What factors should a software company corporation consider when selecting the activity economic type for equipment depreciation?
Ask Blue J any tax question, then go deeper. Follow up, add client-specific context, and explore the sources behind every answer with Blue J’s generative AI solution for tax research.
When a software company corporation selects the “activity economic type” (i.e., the appropriate asset class or activity category) for equipment depreciation under the Modified Accelerated Cost Recovery System (MACRS), it must carefully consider several legal and factual factors to ensure proper classification and compliance with the Internal Revenue Code and Treasury Regulations. The choice of asset class directly determines the recovery period, depreciation method, and convention, all of which affect the timing and amount of depreciation deductions. Below are the key factors and legal principles a software company should consider:
1. Primary Use of the Property
- Legal Standard: Under Treasury Regulation §1.167(a)-11(b)(4)(iii)(b), property is classified according to the activity in which it is primarily used, even if that activity is insubstantial relative to all of the taxpayer’s activities. The “primary use” standard is a functional, use-driven test.
- Application: The company must analyze how each asset is actually used in its business. For example, if a piece of equipment is used primarily for software development, it should be classified under the asset class that best matches that activity, not necessarily the company’s overall business classification.
2. Asset Category vs. Activity Category
- Legal Principle: Rev. Proc. 87-56 (as referenced in IRS guidance) establishes two broad categories:
- Asset Categories (00.11–00.4): Specific assets used in all business activities (e.g., office furniture, computers).
- Activity Categories (01.1–80.0): Assets used in specific business activities or industries (e.g., manufacturing, distributive trades).
- Rule: If an asset is described in both an asset category and an activity category, it is generally classified in the asset category unless specifically excluded or included in the activity category.
3. Nature of the Asset
- Type of Equipment: The company must identify whether the equipment is, for example, office furniture, computers, servers, or specialized manufacturing equipment.
- Examples:
- Computers and Peripheral Equipment: Typically classified as “Information Systems” (asset class 00.12), with a 5-year recovery period under GDS.
- Office Furniture: Classified as “Office Furniture, Fixtures, and Equipment” (asset class 00.11), with a 7-year recovery period under GDS.
- Specialized Equipment: If the equipment is used in a specific activity (e.g., manufacturing), check if it is specifically included in an activity category (e.g., asset class 36.0 for “Manufacture of Electronic Components, Products, and Systems”).
4. Business Activity of the Company
- Industry Classification: The company’s principal business activity may affect classification if the equipment is not specifically described in an asset category. For example, if the company is engaged in software publishing, but the equipment is not described in an asset category, it may fall under an activity category related to “Information” or “Professional, Scientific, and Technical Services.”
- IRS Guidance: The IRS provides detailed tables (Tables B-1 and B-2 in Publication 946) to help determine the correct class life and recovery period based on both asset and activity categories.
5. Specific Inclusions and Exclusions
- Check for Explicit Listings: Some assets are specifically included or excluded from certain categories. For example, “qualified technological equipment” is defined in IRC §168(i)(2) and generally assigned a 5-year recovery period.
- Special Rules for Software: Off-the-shelf computer software is eligible for Section 179 expensing and is depreciated over 3 years using the straight-line method if not acquired as part of a business acquisition.
6. Consistency and Documentation
- Consistency: Once an asset is classified in a particular category, the company must consistently apply that classification for all similar assets placed in service in the same year.
- Recordkeeping: Maintain detailed records showing the asset’s description, use, acquisition date, cost, and the rationale for its classification.
7. Legal Precedent and IRS Guidance
- IRS and Court Rulings: The IRS and courts have emphasized that the classification is based on the asset’s use, not the taxpayer’s overall business. For example, in CCA 200709063, the IRS classified intermodal facility assets based on their use and the specific asset class descriptions, not the taxpayer’s primary business.
8. Election to Use Alternative Methods
- Alternative Depreciation System (ADS): The company may elect to use ADS (straight-line method over a longer recovery period) for any class of property, but this election is irrevocable for that class and year.
- Exclusion from MACRS: If the company wishes to use a method not based on a term of years (e.g., unit-of-production), it must elect to exclude the property from MACRS under IRC §168(f)(1).
9. Interaction with Section 179 and Bonus Depreciation
- Order of Application: Section 179 expensing is applied first, followed by bonus depreciation (if elected), and then regular MACRS depreciation on the remaining basis.
10. Summary of Steps for a Software Company:
1. Identify the asset and its primary use.
2. Check if the asset is described in an asset category (00.11–00.4).
3. If not, check the activity category that matches the company’s business activity.
4. Apply the recovery period and method prescribed for that class.
5. Ensure consistency and maintain documentation.6. Consider elections for ADS or exclusion from MACRS if appropriate.
By following these steps and considering the above factors, a software company can ensure it selects the correct activity economic type for equipment depreciation, maximizing allowable deductions while remaining compliant with the law.
Was this answer helpful?
What Blue J customers are saying
“We are excited to use Blue J to elevate the initial work product our team is able to produce."
"We’re incorporating Blue J to ensure our people are well-equipped with a research tool that delivers on both ease of use and quality of deliverable. It will save us a lot of time as a starting point, so we can focus our efforts on the analysis. Ultimately, it helps us get to the right answer, faster.”
"We’re incorporating Blue J to ensure our people are well-equipped with a research tool that delivers on both ease of use and quality of deliverable. It will save us a lot of time as a starting point, so we can focus our efforts on the analysis. Ultimately, it helps us get to the right answer, faster.”
"We had used Checkpoint for a long time but found it wasn’t particularly well-used in our practice."
"A lot of our practitioners would have to turn to Google to find what they were looking for, which of course isn’t ideal. Blue J is a real game-changer when it comes to this, since it combines the efficiency of Google with the authoritative tax materials our people really need to serve their clients best. At ELO, we pride ourselves on providing services that are focused on value for clients and exceeding their expectations. Adding Blue J to our toolbox will enable us to do just that, as we continue to evolve our service offerings to better serve our clients’ needs.”
"A lot of our practitioners would have to turn to Google to find what they were looking for, which of course isn’t ideal. Blue J is a real game-changer when it comes to this, since it combines the efficiency of Google with the authoritative tax materials our people really need to serve their clients best. At ELO, we pride ourselves on providing services that are focused on value for clients and exceeding their expectations. Adding Blue J to our toolbox will enable us to do just that, as we continue to evolve our service offerings to better serve our clients’ needs.”
"We find this tool to be a game-changer for us and our clients.”
“We had the opportunity to pilot some other AI solutions in the market, and found that the improvement over traditional search was limited - except in Blue J’s case, where the efficiency gain over traditional research methods is significant."
“We had the opportunity to pilot some other AI solutions in the market, and found that the improvement over traditional search was limited - except in Blue J’s case, where the efficiency gain over traditional research methods is significant."
“Blue J is an exciting technology because it enables the practitioner to remain in the driver’s seat of the analysis."
"Thoughtful functions are included to encourage and facilitate deeper analysis, not to replace or reduce it. We’ll continue to find new and impactful ways to leverage the technology, which has benefited our clients and staff alike. At RSM we strive to be compelling to our clients and to be digital by embracing new technologies to fulfill that promise.”
"Thoughtful functions are included to encourage and facilitate deeper analysis, not to replace or reduce it. We’ll continue to find new and impactful ways to leverage the technology, which has benefited our clients and staff alike. At RSM we strive to be compelling to our clients and to be digital by embracing new technologies to fulfill that promise.”
"We wanted to have a tool that people were using at all staff levels."
"We wanted something that lived up on their third screen - something that would be available and helpful to them every day. What we've found is it's been easy to get people to get into the habit of using Blue J because it helps people. Blue J allows us to quickly respond to client questions in a way that they can understand it, which helps us deal with the volume of client questions that come in. We were up and running very quickly with Blue J - within 5 minutes, our staff understood how this will be helpful, and the rest of the training program is refining prompting skills and building use cases and best practices."
"We wanted something that lived up on their third screen - something that would be available and helpful to them every day. What we've found is it's been easy to get people to get into the habit of using Blue J because it helps people. Blue J allows us to quickly respond to client questions in a way that they can understand it, which helps us deal with the volume of client questions that come in. We were up and running very quickly with Blue J - within 5 minutes, our staff understood how this will be helpful, and the rest of the training program is refining prompting skills and building use cases and best practices."
