By Mark E. Battersby
Today, almost everyone is developing a presence on the Internet. Few commercial bird breeders, however, have given any thought to the financial helping hand provided by Uncle Sam in the form of tax breaks. Tax deductions can reduce the captive bird-breeding operation's tax bill and sharply reduce the out-of-pocket costs for developing and operating a Web site.
Not too surprisingly, given the complexity of our tax rules, developing and maintaining a Web site involves a variety of costs that should be identified and accounted for separately. Some costs are deductible immediately as expenses, some are so-called "capital expenses" that can only be deducted over a period of time and some of those costs may even produce tax credits — directly reducing the bird breeding operation's tax bill.
Few Official Ground Rules
It was only recently, almost 30 years after issuing guidelines for deducting software, that the IRS felt it necessary to update those tax rules. Unfortunately, they have never addressed the question of Web expenses and tax deductions. In other words, no regulations exist spelling out how Web development costs should be treated.
Obviously, there are a lot of questions with few answers. Fortunately, there are also a number of precedents that can provide guidance for a number of legitimate tax deductions.
Among the questions that can't be answered is whether your bird breeding operation's foray onto the Internet constitutes a new business. A distributor who opens a retail outlet for the same type of goods it has distributed for years, for example, is considered to have opened a new business. And new business startup costs must be capitalized and written-off over a period of years.
The expenses of a retailer opening another retail outlet or even a distributor opening another warehouse are, however, considered routine, "ordinary and necessary" business expenses and are tax deductible on the annual tax return as "expenses."
Obviously, immediately deductible expenses are far more beneficial in helping reduce out-of-pocket costs than a deduction for depreciation that must be taken over a number of years. Although the IRS has not seen fit to outline, as yet, the specific tax treatment for any Web development costs, clues exist elsewhere. Those areas where 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 captive bird breeding business.
Web Site Software
Software is considered to be an "intangible asset" of the bird breeding business. In this instance, software used to create a Web site is either purchased of self-created. Although the tax rules for purchased software are pretty straightforward, self-created software deductions are more questionable.
Today, the expense of developing software (whether for a bird breeder's own use or for sale to others) may either be deducted currently or amortized for more than a five-year period, so long as such costs are treated consistently. Purchased software, which cannot be characterized as 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 that it is placed in service.
But is a Web-related expenditure really for software? After all, how can any bird breeder differentiate between whether a cost is for software, whether it relates to graphics or whether it relates to content. Each receives its own, unique tax treatment.
Consider, FeatheredBird, Inc. They create a Web site primarily for advertising purposes, although they have the facilities to actually make sales on-line. The Web site uses dozens of digitized photos, some of which are "virtual reality" shots allowing viewers to more fully experience the beauty of their birds and full depth of their unique services. Thousands of dollars go into the creation of these photos. In addition, the bird breeder pays a designer thousands of dollars to design the "look and feel" of the Web site, including the page layouts and navigational buttons.
The cost of page layouts and navigational buttons will probably be part of the software cost while the photo costs will not. As mentioned, the basic rules in this area were created in 1969, and have not been updated since. Those regulations take no account of non-software elements included in today's software applications such as graphics, sound, video and content.
The Elements — And Deductions — Of The Web
Graphics that are integral to a Web page, such as basic design elements and navigational buttons, are generally understood to be part of the software that creates a Web site. Graphics that are part of the content of a Web site are not.
Certain graphics are primarily advertising and are deductible as such. However, for a number of Web sites, most notably adult Web sites, graphics are assets that generate fees. It is questionable whether the costs related to these latter graphics are tax deductible and, if they are, over what period. Are those digitized photos considered "artwork," which is generally not tax deductible?
Strangely, content is not considered to be an integral part of the development of a Web site in the same way as are software and graphics. Content is best defined as what is delivered by a Web site. Software might be viewed as the permanent part of the site whereas the content is the material that can be readily changed without affecting the Web site's basic architecture.
Many Web sites are primarily devoted to advertising. Advertising is generally tax deductible as incurred, even when it may result in a long-term benefit to the bird breeder. But what about the tax treatment of that non-advertising content?
The content of any Web site includes informational content that is clearly not advertising because what attracts "surfers" to many sites is unbiased advice. Obviously, considerable costs are incurred to develop this content. Once again, however, the tax rules related to the deduction of such costs is not clear.
On the one hand, there are a number of authorities backing the assumption that literary content developed for a Web site can be deducted currently. On the other hand, a 1992 decision by the U.S. Supreme Court (INDOPCO) provided a general rule that costs resulting in benefits extending beyond the current year should be capitalized.
Today, more and more bird breeders must pay to acquire an already registered domain name. The rising prices at which domain names change hands begs for a tax deduction. Again, the issue is not a cut-and-dried one.
Section 197 dealing with the acquisition of an intangible asset may apply, resulting in a 15-year life for purchased domain names. Or, a domain name might be judged by some to be an intangible asset to which Section 197 does not apply and which has no ascertainable life. In this case, no deduction would be available for the cost of a domain name until it was sold or abandoned.
The fact that neither our lawmakers nor the IRS has addressed the tax treatment of Web site development costs works both ways for any bird breeder who breaks down, documents and tracks the costs incurred. Any taxpayer whocan justify his or her treatment of expenses and who treats those expenses in a consistent manner from year-to-year will normally do so without question. The IRS may even permit some or all Web site development costs to be considered for the ultimate — a tax credit for research and experimentation.
Research And Experimentation
There still exists in our tax rules a credit for amounts spent on research and experimentation. Extremely regulated and very narrow in scope, the R&E tax credit is available, in some instances, for so-called "internal-use software."
Generally, internal use software is defined as software used primarily for internal purposes, such as software used for bookkeeping, inventory management or order processing. Some software, such as order processing, is sometimes used by customers. However, incidental use by customers does not prevent software from being characterized as internal-use software.
Some Web site software is clearly not internal-use software such as an on-line tax preparation program and an on-line game, both of which are intended primarily for customer use. Other Web site applications, such as an application devoted to network management or pure order processing software, are likely considered to be for internal use.
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 credit.
Fortunately, aside from the controversial tax credit, most of the costs of developing and maintaining a Web site for your bird breeding business are tax deductible. The argument for breaking down those costs in order to qualify for the tax deductions that will do your business the most good is bolstered by the lack of specific rules over what is deductible, depreciable and not deductible at all.
Mark E. Battersby, Pennsylvania resident, is a tax and financial advisor, as well as a free-lance writer and columnist. Battersby writes a weekly farm tax column that is syndicated by more than 45 newspapers and three other topical tax columns syndicated to more than 70 newspapers. His columns appear in 17 trade magazines and six "hobby" publications, and he sells more than 200 features each year to trade magazines and Web sites.