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Web Site Development Costs

Web Site Development Costs

By David Hardesty, November 3, 1999

Many companies developing Web sites seem to see all development costs as one thing – that is “web site development costs.” However, Web sites include a wide variety of costs that must be identified and accounted for separately. The importance of identifying these costs is that different types of costs are accounted for differently for tax purposes. For instance, some types of costs are deductible currently, some are deducted over a period of years, and some may not be deducted at all. In addition, some costs qualify for special credits. A large number of issues must be addressed when considering Web site development costs. For some of these issues there are clear rules, but for most the rules do not exist. This article highlights most of the current issues. For a complete discussion, see Electronic Commerce: Taxation and Planning, by David Hardesty. 1

Web sites are created using a combination of software, graphics, sound, and content. Web site applications are similar in many ways to multimedia software products, sold on CD-ROMs. Web site costs fall into three basic categories, all of which are subject to different rules for deducting these costs –

  •  Web site software, which includes front-end software, server-side software, and applets.
  •  Graphics, sound and video.
  •  Content

Outside of the book, Electronic Commerce: Taxation and Planning, there is little written on the subject of Web site costs. The IRS has not yet published guidance in this area, and is not likely to for some time to come. Therefore, it is difficult for companies and tax preparers to make the proper distinctions between the different Web site component costs. In the absence of clear rules, many taxpayers may be improperly deducting all costs related to Web site development.

Impact of INDOPCO

Overshadowing much of the analysis of Web site development costs is the recent case, INDOPCO v. Commissioner.2 This case emphasizes the fact that cost incurred currently, and which will provide a future benefit, may need to be capitalized. While this is a very old concept, INDOPCO was written in such a way as to potentially require capitalization of a wider variety of costs than in the past. The IRS has, since 1992, tested the limits of INDOPCO in a number of cases.3 INDOPCO may have wide application to Web site development costs, especially the costs of developing content.

Web Site Software

Software used to create a Web site is either purchased or self-created. The rules for purchased software are pretty well developed. The rules for self-created software, on the other hand, are not. Web site software includes –

Front-end software is simple HTML.

Server-side software is complex software that is the heart of good Web sites, and which makes the difference in site performance. The main server-side software applications include search engines, databases, transaction processing systems, Internet telephone systems, order-processing systems, and firewalls. Some of these applications, especially the search engine applications, incorporate jealously guarded trade secrets. Some applications, including some of those used for transaction processing, incorporate patented technologies.

Java Applets reside on a Web site server, and are called by the user, in the same manner as server-side software. These are complex applications that may take over some of the functions previously performed by server-side software.

One of the most difficult things about applying rules to Web site software is the determination of whether a cost relates to software, whether it relates to graphics, sound, and video, or whether it relates to content. Taxpayers must analyze carefully each Web site component cost to determine its proper category. A simple example illustrates the problem.

Example: A hotel creates a Web site for advertising purposes, and to enable guests to book rooms online. The hotel uses dozens of digitized photos as part of the Web site. Some of the photos are 360-degree “virtual reality” shots, allowing guests to experience the hotel’s surroundings. Thousands of dollars go into the creation of these photos. In addition, the hotel pays a designer thousands of dollars to design the “look and feel” of the Web site, including the page layouts and navigational buttons.

What part, if any, of the cost of Web site graphics, and the cost of photos will be characterized as software?

The cost of page layouts and navigational buttons will probably be part of the software cost.
The cost of the photos will probably not be included in software costs.

Purchased Software

Once it is clear that what is being purchased is software, the rules for deducting the cost of purchased software are pretty clear. These rules are given in IRC § 167(f) and § 197.

Self-Developed Software

A much more difficult issue is self-developed software. The basic rules are provided in Rev. Proc. 69-21, a very old procedure that was created in an era when software was recorded on punch cards. Surprisingly, the IRS has not updated this procedure to account for today’s software – much less Web site software. Serious deficiencies in this procedure include the fact that it takes no account of non-software elements included in today’s software applications. These non-software elements include graphics, sound, video and content.

What is disturbing about the continued use of Rev. Proc. 69-21 is that this procedure is the basis for defining software costs as research and experimentation costs under rules similar to those of Section 174. R & E costs are generally deductible as incurred. Therefore, it is critically important to determine what costs meet the requirements of Rev. Proc. 69-21 or Section 174.4 The rules given in Rev. Proc. 69-21 are not sufficient to deal with the wide variety of costs that go into the creation of today’s Web sites.

Graphics, Sound and Video

The difficulty with determining the deductions available for graphics, sound and video comes from the difficulty in characterizing these costs. 5 The Web is a rich multimedia environment, including graphics, sound, and video. What these Web site elements have in common is they are contained in digitized files that are called by Web site software.

Web site graphics include titles, backgrounds, photos, navigation bars and buttons, banner ads, and overall page design.

Sound is not commonly used in today’s Web sites, but it will be in the future. The best applications of sound are found on Web sites that sell recorded music.

Video is also not commonly used in today’s Web sites, but will be in the future, as bandwidth becomes available. Adult Web sites are currently pioneering the development of Web site video.


Graphics that are integral to a Web page, such as basic design elements and navigational buttons are ordinarily considered part of the software that creates a Web site. Graphics that are part of the content of a Web site are not considered part of software costs. For instance, in the example above, photos of a hotel are content. Certain graphics are primarily advertising, and are deductible as such, as explained below. However, for a number of Web sites, such as adult Web sites, graphics are assets that generate fees. There is a serious question as to whether the costs related to these later graphics are deductible, and, if they are, over what period. For instance, are digitized photos considered “artwork” which is generally not deductible? 6

Sound and video

Sound and video share many of the problems associated with Web site graphics. For example, where sound is used in a Web site is it primarily advertising, or is it something else? 7

Web Site Content

Content is the reason people visit Web sites. No one visits a Web site devoted to food recipes because it has great graphics, or a great user interface. However, strangely enough, content is not really an integral part of the development of a Web site in the same way as are software and graphics. Content is best thought of as what is delivered by a Web site.

A Web site is both “software” and “content.” The software side of a Web site might be thought of as the permanent part of the site (i.e., the bones of the site), whereas the content is the material that can be readily changed without affecting the Web site’s basic architecture. Revenue Procedure 69-21, which authorizes a current deduction for most software development costs, does not differentiate between “software” and “content.” Accordingly, at least for now, Revenue Procedure 69-21 (issued before Web sites were conceived) applies only to the software side of a Web site.

Advertising content

Many Web sites are primarily devoted to advertising. Advertising is generally deductible as incurred, even where that advertising results in a long-term benefit to the taxpayer.8 Historically, however, advertising has taken the form of a television commercial, a newspaper or magazine ad, a catalog, etc.

The Web gives us a new form of advertising, the online mega-catalog. A good example is, with millions of pages. There are a few cases dealing with catalogs,9 but Amazon’s Web site can hardly be compared. Amazon’s pages are actually windows into Amazon’s database of books. In the past there has been little need to develop rules related to the cost of developing a database. Now, however, we have thousands of sites, spending millions of dollars, developing databases used primarily to advertise products. New rules must be developed to deal with the cost of developing these databases.

Non-advertising content

One of the things that brings visitors to a Web site is free content. For example, the Web site,, which is devoted to selling products, contains a substantial amount of non-advertising content. This content includes such advice as the benefits of certain nutrients. The content is clearly not advertising, since what attracts readers to many sites is unbiased advice. Considerable cost is incurred to develop this content, and the rules related to the deduction of such costs are not clear. For instance, there is some authority that literary content developed for a Web site can be deducted currently. On the other hand, INDOPCO provides a general rule that costs resulting in benefits extending beyond the current year should be capitalized.10

Research and Experimentation Credits

The most controversial issue relating to software costs is the research and experimentation credit. The IRS has issued proposed regulations that have come under major criticism by taxpayers.11

Discovery test

Chief among the criticisms is the requirement in the proposed regulations that R & E costs will qualify for the credit only if the information discovered refines the common knowledge of skilled professionals in a particular field of technology or science.12 While this requirement seems reasonable enough, the difficulty for taxpayers is proving a discovery meets this test. For practical purposes, to qualify for the credit, a survey of the general field of knowledge must be made to determine if a discovery qualifies. This presents a possibly insurmountable problem for CPAs and other financial people charged with calculating the credit. There is no way to determine whether a discovery qualifies, short of engaging experts in the field. Even then, experts will disagree, as was clearly shown in the recent Norwest case.13

Some critics assert that the proposed regulations thwart Congressional intent, and make it impossible to receive the credit. Some say that IRS field agents are taking the position that nothing qualifies for the credit.14Clearly, the IRS needs to rethink these regulations, and come up with more practical rules.

Documentation requirements

Another requirement of the proposed regulations, and one that is heavily criticized is the requirement that research be documented in a certain way. Critics assert that the documentation required in the regulations goes beyond what is normal documentation for research projects. It will be especially difficult to get software developers to follow the required documentation procedures.15

Internal use software

Before internal use software (IUS) will qualify for the R & E credit, it must meet certain tests, in addition to the normal tests for R & E credit qualification.16 The problem is there is little guidance as to when software should be characterized as IUS. And, in the context of Web site software, there is no guidance at all.

Generally, IUS is software used primarily for internal purposes, such as software used for bookkeeping, inventory management, or order processing. Some software, such as order processing software, is sometimes used by customers. However, incidental use by customers does not prevent software from being characterized as IUS.17

Some Web site software clearly is not IUS. For instance, an online tax preparation program and an online game are both intended primarily for customer use and would not be IUS. Likewise, search engines are primarily for customer use and are not IUS.

Some Web site applications clearly are IUS. These would include applications devoted to network management. Pure order processing software is also likely to be considered IUS.

For many Web site applications, however, classification is not clear. For instance, an online stockbroker’s Web site includes order processing. It also includes, however, a substantial number of tools that can be used by customers to review and price holdings, get news updates, etc. The order-processing applications and the customer tools are so intertwined that they are really part of one software program. Should we consider the entire software application to be IUS, because a substantial portion is devoted to order processing? Should we consider the entire program as non-IUS? Or, should we make an allocation between the two? Clearly, rules must be developed that are specific to Web site software projects.

Domain Names

The rising prices at which domain names are changing hands demands that we accurately characterize these peculiar creatures of the Internet. As discussed at ECTP 8.02[6], domain names do not fit neatly into any category of deduction. For instance, Section 197 may apply, resulting in a 15-year life for purchased domain names. On the other hand, a domain name might be judged 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. Finally, a domain name might be an asset that will soon be obsolete, as the Net moves to a friendlier way of addressing Web sites. If this assertion could be proven, a domain name might be deducted over a relatively short period, such as five years.

1 David E. Hardesty, Electronic Commerce: Taxation and Planning, (Warren, Gorham & Lamont, 1999), hereinafter ECTP.

2 INDOPCO, Inc. v. Comm’r, 503 US 79 (1992). See discussion of this case at ECTP 7.01[1].

3 See FMR Corp., 110 TC 402 (1998), discussed at ECTP 7.01[1]; PNC Bancorp., Inc., 110 TC 349 (1998), discussed at ECTP 7.01[1]; RJR Nabisco, Inc. v. Comm’r, RIA TC Memo. 98,252 (1998). Discussed at ECTP 7.04[4].

4 See ECTP 7.02[3] for a further discussion.

5 See ECTP 7.03 for a complete discussion.

6 For a discussion see ECTP 7.03[1] and 7.04[5].

7 See ECTP 7.03[2].

8 See RJR Nabisco, Inc. v. Comm’r, RIA TC Memo. 98,252 (1998). Discussed at ECTP 7.04[4].

9 See ECTP 7.04[4][b].

10 See ECTP 7.04[2][b] for a discussion of these costs.

11 These regulations are discussed in detail at ECTP 7.05.

12 Prop. Reg. § 1.41-4(a)(3).

13 Norwest Corp. & Subsidiaries v. Comm’r, 110 TC 454 (1998).

14 See ECTP 7.05[2][b] for a discussion of the problems with these regulations.

15 See ECTP 7.05[2][d] for a discussion of the problems with these regulations.

16 These additional tests are discussed at ECTP 7.05[3].

17 See United Stationers, Inc. v. United States, 163 F3d 440, 444 (7th Cir. 1998).

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