Seeking Guidance: Treatment of Web Development Costs - Brief Article

California CPA, Oct, 2000 by Annette Nellen

Waiting from Tax Rules to Align with New WAys of Doing Business Can Be Burdensome

Existing tax rules often do not apply neatly to new ways of doing business. It usually takes a few years for guidance to be issued, and in the interim, it's difficult for practitioners to obtain a high level of confidence when determining the tax consequences of such transactions. The treatment of Web site development costs is no exception.

To determine the proper treatment of Web site development costs, you must identify the expenditures' nature and purpose such as initial content planning, domain name acquisition, content and HTML file creation, testing, redesign, and content updates. Tax treatment of expenditures is often situation-specific and existing guidance is not entirely helpful.

SHADES OF GRAY

On first glance, you might be tempted to treat Web development costs like software development costs, unfortunately it's not that easy. Under Rev. Proc. 69-21, 1969-2 C.B. 303, software development costs may be accounted for similarly to IRC Sec. 174 expenditures, which allow taxpayers to currently expense the costs or to amortize them over 36 months. The issue clouds because this guidance does not define software development or the types of costs it encompasses.

Some Web sites are created via software programs or templates that help write the necessary HTML code. It is unclear whether this constitutes software development. The file created with the program does not, by itself, enable a computer to do something. However, the file also may include some code created by the designer that has some individual functionality, and the program leads to the writing of computer language.

If HTML file creation from a template is not treated as software development, as the IRS has informally suggested, then the costs to create this item must be examined under IRC Secs. 162 and 263. Generally, if the item will provide a significant benefit beyond the current year, the costs to create it need to be capitalized. Otherwise, the costs should be expensed when incurred. If the costs are to be capitalized, then the next issue is to determine the asset's determinable useful life, if any.

The IRS data processing industry specialization group has informally noted that Web site development is not analogous to advertising, but instead is more like a package design or billboard with a long useful life that warrants cost capitalization. While RJR Nabisco Inc. v. Commissioner, T.C. Memo 1998-252, seems to lend support to treating Web sites that promote the company and its products as advertising, the IRS does not agree (nonacquiescence at 1999-40 I.R.B. 2). Of course, if the Web site development costs fall within the purview of software development per Rev. Proc. 69-21, the costs follow IRC Sec. 174.

If instead of developing the software, a taxpayer purchases HTML files designed by someone else, the taxpayer must capitalize the costs (assuming a useful life that exceeds one year and the development was not at the taxpayer's risk).

A business that develops its Web site concurrently with the design or redesign of order fulfillment, manufacturing techniques, payment systems and customer relations functions as part of a reengineering of the business, also faces some uncertainty in applying the tax law.

Here, the IRS is likely to argue that the entire process provides a long-term benefit to the business and warrants capitalization for all project costs (other than costs that fall under Sec. 174 or Rev. Proc. 69-21). Again, the IRS is likely to argue that software development is not taking place if templates are used in the process. The IRS will likely categorize the expenditures as capital under Sec. 263 because of the long-term benefits expected by the taxpayer.

A LITTLE CLARITY

One of the few clear-cut tax treatments of a Web development cost is for continually updating a Web site's content. Since this is a recurring cost that primarily benefits the current period, it is deductible as an ordinary and necessary business expense.

Additionally, guidance has been issued for GAAP purposes (EITF Issue 00-2, Accounting for Web Site Development Costs). The EITF calls for expensing most types of costs, other than those to actually create the site's functionalities and features. For tax purposes, if such costs fall within the definition of software development under Rev. Proc. 69-21, expensing is permitted.

Hopefully, the IRS will provide guidance on the tax treatment of Web development costs sooner, rather than later, but it's not on the IRS-Treasury Business Plan for 2000.

Annette Nellen, CPA, Esq., is a professor in San Jose State University's Graduate Tax Program. She is currently the chair of the ABA Tax Section's Sales, Exchanges & Basis Committee.