Making sure your company is Y2K-prepared doesn't start and end with updating your computer systems. You can also reap tax savings for making those corrections and adjustments. The IRS recently issued an announcement indicating that companies can deduct the cost of modifying or converting their existing software to make it Y2K-compliant.
The new IRS provision includes the costs of using either in-house personnel or an outside firm to search through the software code and fix any date-related problems within existing software programs. It's important to keep in mind, however, that the announcement doesn't cover the purchase of new software or hardware, says Gary Juhnke, a CPA and tax partner with Deloitte & Touche LLP. Different tax provisions apply in those cases, as we discuss later in this column.
Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.
Know Your Options
Entrepreneurs actually have two tax-saving options for deducting the costs of Y2K-related software fixes. First, you can deduct all the costs of making your software Y2K-compliant in one lump sum from the current year's income no matter what year the changes were made. The second option is to treat the cost as a capital software-development expense and amortize the cost over a five-year period. But you can't do both.
What factors should you consider when deciding which option to select? It boils down to whether your business would be better off taking one large deduction in one year or spreading the cost out over five years, says Susan Jacksack, a tax attorney and small-business analyst with CCH Inc., a Riverwoods, Illinois, provider of legal, tax and business information. Jacksack is the author of CCH Business Owner's Toolkit Tax Guide 1999, a publication designed to help small, single-owner businesses prepare their 1999 income tax returns.
While deducting your Y2K-related costs in a single year means the money you save will be more quickly available to use for other business purposes, there are situations in which having more cash right now isn't as important as other considerations. One example, says Jacksack, is the business owner who's getting ready to sell his or her business and has to meet certain financial ratios under a covenant with a bank. If he or she wants to avoid large fluctuations in the company's financial statements, amortizing Y2K-related computer costs over five years is likely to be the more attractive option.
You'll also need to anticipate future developments for your business. If you expect to receive a large contract in a year or so, for example, it may make greater tax sense to utilize the five-year option, Jacksack suggests.
Another factor that will influence your decision has to do with how you've treated capital software-development expenses in the past. If you've always amortized such expenses, the IRS requires that you treat Y2K costs in the same manner. If you decide to alter the overall way you treat capital software-development expenses, you have to file Form 3115 during the tax year in which you make the change.
Out With The Old
What if you decide to replace your computer system with an entirely new one? At this point, you'll get no special or additional tax relief for taking such a step, although the usual software and hardware depreciation schedules will still apply. This generally means you can amortize the cost of new software over a 36-month period, starting with the first month you begin using the new system.
Another option available to entrepreneurs purchasing new hardware is the expensing provision, or what's known as the Section 179 deduction. This provision allows you to write off up to $19,000 in new equipment for the 1999 tax year. The limit increases to $20,000 next year. If you decide not to use this option, you can still depreciate the cost of the new hardware over a five-year period.
Keep in mind, however, that if you sell the equipment after you claim the expensing provision or stop using it in your business as significantly as you initially claimed it for, you may have to recapture, meaning give back, part of the tax benefits you previously filed, says Jacksack.
What if the system you purchase comes loaded with software? In that case, it's treated as a single item for tax purposes--the IRS views the software as an integral part of the hardware system.
Remember, if you only buy new software, you can't take an immediate write-off because the IRS treats software as intellectual property, says Jacksack. Software by itself must be written off using the software and hardware depreciation schedule. The exception to this rule relates to software that becomes obsolete in less than a year, such as annual tax preparation software.
Juhnke warns that the IRS is expected to thoroughly scrutinize Y2K-related deductions. When making changes for Y2K compliance, carefully document your expenses, being sure to give detailed explanations of why you needed to make various software and hardware changes. Jacksack also recommends getting a guarantee in writing from the company you buy any technology-dependent product from that the product is Y2K-compliant.
More Deductive Reasoning
You may also be able to deduct other expenses you incur in the process of making your business Y2K-compliant. Such expenses include seminars on solutions to the problem and travel costs associated with attending these seminars. You can even deduct the travel costs of going from store to store to compare the costs of new computer systems. And if you take out a business loan to pay for the cost of fixing your existing computer system or to buy a new one, the interest on the loan is deductible.
If you're able to find an insurance carrier willing to offer you protection against business losses due to Y2K-compliance problems--whether they're caused by failures in your computer system or one outside your business--the cost of that coverage is also deductible. (Finding such insurance is highly unlikely, however. See the February 1999 "Insurance" column for more on this topic.)
What if a Y2K-related problem somehow causes physical damage to your company? It's possible to claim a casualty loss in some cases, such as if your business is burglarized as a result of an alarm system failure. However, Jacksack notes, the claim is subject to the usual rules for casualty losses, which don't include losses incurred because of a slowdown in business activity or a decline in business reputation. (For details, see IRS publication #547, Casualties, Disasters and Thefts).
Is More Relief On The Way?
For many entrepreneurs, existing tax relief might not be sufficient to help correct their Y2K problems. As it is, most businesses already use up the Section 179 expensing deduction each year on new equipment purchases they need to grow their businesses, says accountant Debbi-Jo Horton of DJ Horton & Associates in East Providence, Rhode Island.
To provide entrepreneurs with a little more tax relief, there's an effort under way in Congress to offer small companies greater deductions under Section 179. Sponsored by Rep. Karen L. Thurman (D-FL), The Businesses Undergoing the Glitch (BUG) Act (H.R. 179) would offer small-business owners a deduction of up to $40,000 for the purchase and installation of Y2K-compliant hardware and software acquired in 1999.
Thurman says her legislation is needed to encourage small companies to purchase Y2K-compatible equipment now before it's too late. In addition, under the bill, small-business owners who purchased Y2K-compliant equipment in 1997 and 1998 would be allowed to accelerate depreciation up to $40,000 for that equipment.
During the last Congressional session, Rep. Thurman's bill made it through the Oversight subcommittee of the House Ways and Means Committee. She's optimistic that it will make headway this year as lawmakers become even more aware of the Y2K-compliance problems facing small-business owners.
Making computers Y2K-compliant and receiving tax deductions to boot should be a high priority for entrepreneurs this year. Taking a wait-and-see approach is a dangerous strategy. Says Jacksack, "If you lose business because your systems aren't compliant, that's your own loss and it can't be recouped [through the tax code]."
Restoring a lost tax break
Congressional efforts are underway to provide entrepreneurs with some tax relief. A bill introduced in the House would partially restore the business and entertainment meal deduction, increasing deductibility from the current 50 percent to 80 percent. The boost would take place gradually over a six-year period, rising 5 percent each fiscal year starting in 2000.
Ten years ago, businesses were permitted to deduct 100 percent of business meals as necessary business expenses. In 1987, the deduction was cut to 80 percent, and then reduced again in 1994 to 50 percent. When the business meal and entertainment deduction was cut, small businesses suffered, says House Small Business Committee chair Jim Talent (R-MO), co-sponsor of the bill. Restoring a portion of the deduction, he says, will represent an important step in ending "an unfair and punitive policy."
To show your support for H.R. 1195, contact your congressperson. The "find your reps" feature at http://www.congress.org can help put you in touch. Or if you already know your congressperson by name, call the U.S. Capitol switchboard at (202) 224-3121 and ask to be transferred.
CCH Inc., see listing for page 36
DJ Horton & Associates, (401) 435-4988, http://www.dj-horton.com