If you’re in the software industry, there’s a good chance you may have overpaid your taxes due to recent changes in tax law and the misinterpretation of §174 amortization rules by tax preparers. Over the past year, I’ve noticed a recurring issue when reviewing tax returns for software companies: many tax accountants have mishandled the application of the §174 rules, particularly in regard to R&D expenses.

The consequences of these errors can be costly, but there’s good news. By understanding the nuances of these rules, especially which activities are excluded from §174 treatment, software companies may be able to amend past tax returns and reclaim overpaid taxes.

Understanding §174 and the Changes Impacting Software Companies

Under §174 of the Internal Revenue Code, companies are required to capitalize and amortize research and development (R&D) expenses over a period of years, rather than deducting them immediately. Historically, companies could choose to deduct R&D costs in the year they were incurred, but the Tax Cuts and Jobs Act (TCJA) of 2017 changed this treatment. As of January 1, 2022, R&D expenses must be capitalized and amortized over five years (for U.S. costs) or fifteen years (for foreign costs).

For software companies, especially those heavily involved in product development and innovation, this change can have a significant impact on cash flow and tax liabilities. However, not all costs related to development activities fall under the definition of R&D for §174 purposes. This is where many tax preparers are making critical mistakes.

The Common Misconception: Over-Capitalizing Costs

One of the most common errors we’re seeing in software company tax returns is that many tax accountants are capitalizing costs that don’t need to be included under §174. By misunderstanding the nature of certain activities, they are improperly categorizing routine tasks as R&D expenses, leading to unnecessary capitalizations. This means companies may be paying more in taxes than necessary.

Excluded Activities That May Qualify for Refunds

According to the IRS guidance on §174, several types of activities should not be capitalized, yet many accountants are mistakenly including them. Here’s a list of some common excluded activities that may qualify your company for a refund if they were incorrectly treated as R&D expenses:

• Routine Maintenance of Existing Products: Regular updates or bug fixes on software products that are already in use do not count as R&D under §174. These activities should be expensed in the year they occur.

• Data Management, Quality Control, or Data Cleansing: Tasks related to managing or cleaning data, or ensuring quality control, are typically not considered R&D. If these were capitalized, they might be eligible for adjustment.

• Bundling Existing Products into a Suite: If your company is bundling existing products into a suite without significant new development, the costs associated with this bundling should not be capitalized.

• Upgrading to Newer Versions of Hardware or Software: Routine upgrades to newer versions of software or hardware without significant new development also do not fall under §174.

• Installing Vendor Fix Releases: Installing patches or updates provided by vendors does not count as R&D and should not be capitalized.

• Reverse Engineering Existing Software: This activity is typically not considered R&D unless it’s part of a larger development process that leads to the creation of a new or improved product.

• Software Application Configurations: Configuring a software application to meet a client’s specific needs is often not considered R&D, as it usually involves tailoring existing software rather than creating something new.

• Studies to Select Vendor Products: Research related to selecting the best vendor product or solution is not considered R&D under §174.

The Impact on Agile and Scrum Development Methods

For software companies utilizing Agile or Scrum development methods, understanding the §174 amortization rules is even more critical. These development processes often involve ongoing iterations, with continuous improvement on a product that is already in service. Much of the development work done in these environments may not rise to the level of R&D that requires capitalization under §174.

For example, let’s say your team is regularly updating a software product after it has been placed in service. These updates might involve bug fixes, minor improvements, or new features based on customer feedback. While these activities are important for maintaining and improving the product, they likely do not qualify as R&D for the purposes of §174, and therefore should not be capitalized.

Many tax preparers are mistakenly capitalizing these types of costs, leading to unnecessary tax liabilities. By properly distinguishing between ongoing development and true R&D, you may be able to reduce your taxable income and improve cash flow.

Contract Labor and §174: The Importance of Contract Structure

Another key area to pay attention to is the structure of your contracts when doing development work for another company. Under §174, if a software company is hired to develop a product for a third party, the costs involved may or may not need to be capitalized depending on how the contract is structured.

Here’s the rule: If the service provider (your company) does not retain any right to use the developed software for other purposes and does not assume financial risk for the project, then the work is not considered R&D under §174. This means that the costs associated with the project should not be capitalized.

This is an important distinction, as many software companies are providing development services under contracts that do not meet the criteria for capitalization. By revisiting how your contracts are structured, you may find opportunities to amend past returns and claim back overpaid taxes.

Case Study: How We Helped a Software Company Recapture Overpaid Taxes

Let’s take a look at a real-world example. We recently worked with a software company that specializes in developing custom solutions for other businesses. They had been working on several projects over the past few years, and their tax preparer had capitalized nearly all of their development costs under §174.

After a careful review, we found that many of the activities being capitalized did not meet the IRS’s definition of R&D. For instance:

• Routine product updates and bug fixes were being treated as R&D expenses, even though the products were already in service and the changes were minor.

• Software configurations and customizations for clients were being capitalized, even though these tasks involved tailoring existing products, not creating new ones.

• The company had several contracts where they did not retain ownership or financial risk, meaning the development work should not have been capitalized under §174.

By amending their tax returns to properly categorize these expenses, we were able to help the company recapture over $200,000 in overpaid taxes over a three-year period.

Could Your Company Benefit from a Review?

If your software company has been capitalizing a significant amount of R&D expenses, it’s worth revisiting how those costs are being categorized. With the complexities of §174 and the potential for errors, even a small adjustment could result in substantial tax savings.

By taking a closer look at how your R&D costs are being handled, you may be able to reduce your tax liabilities and put more money back into your business. Especially the changes to §174 have added new layers of complexity to tax planning for software companies. But with the right understanding of the rules and a careful review of your expenses, you may be able to recapture overpaid taxes and improve your bottom line.