8164 / How does a taxpayer treat the costs incurred in developing software?

The creator of software generally has three options for recovering expenses incurred in creating software. First, the taxpayer may deduct the costs in full under IRC Section 174(a). Pursuant to this option, the expenses must be research or experimental expenditures that were paid or incurred by the taxpayer in connection with his or her trade or business. This option may be elected without consent for the first year in which the expenses are incurred, or with the consent of the Secretary of Treasury at any other time.¹

Second, the taxpayer may choose to depreciate the costs over a three-year period under IRC Section 167. Generally, if a depreciation deduction is allowable for computer software, the straight-line method of depreciation is used, and a useful life of 36 months is applied.²

Finally, if the expenses are not deducted under Section 174(a), the taxpayer may elect to amortize the costs over 60-month period under IRC Section 174(b), beginning with the month in which the taxpayer first realizes benefits from the expenses. As with the deduction permitted under Section 174(a), such costs must be incurred in connection with the trade or business. Further, to elect amortization under Section 174(b), the research or experimental expenses must be chargeable to a capital account, but not subject to depreciation or depletion.³