I paid 20K for someone to develop a website. The 20K was for their programming ability and not for the end product itself (sort of). After the programmer renders their "service" worth 20K, then a product becomes available which is then an asset.
The basic test for whether the cost is capitalized is whether it is an expense that goes into creating an asset that will have a useful life of greater than one year. The asset with a useful life of more than one year is thus a capital asset, and you do not deduct the costs you incurred to create or buy the capital asset. At best, you may depreciate it or amortize it over a period of years.
You are creating a web site to sell your goods. The program used for that web site is an asset that will have a useful life of more than one year. That makes making the web site program a capital asset. Because it is a capital asset, all the costs you pay that go into creating it it must be depreciated over the useful life of the program starting in the year that the program is placed in service in an active trade or business. The $20,000 you paid the programmer is a cost you incurred to create the asset. Thus, you'd include that cost as part of your basis in the program and you recover that with depreciation deductions over a period of years starting the year you place it in service.
Even if it were not a capital item and was a cost you could ordinarily deduct in the year paid, you could not do that here when the cost was incurred in the start-up phase of the business. You'd have to instead amortize that over 15 years starting the year that the you start the active trade or business (i.e. put the site online and start selling to customers) with the possible exception of up to $5,000 of start expenses that you may elect to deduct in the year that you start the active trade or business. There are restrictions to when you can take that election. But start-up expenses exclude those costs that are part of a capital asset.
Would things have changed if I paid a marketing fellow in India 20K to market my US consulting services and bring me clients? Is that a "pure" service which doesn't get tainted as a capital expenditure? I am just trying to understand the difference between those two here.
If the marketing involved is advertising type activities, that is pretty much always a deductible expense in the year you pay it IF it is paid after the business is up and running, i.e. not in the start-up period. Remember, during the start-up period you pretty much don't have anything to deduct for the business the way the rules work. A lot of advertising is for immediate benefit and doesn't develop any asset that will be used for more than one year.
And, in the case of advertising, it is generally deductible even if it was part of a long term ad campaign that built goodwill or tradname assets that would have a very long useful life. While under the basic theory of capital assets and depreciation that long term ad campaign should be capitalized and depreciated (and the IRS has sometimes argued for that) it is nevertheless typically allowed. The reason for this is tradition: adverstising has since the beginning of income tax been a deductible expense. Congress and the courts are loathe to change that now.
Marketing activities other than advertising, however, will face the same analysis as with the web site: if they contribute to creating an asset with a useful life of more than one year, they are capital expenses, not ordinary expenses, and you recover those through deprecation or amortization in most cases.
I mean, using that logic, I could hire 30 programmers and pay them a million dollars a year to create, support and run the software and none of that would be a tax deductible expense? Somehow I am not able to come to terms with that.
The cost to create or improve it would again be costs that contributed to a capital asset and would be subject to depreciation. The fact that you pay millions to create it doesn't change the analysis any. Costs simply to maintain it, on the other hand, would be a deductible expense in the year paid for a cash basis taxpayer if the cost is incurred after the start-up period.
It's like the costs that go into constructing an office building. Let's say you directly employed a lot of workers to do the labor needed to construct your office building for your business. Those costs are part of the cost of the building and will be recovered through depreciation, not as a wage expense that is deducted in the year you paid it. The cost of the building is not simply the building materials you purchased for constructing it. It is also the labor that went into it as well. I think that example is pretty easy to understand, and the web site expenses are analyzed the same way.
If what you are thinking is that all costs of personal services are deducted in the year paid, that's obviously not correct based on the discussion above. If those personal service costs are part of creating an asset that will have a useful life of more than one year, then they are part of the cost of that asset and are depreciated or amortized over a period of years in most cases.
This is one of many issues that trip up new small businesses when it comes to taxes, and is one reason why I strongly suggest anyone going into business consult CPA or tax attorney for advice on the tax issues that are involved in the business.