To Capitalize or Expense: How to Treat Website Costs for Tax Purposes
For most small businesses, having a website is a necessity. But what's the proper tax treatment of the costs to develop a website?
Unfortunately, the IRS hasn't yet released any official guidance on these costs. Therefore, you must extend the existing guidance on other subjects to the issue of website development costs.
Depreciable Fixed Assets
The cost of hardware needed to operate a website falls under the standard rules for depreciable equipment. Similar rules apply to purchased off-the-shelf software.
Specifically, once these assets are up and running, you can deduct 100% of the cost in the first year they're placed in service, as long as that year is before 2023. This favorable treatment is allowed under the 100% first-year bonus depreciation break established by the Tax Cuts and Jobs Act (TCJA).
In later years, you can probably deduct 100% of these costs in the year the assets are placed in service under the Section 179 first-year depreciation deduction privilege. However, Sec. 179 deductions are subject to several limitations.
For tax years beginning in 2019, the maximum Sec. 179 deduction is $1.02 million, subject to a phaseout rule. Under the rule, the deduction is phased out if more than a specified amount of qualifying property is placed in service during the tax year. The threshold amount is $2.55 million for tax years beginning in 2019.
There's also a taxable income limit. Under that limit, your Sec. 179 deduction cannot exceed your business taxable income. In other words, Sec. 179 deductions can't create or increase an overall tax loss. However, any Sec. 179 deduction amount that you can't immediately deduct is carried forward and can be deducted in later years (to the extent permitted by the applicable dollar limit, the phaseout rule and the taxable income limit).
Important: Software license fees are treated differently from purchased software costs for tax purposes. Payments for leased or licensed software used for your website are currently deductible as ordinary and necessary business expenses under Sec. 162.
Internally Developed Software
If you take the position that your website is primarily for advertising, you can currently deduct internal website software development costs as an ordinary and necessary business expense.
An alternative position is that your software development costs represent currently deductible research and development costs under Sec. 174. To qualify for this treatment, the costs must be paid or incurred by December 31, 2022.
A more conservative approach would be to capitalize the costs of internally developed software. Then you would depreciate them over 36 months under Sec. 167(f).
Payments to Third Parties
Some companies take the easy way out. They hire third parties to set up and run their websites. Payments to such third parties should be currently deductible as ordinary and necessary business expenses.
Expenses Incurred before Business Commences
Up to $5,000 of otherwise deductible expenses that are incurred before your business commences can generally be deducted in the year business commences. These so-called "start-up expenses" are covered by Sec. 195.
However, if your start-up expenses exceed $50,000, the $5,000 currently deductible limit starts to be chipped away. Above this amount, you must capitalize some or all of your start-up expenses and amortize them over 60 months, starting with the month that business commences.
Important: Start-up expenses can include website development costs. But they don't include costs that you treat as deductible research and development costs under Sec. 174. You can deduct those costs when they are paid or incurred, even if your business hasn't yet commenced.
Until the IRS issues specific guidance on deducting vs. capitalizing website development costs, you can apply existing guidance for other subjects. Your tax advisor will determine the appropriate treatment for these costs for federal income tax purposes. Contact your advisor if you have questions or want more information.