It is imperative for today’s retailers to connect with customers when, where and how their customers prefer. This means frequent innovation to create new and better brand experiences across the web, on mobile devices and right next door. Staying ahead of the curve—or even keeping up with it—requires investment.
Integrating traditional and e-commerce sales strategies provides great opportunity for retailers. It can also create both opportunities and issues in the world of taxation. One important opportunity involves identifying and properly claiming tax deductions related to improving your omnichannel strategy.
Website development and tax savings
Your website is much more than a digital storefront. It is an integrated part of your brand experience and, increasingly, the experience of choice for your customers. Continuous investment in website improvement creates an opportunity for tax savings. However, the treatment of website development costs can become complex. Various components of website design and content must be reviewed and properly classified. In general, the following costs should be considered:
- Software—May be deductible or capitalizable depending on whether such costs are for the development or acquisition of software
- Content—May be treated as deductible advertising costs or may be subject to capitalization and amortization if content is copyrighted
- Graphic design—May include both software elements (i.e., those that are integral to the website's design) and content elements
Software development and acquisition costs are important enough to warrant a distinct IRS revenue procedure (Rev. Proc. 2000-50). Under this guidance, internally developed software costs may be deducted or capitalized and amortized depending on various factors. Software development costs may also be deducted or deferred and amortized under section 174 of the Internal Revenue Code, if they qualify as research and experimentation costs. Rev. Proc 2000-50 was created as a safe harbor for software development costs to relieve the administrative burden of documenting which software development costs qualify as research and experimentation.
Website software development costs—such as those to enhance your customer’s online and mobile shopping experience—may be treated as internal development, even if the service is contracted out, as long as you maintain the benefit and burdens of development within your operations. Acquired software costs generally must be capitalized and amortized over 36 months from the date the software is placed into service. Many website development costs may be deductible but that depends, in part, on your historical tax accounting method for software development costs and whether it has been consistently applied. A change of accounting method may be required and any method change adjustment is calculated differently depending on whether you elect the safe harbor for software development costs under Rev. Proc. 2000-50 or treat them as research and experimentation costs under section 174. Therefore, it is important to know the tax benefits or drawbacks associated with your e-commerce omnichannel development.
Website content, on the other hand, may be deductible or capitalizable depending on the type of content. This includes:
- Cost of content for advertising purposes, which may generally be currently deducted as an advertising expense under section 162;
- Costs of internal employee compensation or overhead may be currently deducted under Reg. section 1.263(a)-4(e)(4)(ii);
- Costs associated with acquiring (or developing) content copyright (other than internal employee compensation or overhead), which may be capitalizable and amortizable over its useful life (to the extent the content does not have a useful life it could be capitalized indefinitely); or
- Costs associated with acquiring content as part of the acquisition of a trade or business may be capitalizable and amortizable over 15 years under section 197.
The determination of whether section 167 or section 197 applies to the costs of copyrighted material depends on whether the copyright is self-created or acquired, either separate from or as part of the acquisition of a trade or business.
Understanding expansion versus startup costs
As brick and mortar companies expand both online and offline, and e-commerce companies look to create offline customer experiences, tax planning becomes increasingly important. The initial structuring of any expanded channel can significantly affect cash flow due to differing tax treatments.
Generally, you must capitalize costs incurred to start a new business. Under regulations, start-up costs may be deductible up to a certain limit, with any excess amortized over 180 months, beginning with the month the trade or business begins. However, costs incurred to expand an existing business may be currently deductible as an ordinary and necessary business expense when incurred. The determination of whether costs are incurred to start a new business or expand an existing one has caused controversy in the past and can affect taxpayers incurring costs to move from brick and mortar to online operations.
Here are three distinct business expansion examples and the tax treatment of the expansion expenses:
1. Expansion of an existing business: Deduct
Briarcliff Candy Corp. is a leading case in the area of start-up versus expansion. Briarcliff, a manufacturer and seller of candy products seeking to combat falling sales, incurred costs to solicit and enter into franchise agreements for drugstores in a different geographical area to sell their candy. Briarcliff incurred promotional and advertising costs, which it treated as currently deductible. The IRS argued that such costs should be capitalized since they created a benefit for future years (i.e., increased revenue). The court of appeals for the second circuit, however, agreed with Briarcliff because the costs were incurred to protect and expand an existing business and not to create a separate and distinct intangible asset.
2. Start of a new business: Capitalize and amortize
Alternatively, in Specialty Restaurant Corp, the tax court held that amounts incurred by a restaurant operator to open new restaurant locations must be capitalized as start-up costs. Although the opening of a new restaurant would normally be considered an expansion of the existing business, in this case, Specialty Restaurant created a new subsidiary (i.e., a separate tax entity) to hold each new restaurant that was opened. As a result, each new subsidiary was treated as a new trade or business. The costs incurred for the start-up of each was therefore required to be capitalized. However, it is important to note that structuring plays in important role in how these costs would be treated. For example, if the subsidiaries were all disregarded single member LLCs then the tax answer would have been different.
3. Online expansion of an existing business: Deduct
Finally, in Rev. Rul. 2003-38, the IRS ruled that a retail shoe store business was expanding its business when it created a website for the online sales of its shoes. The IRS ruled that although the operation of an online sales business requires some knowledge apart from that required to operate a brick and mortar store (e.g., different marketing approaches and technical operations), the website's operations depended significantly on the business’s existing experience, knowledge and goodwill. Additionally, the principal business activity of the two operations was the same. As such, the move to online sales was properly treated as an expansion of the existing business rather than the creation of a new trade or business.
You can see from the above examples that upfront planning is important to avoid unnecessary taxation (or to optimize deductibility). Fortunately, case law and rulings generally provide that such costs should be treated as costs incurred to expand an existing business. However, if you choose to open an online or brick and mortar operation as a separate taxable entity (and there are many reasons to do so), the costs associated with the expansion is likely treated as start-up costs requiring capitalization and a lengthy amortization period for tax purposes.
Engage your tax professionals
As you embrace a variety of communication and selling channels to reach increasingly demanding and location-agnostic customers, it will be important to regularly review the tax treatment of your product sales, omnichannel efforts and related business investments. Sales and use tax, in particular, becomes increasingly complicated by an omnichannel approach (see Why go looking for trouble? Benefits of a proactive sales tax review). Work closely with your tax advisor to monitor developments, evaluate the related implications and take the necessary steps to remain in compliance and proactively manage risk.
