Tax Court Rules that Software Development Doesn’t Give Rise to Research and Development Deduction

Research and development expenses, if they are incurred in a trade or business, are currently deductible.   That rule also applies to new businesses despite the fact that no trade or business was being conducted at the time, if there is a realistic prospect that the taxpayer will later enter into a trade or business utilizing the technology developed.   If no trade or business exists, the expenses must be capitalized into the cost of the developed technology and cannot be currently deducted.

Here, a married couple went into the software development business with the intent to license the software to another company.  The husband deducted research and development expenses of $68,000 and $1,422,000 in 1995 and 1996, respectively, but the IRS denied the deductions on the basis that the taxpayer was not going to use the developed software in his own business.  The Tax Court agreed with the IRS and the U.S. Court of Appeals for the Ninth Circuit affirmed.  That’s a tough outcome.  Developing software for licensing purposes can give rise to a current deduction if the taxpayer intends to use the software in the taxpayer’s own trade or business.  But, that wasn’t the case here.  The taxpayer did not intend to use the developed technology personally, so he couldn’t the research and development expenses currently.  That could make a big impact for a start-up business.  Saykally v. Comr., No. 05-75128, 2007 U.S. App. LEXIS 21878 (9th Cir. Sept. 7, 2007), aff’g, T.C. Memo. 2003-152.