A Tangled Web: Understanding the IRS’s Stance on Website Design Costs
The marketing and general business use of websites is widespread. Many businesses now use their websites as their main information delivery source, but the IRS has not yet issued formal guidance on when Internet website costs can be deducted.
Fortunately, established rules that apply to the deductibility of business costs in general, and formal IRS guidance that applies to software costs in particular (the “software guidelines”), provide a taxpayer launching, or significantly changing, a business website with some guidance as to the proper treatment of the costs. Here is a brief discussion of some relevant principles:
The time for deducting website design costs (i.e., costs of the website’s overall structure, functionality and appearance) depends on whether the costs are costs of software within the meaning of the software guidelines. Generally, the portions of the website’s design that are produced from sophisticated programming languages—for example, the “C++” language widely used in website design—will qualify as software. On the other hand, there is some doubt as to the extent to which the portions of a design produced from HTML (hypertext markup language) will qualify as software.
Website design costs that are software costs are deductible under safe-harbor rules.
The deductibility of website design costs that are software costs is governed by the following safe-harbor rules.
Generally, if the individual or company launching the website purchases the design (i.e., acquires the design from a contractor who is at economic risk should the software not perform), the design costs are amortized (ratably deducted) by that individual or company over the three-year period beginning with the month in which the website is placed in service. Also, noncustomized computer software placed in service in tax years beginning before 2011 qualifies as Section 179 property, and is thus eligible for the Code Sec. 179 elective expensing deduction that is generally available only for machinery and equipment. For tax years beginning in 2010, the deduction is limited to $250,000.
The limits are reduced by the cost of other Section 179 property for which the election is made. Also, the election is phased out for taxpayers placing more than $800,000 of Section 179 property into service during tax years beginning in 2010. Non-customized software acquired and placed in service during calendar years 2008 and 2009 was also eligible for a 50-percent-of-cost depreciation deduction in the year that the software was placed in service (bonus depreciation). At the time of this writing, bonus depreciation has not been extended to include the 2010 year, but an extension to include 2010 may be approved.
If, instead of being purchased, the website design is developed (designed in-house by the individual or company launching the website or designed by an independent contractor who is not at risk should the software not perform), the individual or company launching the website can choose among alternative treatments, including, but not limited to, currently deducting the costs (deducting the costs in the year that the costs are paid, or accrued, depending on the taxpayer’s overall accounting method) or amortizing the costs under the three-year rule, discussed above, for a purchased design.
Website design costs that aren’t costs of software are deductible in accordance with useful life. The time for deducting website design costs that are costs of portions of the design that aren’t software depends on the expected useful life of these non-software portions of the design. Thus, these costs must be amortized over the number of years that it is expected that the non-software portions of the design will be used in the business (except if it is expected that these non-software portions of the design will have a useful life of no more than a year, in which case the costs can be currently deducted).
Website content that is advertising is generally currently deductible; the treatment of other content costs will vary. Advertising costs are, generally, currently deductible. Thus, the costs of website content that is advertising are, generally, currently deductible.
Website content that isn’t advertising will be currently deductible, or amortized over a multi-tax year period, depending on its useful life.
The deductibility of some website costs that are business start-up costs is limited. Where website costs that would otherwise be currently deductible are paid or accrued before a business begins, the taxpayer can elect a current deduction for a limited amount (up to $5,000) of start–up expenditures in the tax year in which the trade or business begins.
However, this $5,000 amount is reduced (but not below zero) by the amount by which the cumulative cost of start-up expenditures exceeds $50,000. The remainder of the start-up expenditures can be claimed as a deduction ratably over a 15-year period.
The above principles, and others that affect the deductibility of website costs, suggest ways in which the individual or company launching the website can take charge of the treatment of website costs. For instance, an individual or company who contracts for a website design that qualifies as software, and who seeks the favorable tax treatment that applies to the costs of developed software, can, if acceptable as a business matter, include, in its written agreement with the developer/contractor, terms that will put the risk that the software won’t perform on the individual or company. Another example of a way to manage the tax treatment of website costs is detailed, descriptive allocations of costs, both in contracts and in internal records.
If you are considering launching a business website, we would like to discuss with you further—and help you implement—the above planning steps or others that will help you manage the tax treatment of your website costs.
This article provides general information and may not apply to your particular situation. In addition, this article does not offer legal or tax advice.
The Internal Revenue Service recently issued regulations that require written advice regarding tax matters to meet very detailed and comprehensive requirements before it can be relied upon by a taxpayer to avoid penalties that might apply if the tax benefits or results discussed in this article are disallowed. Compliance with these rigorous standards and requirements exceeds the scope of this article. Consequently, the analysis and advice contained in this article regarding federal tax matters is not intended to be used, and may not be relied upon by you or anyone else, for the purpose of avoiding any federal tax penalty.
D. Craig Godfrey, firm managing partner of Godfrey Wise Berg CPAs and Advisers, LLC, has over 20 years of experience in taxation. Godfrey has a diverse client base and provides a wide range of services specializing in the areas of individual and business taxation.
This article was written August 2010