Section 174 Software Development Accounting Primer

Okay. So, yeah, Section 174 software development accounting.  A bit of mess, right?

I hear you. We had more than a few client questions last tax season about how to handle this complexity. Thus a quick overview.

But one clarification: This discussion of Section 174 and software development cost capitalization rests on the new § 174 statute, which appeared in late 2017. And then on IRS Notice 2023-63, which was published in September 2023.

However, taxpayers and tax accountants really all need updated Treasury Regulations to plan ahead. And to get the bookkeeping right for 2024.

That qualification made? We can dig into the details.

Section 174 in a Nutshell

Section 174 changed in the 2017 Tax Cuts and Jobs Act, as noted. The old law said you could just currently deduct these expenditures.

The (sort of) “new” law says you need to capitalize “specified research or experimental” (aka “SRE”) expenditures. And then you amortize the capitalized amounts.

If you do the research in the US, you amortize the expenditures over five years. If you do the research outside the US, you amortize over fifteen years.

The law includes another big change. Tax law now wants to treat software development costs as a SRE expenditure. Quoting the statute, Section 174(c)(3), says this:

For purposes of this section, any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.

I added the boldfacing to the statutory language. But you see this is big. Apparently, nearly every software development cost a developer pays or incurs should be capitalized and amortized.

To put this into perspective, if you spend $1,000,000 developing a piece of software? You might think you get to deduct the $1,000,000 when you spend the money. But you don’t. You deduct $200,000 a year over five years. Or you deduct $66,666 a year over fifteen years.

Example of Section 174 Software Development Accounting

Notice 2023-63 provides a good example of precisely how a taxpayer handles the accounting. Tax advisors and company accountants want to read those pages carefully or their updated replacement in the regulations.

But essentially, you or your accountants add up all the direct and indirect costs of your software development activities. Pull that cost out of your profit and loss statement. Temporarily hold those dollars on your balance sheet. And then, as noted earlier, amortize this cost over either five or fifteen years.

One thing to note: You use a mid-year starting point for the first year. For example, if a taxpayer incurred $1,000,000 of direct and indirect costs of software development in year 1, this results in a $200,000 amortization expense each full year. (Because $1,000,000 divided by five years equals $200,000.) But the first year? A taxpayer only amortizes a half-year.

For year 1 in this example, then, the taxpayer deducts $100,000 of software development costs. The next four full years, he or she deducts a full $200,000. The last “half year?” The taxpayer deducts $100,000 of remaining software development costs.

Two Weird Accounting Aspects of Section 174

Two weird things to note about the Section 174 statute’s accounting.

First, the amortization starts in the year the costs are paid or incurred. Not the year the software developed is finished and placed into service. A two year software development project that costs $1,000,000 a year? You amortize each year’s $1,000,000 separately. And starting the middle of each year.

A second point: If you sell or retire or abandon the software you develop before the full five years runs? Like, say, in year 3? You ignore the sale, retirement or abandonment. And you keep on amortizing. You do not, in other words, start amortizing and then just “write off” the remaining unamortized bit.

Many Research and Experimentation Costs Don’t Need to Be Capitalized

After a bit of fiddling, I got ChatGPT 4o to summarize in a table the general SRE costs Notice 2023-63 says you should and shouldn’t capitalize. A crude replica of that table, lightly edited, follows:

Not All Software Development Costs Need to be Capitalized

And then the following computer-y costs (again I’m mostly quoting directly from Notice 2023-63) also don’t need to be capitalized:

• Training employees and other stakeholders that will use the computer software a business develops internally
• Maintenance activities after the computer software is placed in service that do not give rise to upgrades and enhancements (for example, corrective maintenance to debug, diagnose, and fix programming errors)
• Data conversion activities, except for activities to develop computer software that facilitate access to existing data or data conversion
• Installing the computer software and other activities relating to placing the computer software in service
• For software developed for external users, maintenance activities that do not give rise to upgrades and enhancements, distribution activities (for example, making the software available via remote access), and customer support activities.

The Notice explains that upgrades and enhancements to software in order to be capitalized and amortized need to be “significant.”

In defining what’s significant, the Notice appears to look at whether the software development resulted in “additional functionality.”  The language seems say “additional functionality” means the software can perform tasks it was previously incapable of performing. Or that it works with material increases in speed and efficiency.

Thus, not everything a software programmer does creates Section 174 software development costs a taxpayer needs to capitalize.

What If You Didn’t Do the Section 174 Accounting Correctly?

I’m going to guess if you’re a developer working on games or apps, you probably haven’t been doing this completely right. Thus, the $64 question: Where does this leave you? And, yeah, that’s a tricky question.

The new “capitalize software development costs” rule became effective January 1, 2022. But the IRS didn’t provide meaningful instructions until September 23, 2023. Just to gripe a bit here, roughly six years after the law was passed in 2017. And nearly two years after the law became effective on January 1, 2022. Thus, don’t beat yourself up about finding yourself late. Looking backwards? I’m not sure what you should or could have realistically done.

But looking forward? Unless Congress changes the law before next tax season, you want to get your accounting working right. Thus, talk with your bookkeeper. Or your accountant.

Make sure you tax advisor knows you’ve got software development costs you’re possibly not handling correctly.

Finally, do stay alert so you spot the new regulations when they appear. They should explain how taxpayers handle any honest fumbles. And how to request and make accounting method changes which are surely needed if prior to 2022 you followed the old conventional approach.

Related Articles

We’ve got a good discussion about how the research and development credit works here: Research and Develop Credits Explained.