lower your tax bill and increase your bottom line—for years to come.

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