A study by the Government Accountability Office (GAO), Congress's watchdog agency, attributed the majority of the whopping number of errors discovered on almost every tax return prepared by the outlets of the major tax preparation firms to the complexity of our tax laws. If the pros make that many mistakes, what chance does the owner or manager of a small business attempting to prepare their operation's tax returns have of properly labelingâ€"and deductingâ€"expenses that are not mentioned in the tax laws?
One major omission: web-related expenditures.
That's right, the Internal Revenue Service (IRS) has not issued guidelines about, and there is nothing in our tax laws for treating, web site development or maintenance costs. Further complicating matters, every franchise business owner/manager is faced with the question of whether claiming the maximum tax deduction possible is the best strategy for achieving consistently lower tax bills, year after year.
Would your operation be better off with an immediate tax deduction to offset taxable income, or with deductions spread over a number of years, offsetting what you hope might prove to be higher income in those later years?
The official position
The IRS has not issued formal guidelines on the tax treatment of web site development costs. However, informal internal IRS guidance suggests that one appropriate approach is to treat those costs like an item of software and depreciate those amounts over three years.
In reality, many taxpayers who pay large amounts to develop sophisticated web sites have been allocating their costs to items such as software development (currently deductible as Section 174, research and development costs, or currently deductible advertising expenses).
It is obvious that, in the absence of formal IRS guidelines, the strategies utilized by the owners and operators of franchised businesses will vary greatly, often depending on the financial status of the operation. Would your franchised businesses benefit more from an immediate deduction for those expenditures, or would it be better served by a smaller current tax deduction with similar smaller tax write-offs spread over future years?
Web site software
Software is usually an "intangible" business asset. Thus, software used to create a web site is usually treated as either "purchased" or "self created." Although the tax rules for purchased software are straightforward, self-created software deductions are more questionable.
Today, the expense of developing software (whether for a franchisee's own use or for sale to others) may either be deducted currently or amortized over a five-year period, as long as such costs are treated consistently. Purchased software, other than an intangible asset acquired as part of a business acquisition, is usually depreciated using the straight-line method over three years beginning in the month it is placed in service.
Are those web-related expenditures really for software? After all, how can any franchised business owner or operator differentiate between whether a cost is for software, whether it relates to graphics, or whether it relates to content? It might even be considered and advertising expenditure.
Advertising expenses are deductible if they are reasonable in amount and bear a reasonable relation to the franchise or business. The expenses may be for the purpose of developing goodwill as well as gaining immediate sales. The cost of advertising is tax deductible even though the advertising program extends over several years, or is expected to result in benefits extending over a period of years.
The U.S. Tax Court and the IRS require that the cost of printing a catalog that is not replaced annually be amortized over the expected life of that catalog. However, other courts have ruled to the contrary, taking the view that catalog costs are in the nature of an advertising expense.
It is easy to understand why many multi-unit and multi-brand franchise owners (as well as their tax professionals) consider the costs of developing and maintaining a web site to be similar to advertising costs and, thus, deductible as an expense on the annual tax return. This position is further supported by another ruling by the Tax Court, in which packaging design costs were treated as a deductible advertising expense even though the design provided the company with "significant future benefits."
Research and experimentation
There exists in our tax rules a credit for amounts spent on research and experimentation (R&E). Extremely regulated and very narrow in scope, the R&E tax credit is available, in some instances, for so-called "internal use software." A franchisee can elect to currently deduct certain expenditures for research and experimentation by claiming the deduction on the annual tax return.
However, only costs of research in the laboratory or experimental purposes qualify. This is true whether carried on by the franchise operation or on behalf of that business by a third party. Market research and normal product testing costs are not legitimate research expenditures, although many taxpayers routinely label web development costs as research and development to reap an immediate tax write-off. Remember, once made, the R&E election applies to all research costs incurred in the project for both the current and all subsequent years.
Some web site software clearly does not qualify as internal use software, such as an online tax preparation program or an online game, both of which are intended primarily for customer use. Other web site programs, such as an application devoted to network management or pure order processing software are likely to be considered as intended for internal use.
A tax credit, such as that for R&E expenditures, is a direct reduction of the franchise operation's tax bill, as opposed to a reduction in its taxable income. A newly passed law extends the research tax credit to amounts paid in 2006 and 2007. For 2007, the new law also makes two enhancements that could make the credit more valuable to small businesses.
As an alternative, a franchise owner or operator can elect to capitalize research and experimental costs, amortizing (writing off or deducting) them ratably using a period of at least 60 months beginning in the month the benefits are first realized from them. This assumes, of course, that the property created does not have a determinable useful life at the time of the deduction or write-off. Costs associated with property that has a determinable useful life must, of course, be amortized or depreciated over its useful life.
The IRS recently proposed regulations that would, in the view of many experts, thwart Congressional intent and make it impossible for anyone to claim the tax credit for R&E. Some say that IRS field agents are already taking the position that nothing qualifies for the credits.
Buying a web site or business
Today, the capitalized cost of goodwill and most other intangible assets are ratably amortized, or written off over a 15-year period generally beginning in the month of acquisition. Generally, self-created intangibles are not amortized under Section 197 unless created in connection with the acquisition of a trade or business. However, certain self-created intangibles without an ascertainable useful life may be amortized over 15 years.
A unique 15-year safe harbor exists for self-created intangibles. A business is permitted to amortize certain created intangibles that do not have readily ascertainable useful lives over a 15-year period using the straight-line depreciation method and no salvage value. Any franchised business may use the 15-year amortization period for intangible assets other than one acquired from another person. But is a 15-year write-off period for the cost of developing and maintaining your operation's web site beneficial?
Computer software costs
Web-related costs aside, the cost of developing software (whether for the multi-brand or multi-unit franchised operation's own use or for sale or lease to others) may be deducted currently or it may be amortized over a five-year period (or shorter if established as appropriate), as long as such costs are treated consistently.
For today's software purchases, computer software that is not amortizable over 15 years as a Section 197 intangible asset is depreciated using the straight-line method over three years. The cost of computer software that is included as part of the cost of computer hardware and is not separately stated is treated as part of the cost of the hardware. Computer software with a useful life of less than one year is currently deductible. A deduction is allowed for rental payments made for software licensed for use in a trade or business.
Obviously, immediately deductible expenses, whether for software or guideline-less web costs, are far more beneficial in helping reduce out-of-pocket costs than a depreciation deduction that spreads those costs over a number of years. Although the IRS has not, as yet, outlined a specific tax treatment for web development costs, clues exist elsewhere. Those areas in which the IRS (or our lawmakers) have provided examples of the proper tax treatment of web development-"related" costs can produce substantial tax savings for your multi-brand or multi-unit franchised businessâ€"if handled properly.
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