Source: http://padgettnorthland.com/resources/tax-articles/web-site-development-costs/
Timestamp: 2019-04-25 14:58:07+00:00

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Web site software, which includes front-end software, server-side software, and applets.
Outside of the book, Electronic Commerce: Taxation and Planning, there is little written on the subject of Web site costs. The IRS has not yet published guidance in this area, and is not likely to for some time to come. Therefore, it is difficult for companies and tax preparers to make the proper distinctions between the different Web site component costs. In the absence of clear rules, many taxpayers may be improperly deducting all costs related to Web site development.
Overshadowing much of the analysis of Web site development costs is the recent case, INDOPCO v. Commissioner.2 This case emphasizes the fact that cost incurred currently, and which will provide a future benefit, may need to be capitalized. While this is a very old concept, INDOPCO was written in such a way as to potentially require capitalization of a wider variety of costs than in the past. The IRS has, since 1992, tested the limits of INDOPCO in a number of cases.3 INDOPCO may have wide application to Web site development costs, especially the costs of developing content.
Front-end software is simple HTML.
Server-side software is complex software that is the heart of good Web sites, and which makes the difference in site performance. The main server-side software applications include search engines, databases, transaction processing systems, Internet telephone systems, order-processing systems, and firewalls. Some of these applications, especially the search engine applications, incorporate jealously guarded trade secrets. Some applications, including some of those used for transaction processing, incorporate patented technologies.
Java Applets reside on a Web site server, and are called by the user, in the same manner as server-side software. These are complex applications that may take over some of the functions previously performed by server-side software.
One of the most difficult things about applying rules to Web site software is the determination of whether a cost relates to software, whether it relates to graphics, sound, and video, or whether it relates to content. Taxpayers must analyze carefully each Web site component cost to determine its proper category. A simple example illustrates the problem.
Example: A hotel creates a Web site for advertising purposes, and to enable guests to book rooms online. The hotel uses dozens of digitized photos as part of the Web site. Some of the photos are 360-degree “virtual reality” shots, allowing guests to experience the hotel’s surroundings. Thousands of dollars go into the creation of these photos. In addition, the hotel pays a designer thousands of dollars to design the “look and feel” of the Web site, including the page layouts and navigational buttons.
What part, if any, of the cost of Web site graphics, and the cost of photos will be characterized as software?
The cost of page layouts and navigational buttons will probably be part of the software cost.
The cost of the photos will probably not be included in software costs.
Once it is clear that what is being purchased is software, the rules for deducting the cost of purchased software are pretty clear. These rules are given in IRC § 167(f) and § 197.
A much more difficult issue is self-developed software. The basic rules are provided in Rev. Proc. 69-21, a very old procedure that was created in an era when software was recorded on punch cards. Surprisingly, the IRS has not updated this procedure to account for today’s software – much less Web site software. Serious deficiencies in this procedure include the fact that it takes no account of non-software elements included in today’s software applications. These non-software elements include graphics, sound, video and content.
What is disturbing about the continued use of Rev. Proc. 69-21 is that this procedure is the basis for defining software costs as research and experimentation costs under rules similar to those of Section 174. R & E costs are generally deductible as incurred. Therefore, it is critically important to determine what costs meet the requirements of Rev. Proc. 69-21 or Section 174.4 The rules given in Rev. Proc. 69-21 are not sufficient to deal with the wide variety of costs that go into the creation of today’s Web sites.
The difficulty with determining the deductions available for graphics, sound and video comes from the difficulty in characterizing these costs. 5 The Web is a rich multimedia environment, including graphics, sound, and video. What these Web site elements have in common is they are contained in digitized files that are called by Web site software.
Web site graphics include titles, backgrounds, photos, navigation bars and buttons, banner ads, and overall page design.
Sound is not commonly used in today’s Web sites, but it will be in the future. The best applications of sound are found on Web sites that sell recorded music.
Video is also not commonly used in today’s Web sites, but will be in the future, as bandwidth becomes available. Adult Web sites are currently pioneering the development of Web site video.
Content is the reason people visit Web sites. No one visits a Web site devoted to food recipes because it has great graphics, or a great user interface. However, strangely enough, content is not really an integral part of the development of a Web site in the same way as are software and graphics. Content is best thought of as what is delivered by a Web site.
A Web site is both “software” and “content.” The software side of a Web site might be thought of as the permanent part of the site (i.e., the bones of the site), whereas the content is the material that can be readily changed without affecting the Web site’s basic architecture. Revenue Procedure 69-21, which authorizes a current deduction for most software development costs, does not differentiate between “software” and “content.” Accordingly, at least for now, Revenue Procedure 69-21 (issued before Web sites were conceived) applies only to the software side of a Web site.
Many Web sites are primarily devoted to advertising. Advertising is generally deductible as incurred, even where that advertising results in a long-term benefit to the taxpayer.8 Historically, however, advertising has taken the form of a television commercial, a newspaper or magazine ad, a catalog, etc.
The Web gives us a new form of advertising, the online mega-catalog. A good example is Amazon.com, with millions of pages. There are a few cases dealing with catalogs,9 but Amazon’s Web site can hardly be compared. Amazon’s pages are actually windows into Amazon’s database of books. In the past there has been little need to develop rules related to the cost of developing a database. Now, however, we have thousands of sites, spending millions of dollars, developing databases used primarily to advertise products. New rules must be developed to deal with the cost of developing these databases.
Some critics assert that the proposed regulations thwart Congressional intent, and make it impossible to receive the credit. Some say that IRS field agents are taking the position that nothing qualifies for the credit.14Clearly, the IRS needs to rethink these regulations, and come up with more practical rules.
Before internal use software (IUS) will qualify for the R & E credit, it must meet certain tests, in addition to the normal tests for R & E credit qualification.16 The problem is there is little guidance as to when software should be characterized as IUS. And, in the context of Web site software, there is no guidance at all.
Some Web site software clearly is not IUS. For instance, an online tax preparation program and an online game are both intended primarily for customer use and would not be IUS. Likewise, search engines are primarily for customer use and are not IUS.
Some Web site applications clearly are IUS. These would include applications devoted to network management. Pure order processing software is also likely to be considered IUS.
For many Web site applications, however, classification is not clear. For instance, an online stockbroker’s Web site includes order processing. It also includes, however, a substantial number of tools that can be used by customers to review and price holdings, get news updates, etc. The order-processing applications and the customer tools are so intertwined that they are really part of one software program. Should we consider the entire software application to be IUS, because a substantial portion is devoted to order processing? Should we consider the entire program as non-IUS? Or, should we make an allocation between the two? Clearly, rules must be developed that are specific to Web site software projects.
The rising prices at which domain names are changing hands demands that we accurately characterize these peculiar creatures of the Internet. As discussed at ECTP 8.02, domain names do not fit neatly into any category of deduction. For instance, Section 197 may apply, resulting in a 15-year life for purchased domain names. On the other hand, a domain name might be judged to be an intangible asset to which Section 197 does not apply, and which has no ascertainable life. In this case no deduction would be available for the cost of a domain name until it was sold or abandoned. Finally, a domain name might be an asset that will soon be obsolete, as the Net moves to a friendlier way of addressing Web sites. If this assertion could be proven, a domain name might be deducted over a relatively short period, such as five years.
1 David E. Hardesty, Electronic Commerce: Taxation and Planning, (Warren, Gorham & Lamont, 1999), hereinafter ECTP.
2 INDOPCO, Inc. v. Comm’r, 503 US 79 (1992). See discussion of this case at ECTP 7.01.
3 See FMR Corp., 110 TC 402 (1998), discussed at ECTP 7.01; PNC Bancorp., Inc., 110 TC 349 (1998), discussed at ECTP 7.01; RJR Nabisco, Inc. v. Comm’r, RIA TC Memo. 98,252 (1998). Discussed at ECTP 7.04.
4 See ECTP 7.02 for a further discussion.
5 See ECTP 7.03 for a complete discussion.
6 For a discussion see ECTP 7.03 and 7.04.
8 See RJR Nabisco, Inc. v. Comm’r, RIA TC Memo. 98,252 (1998). Discussed at ECTP 7.04.
10 See ECTP 7.04[b] for a discussion of these costs.
11 These regulations are discussed in detail at ECTP 7.05.
12 Prop. Reg. § 1.41-4(a)(3).
13 Norwest Corp. & Subsidiaries v. Comm’r, 110 TC 454 (1998).
14 See ECTP 7.05[b] for a discussion of the problems with these regulations.
15 See ECTP 7.05[d] for a discussion of the problems with these regulations.
16 These additional tests are discussed at ECTP 7.05.
17 See United Stationers, Inc. v. United States, 163 F3d 440, 444 (7th Cir. 1998).

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