The Internal Revenue Service has issued new guidelines that let you quickly deduct the cost of fixing your company's software to keep your computers humming as the millennium turns. But there's a nasty little catch.

You get the break only if -- after pumping in thousands of dollars and hours -- you end up with a system that does nothing more than it did when the repairs began.

Here's how the IRS treatment of the problem, officially called a Revenue Procedure, works: An agency spokesperson says a company may take an accelerated one-year tax deduction of expenses for "repairing" existing software affected by Y2K, as the problem is known in computer lingo. If, however, the conversion "improves" the software in some way, that spreads the deduction over three years, the normal deduction period for software expenses. Basically, the IRS has expanded its definition of "developmental" software expenses, which can be deducted all in one year, to accommodate the exceptional Y2K situation.

Of course, the difference between a "repair" and an "improvement" is often murky. And that will be a source of no small anxiety on the part of small businesses, as many of the distinctions are likely to be hashed out case-by-case. However, the agency has provided some basic direction. Paying a computer consultant to make an accounting program recognize four-digit dates is clearly a repair, as it has not substantively improved the software. But installing a brand-new accounting package with added features, while you're at it, will fall under the improvement category. According to the IRS, no new software will qualify for the full deduction.

Things get cloudier, though, when you buy software designed solely to fix the Y2K bug. While the IRS does not comment explicitly on the subject, some tax lawyers contend that such a purchase would reasonably qualify as a repair. "It's like fixing a car, and the carburetor's broken," says Jeffrey H. Kahn, an associate at law firm McDermott, Will & Emery. "You're bringing in a new product, but it's just a repair."

Kahn advises any company that hopes to qualify for the full deduction to be "careful that it doesn't make too many improvements" in the conversion process. As a defense against IRS challenges, he further recommends that a company "document that it's really only fixing its Y2K problem."

The IRS guidelines also fail to address other computer-controlled equipment that might be stricken with the Y2K bug -- such as elevators or heating systems. But the agency has said that these software fixes -- again, as long as they stay within the realm of repair not upgrade -- will most likely be fully deductible, too.

One note of caution: The IRS doesn't apply its rules proportionately. You can't, therefore, upgrade certain software but claim that, say, 60% of those costs were simply repairs -- and thus 60% were fully deductible. Companies that misclassify their expenses will be liable for the full amount of the tax, plus interest and possible penalties.

By Dennis Berman in New York
dennis_berman@businessweek.com

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