Under Code Section 174, research and development expenses are immediately deductible when incurred in a trade or business. This provision will also apply 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 deductibility is not allowed under Code Section 174, the expenses usually must be capitalized into the cost of the developed technology and thus not available for immediate tax deduction.
David Saykally went into the software development business. His intent at the time he was developing his software was to license the software to a wholly owned company, which would use the software in its business. In 1995 and 1996, Saykally deducted R&D expenses of $68,000 and $1,422,000.
The IRS challenged the deductions claiming that Saykally was not going to use the developed software in his own business. The Tax Court held for the IRS, and the 9th Circuit Court of Appeals has now affirmed the Tax Court.
Therefore, software developers who incur R&D expenses for software that they will license need to be careful if they want to currently deduct those expenses. As noted in the Tax Court case, development for license is NOT necessarily fatal to a Code Section 174 deduction. In distinguishing Saykally's situation from that in Scoggins v. Commissioner, 46 F.3d 950 (9th Cir. 1995), rev'g T.C. Memo. 1991-263, the Tax Court noted that a deduction was allowed in Scoggins even when there was a licensing arrangement because the taxpayer there still intended to otherwise use the developed technology in its own trade or business. Since Saykally had no intent to otherwise use the developed technology himself, no R&D deduction is allowable.
David M. Saykally, 100 AFTR2d Para. 2007-5250 (CA 9 8/16/2007).