A pragmatic approach to amortization of intangibles.by Young, James C.
In response to the controversy between taxpayers and the IRS over intangible asset amortization, the Revenue Reconciliation Act of 1993 created new IRC Sec. 197. This section permits the amortization of the capitalized costs of specified intangible assets over a 15-year period. Here is an explanation of the new rules with some practical guidance on their application.
The tax treatment of intangible assets has been controversial for many years. Taxpayers and the IRS have engaged in intangible asset disputes since 1925. Prior to enacting IRC Sec. 197 as part of the Revenue Reconciliation Act of 1993 (RRA 93), intangible asset amortization was one of the biggest issues facing the IRS. As of mid-1989, the IRS had proposed over $8 billion in adjustments related to intangible assets.
In general, taxpayers are allowed to recover the costs of long-lived assets through depreciation or amortization deductions. Tangible assets are depreciated over specific statutory periods, whereas taxpayers determine the recovery periods for intangible assets. Goodwill and intangible assets with indeterminable lives were not eligible for amortization prior to the enactment of IRC Sec. 197.
Prior law rules encouraged disputes between taxpayers and the IRS. Taxpayers strove to establish values and useful lives for intangibles. Conversely, the IRS wished to classify intangibles as either goodwill or as having indeterminable lives. The issue was further complicated by the lack of a statutory definition of goodwill. As a result, disputes had to be settled on a case-by-case basis. When taxpayers and the IRS could not reach an agreement, the dispute had to be litigated. Due to the lack of guidance provided by the statutes, taxpayers in similar situations were treated differently.
Increasing the opportunities for disputes was the rise in reported intangible asset values. According to a 1991 GAO report, intangible asset values increased from $45 billion in 1980 to $262 billion in 1987. Furthermore, this figure was expected to increase as the result of more corporate mergers and acquisitions. For example, in the $12.9 billion purchase of Kraft, Philip Morris allocated $11.6 billion to intangible assets. It had also been suggested that the law provided foreign companies with a competitive advantage. Many of our trading partners allow the amortization of goodwill for tax purposes. As a result, foreign companies could afford higher acquisition costs because of the increased after-tax cash flows goodwill amortization provides.
Under prior law, the controversies centered on existing regulations (Reg. Sec. 1.167(a)-3; fundamentally unchanged since their adoption in 1927). Under those regulations, taxpayers were required to pass a two- pronged test to amortize intangible assets. First, they had to prove an intangible asset had value separate and distinct from goodwill. Second, they had to prove an intangible asset had a useful life that could be estimated with reasonable accuracy. As mentioned earlier, because of a lack of statutory guidance, the definition of goodwill was formulated by the courts. The two most commonly used definitions of goodwill are--
* the expectancy of continued patronage, for whatever reason; and
* the expectancy that old customers will resort to the old place.
Early in 1993, the U.S. Supreme Court, in Newark Morning Ledger Company v. U.S. (113 S.Ct. 1670, 93-1 USTC 50228), held that a taxpayer who is able to prove a particular asset can be valued and has a limited useful life that can be ascertained with reasonable accuracy may depreciate the value over the useful life regardless of how much the asset appears to reflect the expectancy of continued patronage. However, the Supreme Court also indicated that the taxpayer's burden of proof is "substantial" and "often will prove too great to bear."
Congressional Response (An Overview of IRC Sec. 197)
IRC Sec. 197 allows the amortization of goodwill and eliminates the need to establish separate and distinct values for goodwill vs. other intangible assets. It should also eliminate disputes arising from the need to place individual values on intangible assets. Under IRC Sec. 197, all intangible assets receive the same tax treatment. The only valuation task is to separate the values of tangible and intangible assets. Because the market value of tangible assets is relatively easy to determine, this task should pose no problems. Furthermore, under IRC Sec. 338(b) and related regulations, the residual method has already been established as the accepted method of separating tangible and intangible asset values. Finally, the need to determine useful lives for intangible assets is eliminated through the statutory recovery period of 15 years, which treats all intangibles as if they had the same useful life.
While reducing the costs associated with dispute resolution, the greatest benefit of IRC Sec. 197 may be the certainty it brings to the marketplace. Given the value placed on intangible assets, their tax treatment can affect an acquisition decision. Before IRC Sec. 197, taxpayers were involved in a "crap shoot" regarding intangibles.
Important Exception to IRC Sec. 197 Coverage. The statute does not apply to self-created intangible assets, such as goodwill created through advertising and other such expenditures. Therefore, IRC Sec. 197 does not prevent the current deduction of such costs.
Key Strategy Change. Prior to the enactment of IRC Sec. 197, taxpayers would attempt to unbundle goodwill into its components so those components would be amortizable. For instance, subscriber lists for a newspaper would be valued and then amortized, rather than simply being lumped in with overall goodwill arising from purchase of the newspaper. Now, taxpayers may be willing to simply lump all intangibles together because the amortization period is 15 years for all of them, and significant valuation and documentation costs may be avoided. Also, as discussed later, no loss from disposition of an intangible can be recognized until either the 15-year amortization period has expired or the business acquired is disposed of.
Variable Impact of IRC Sec. 197. Some formerly non-amortizable intangibles (e.g., goodwill) are now amortizable and some formerly non- capitalizable and currently deductible intangibles (e.g., costs related to covenants not to compete) are now capitalizable and amortizable.
Effective Dates. In general, IRC Sec. 197 applies to property acquired after August 10, 1993 (the RRA '93 date of enactment). However, a retroactive election and a binding contract exception also apply. Reg. Sec. 1.197-1T (issued March 10, 1994) contains specific details regarding these items. They are briefly summarized below.
An election may be made to apply IRC Sec. 197 to all property acquired after July 25, 1991. If the election is made, it also applies to any taxpayer under common control with the electing taxpayer during the period beginning November 22, 1991, and through the date of the election. The election must be made on a timely filed federal income tax return (including extensions) for the election tax year. The election may only be revoked with IRS consent. Certain "anti-churning rules" may prohibit the election when the property is acquired after July 25, 1991 and either a) the acquisition is from a related taxpayer or b) the user of the property does not change.
Prior law may be applied if property acquired after August 10, 1993, is acquired pursuant to a binding written contract that was in effect on August 10, 1993, and at all times thereafter until the property was acquired. If the taxpayer uses the retroactive election, the taxpayer may not use the binding contract exception.
Definition of IRC Sec. 197 Intangible
An IRC Sec. 197 intangible is an intangible acquired and held in connection with a business or an activity engaged in for the production of income. Although an IRC Sec. 197 intangible is usually acquired as part of a business acquisition, such an acquisition is not always required. Also, a stock acquisition followed by an IRC Sec. 338 election (a deemed liquidation of a subsidiary treated as though assets were purchased) may involve IRC Sec. 197 intangibles.
An IRC Sec. 197 intangible is any property included in any one or more of the following categories:
* Going concern value;
* Any of the following intangible items:
-- Workforce, including its employment composition, terms, and conditions, contractual or otherwise,
-- Information base, including business books and records, operating systems, lists of information concerning current or prospective customers, and similar information.
-- Know-how, including patents, copyrights, formulas, processes, designs, patterns, formats, and similar items,
-- Customer-based intangibles including market composition, market share, and any other value resulting from provision of goods or services pursuant to relationships, contractual or otherwise, in the ordinary course of business with customers,
-- Supplier-based intangibles, including any value resulting from future acquisitions of goods or services pursuant to relationships, contractual or otherwise, in the ordinary course of business with suppliers of goods or services to be used or sold by the taxpayer, and
-- Other similar items.
* Government-granted rights--any license, permit, or other right granted by a governmental unit or a related agency;
* Covenant not to compete--any covenant not to compete, or other arrangement that has substantially the same effect as a covenant not to compete, that is entered into in connection with the direct or indirect acquisition of an interest in a business, or a substantial portion of a business; and
* Identity rights--any franchise, trademark, or trade name.
IRC Sec. 197 Intangible--Excluded Assets
IRC Sec. 197 intangibles do not include the following:
* Financial interests--any interest in a corporation, partnership, trust, or estate; any interest under an existing futures contract, foreign currency contract, notional principal contract, interest rate swap, or other similar financial contract;
* Land--any interest in land;
* Computer software--any computer software that is readily available for purchase by the general public, is subject to a non-exclusive license, and has not been substantially modified, and other computer software that is not acquired in a transaction, or a series of related transactions, involving the acquisition of assets constituting a business or a substantial portion of a business. ("Computer software" means any program designed to cause a computer to perform a desired function. Computer software does not include any database or similar item unless the database or item is in the public domain and is incidental to the operation of otherwise qualifying computer software);
* Interests or rights acquired separately--Any of the items below if they are not acquired in a transaction, or a series of related transactions, that is the acquisition of assets constituting a business or a substantial portion of a business:
-- Any interest in a film, sound recording, video tape, book, or similar property,
-- Any right to receive tangible property or services under a contract or granted by a governmental unit or agency or instrumentality thereof,
-- Any interest in a patent or copyright, and
-- Under forthcoming regulations, any right under a contract, or granted by a governmental unit or an agency or instrumentality thereof, if such fight has a fixed duration of less than 15 years, or is a fixed amount and, without regard to IRC Sec. 197, is amortizable under a method similar to the unit-of-production method;
* Interests under leases and debt instruments--any of the items below if the interest arose as a result of a lease or a debt instrument:
-- An existing lease of tangible property, or
-- An existing debt (unless it is a financial institution's customer debt);
* Sports franchises--any franchise to engage in professional sport (e.g., football, basketball, or baseball), or any item acquired in connection with the acquisition of such a franchise;
* Mortgage servicing rights--any right to service mortgage debt secured by residential real property, unless the right is acquired in a transaction, or a series of related transactions, involving the acquisition of assets constituting a business or a substantial portion of a business; and
* Transaction costs--any fees for professional services, and any transaction costs, incurred in a corporate acquisition that is nontaxable under Part III of Subchapter C (corporate organizations and reorganizations, IRC Secs. 351-368).
Relationship to IRC Sec. 1060 (Allocation of Business Purchase Price)
IRC Sec. 1060 (a) and Reg. Sec. 1.1060-1T require the buyer and seller to allocate the purchase price according to the rules of IRC Sec. 338(b). If an IRC Sec. 338 election is made, the rules of IRC Sec. 1060 do not apply because the IRC Sec. 338 rules apply. IRC Sec. 1060 applies to applicable asset acquisitions. Thus, the buyer and the seller must use the residual method as described in Reg. Sec. 1.338(b)- 2T.
This regulation states that basis is allocated by categorizing assets into four classes and then allocating the total purchase price to those classes. The four classes of assets are defined as in Exhibit 1.
The purchase price is allocated first to Class I assets, with any remainder allocated first to Class II assets, then Class III assets, and finally to Class IV assets in proportion to their fair market values. This allocation approach prevents allocating more than FMV to Class I, II, and III assets and, thus, has a tendency to increase allocations to goodwill.
The IRC Sec. 197 committee reports instruct the IRS to amend the IRC Sec. 1060 regulations to move all IRC Sec. 197 intangibles to Class IV. Presently, many IRC Sec. 197 intangibles fall in Class III because Class IV includes only goodwill and going concern value.
Applicable Asset Acquisitions Defined. Applicable asset acquisitions means any transfer, whether directly or indirectly, of assets that constitute a business, with respect to which the transferee's basis in the acquired assets is determined by reference to the consideration paid for them.
The information required to be reported from the parties of an applicable asset acquisition include 1) amounts allocated to goodwill or going-concern value, 2) amounts allocated to other categories of assets or specific assets, and 3) other information the IRS deems necessary or appropriate. Form 8594 must be filed by the purchaser and seller of assets to which goodwill or going-concern value could attach. The form is filed for all applicable asset acquisitions.
Example: On January 1, 1993, Sarah, a sole proprietor, sells to Parsons, Inc. a group of assets that constitutes a business. Parsons pays Sarah $2,000 in cash and assumes $1,000 in liabilities for a total consideration of $3,000. On the purchase date, Parsons acquires no Class I assets, $400 of Class II assets, and $2,400 of Class III assets including $100 relating to a covenant not to compete, all at fair market value.
Result Prior to RRA '93. The amount of consideration allocable to the Class II, III, and IV assets is the total consideration reduced by the amount of any Class I assets. Since Parsons acquired no Class I assets, the total consideration of $3,000 is next allocated first to Class II and then to Class III assets. Since the fair market value of Class II assets is $400, $400 of consideration is allocated to Class II assets. Since the remaining amount of consideration is $2,600, an amount that exceeds the fair market values of the Class III assets ($2,400), the amount allocated to each Class III asset is its fair market value. Thus, the total amount allocated to Class III assets is $2,400. The amount allocated to the Class IV assets (assets in the nature of goodwill and going-concern value) is $200.
Result Under RRA '93. If the transaction occurred after August 10, 1993, or the acquiring corporation made the retroactive IRC Sec. 197 election, the covenant not to compete would become a Class IV asset. The FMV and amount allocated to the Class III assets would be $2,300. The residual amount would be $300. That amount would be allocated to the covenant not to compete and to goodwill based on their relative FMV. The covenant not to compete would be capitalized at $100 and amortized over 15 years-- regardless of the payment scheme the covenant agreement calls for. The $200 goodwill would also be amortized over 15 years.
What if the assets FMV was $3,000, and the purchase price only $2,500? Before RRA '93, the covenant not to compete would be allocated some basis because it was a Class III asset. After RRA '93, the covenant not to compete is a Class IV asset and would have no basis because all of the purchase price is used up in the allocations to the Class II and III assets.
Generally, an IRC Sec. 197 intangible is not an "amortizable IRC Sec. 197 intangible" if it is created by the taxpayer. Consequently, an intangible (e.g., goodwill) is not amortizable, even if for some reason it has a tax basis, unless the intangible is created in a transaction, or a series of related transactions, that involve the acquisition of assets that constitute a business or a substantial portion of a business.
A "substantial portion of a business" is determined based on all the facts and circumstances. The nature and amount of the assets acquired as well as the nature and amount of the assets retained by the transferor are important. However, the relative value of the assets retained by the transferor vs. the assets transferred is not determinative of whether a substantial portion of a business has been transferred.
Certain intangibles are not included in the self-created intangibles exception. Any license, permit, or other right granted by a governmental unit or agency or instrumentality of such an organization, any covenant not to compete, and any franchise, trademark, or trade name, even if self-created, is still an amortizable IRC Sec. 197 intangible.
Determination of Adjusted Basis
The adjusted basis of an IRC Sec. 197 intangible is generally equal to its purchase price. However, if a portion of the purchase price is contingent, the adjusted basis is increased at the beginning of the month the contingent amount is paid (cash basis) or incurred (accrual basis). The increased adjusted basis is then amortized over the remaining portion of the original 15-year amortization period.
IRC Sec. 197 amortization occurs monthly, beginning with the month the property is acquired. Consequently, there are 180 months (15 years x 12 months) of amortization. In a short tax year, the number of months in the short year is used to amortize the IRC Sec. 197 intangible.
Dispositions of IRC Sec. 197 Intangibles
No Loss Recognition. If an IRC Sec. 197 intangible is disposed of at a loss, the loss is not deductible unless there are no remaining IRC Sec. 197 intangibles from the transaction, or series of related transactions, that created the IRC Sec. 197 intangibles. The non-deductible loss increases the basis of the remaining IRC Sec. 197 intangibles, and is allocated to them based upon their relative remaining adjusted bases.
Related Taxpayer Rule. A disposition of an IRC Sec. 197 intangible has not occurred if the intangible is still held by a person that is a related taxpayer under IRC Sec. 41(f)(1), the related taxpayer rule for research and development. This definition of a controlled group includes parent-subsidiary and brother-sister controlled groups as well as a combined group under common control.
Special Rule for Covenants not to Compete. A covenant not to compete cannot be treated as disposed of until all interests in the business that was directly or indirectly acquired in connection with the creation of the covenant are disposed of or become worthless.
Example: Kajawa Corporation buys all the stock of Steven Smith Enterprises and obtains a covenant not to compete from Steven Smith, the company's sole shareholder. Two years later, Kajawa and Steven Smith mutually agree to abandon the covenant. Kajawa retains ownership of all the stock of Steven Smith Enterprises anti continues to operate the company. Kajawa must continue to amortize the covenant over its 15-year life even though the covenant no longer has legal effect.
Three years later Kajawa sells its Steven Smith Enterprises stock to an unrelated third party. At that time, Kajawa may deduct the remaining basis of the covenant.
Gain Recognition. If IRC Sec. 197 intangibles are disposed of at a gain, the gain is recognized. To the extent the gain recognized represents a recapture of previous IRC Sec. 197 amortization, the gain is recaptured as ordinary income under IRC Sec. 1245.
Exchange of IRC Sec. 197 Intangibles. If IRC Sec. 197 intangibles are disposed of in an exchange transaction, the transferee succeeds to the IRC Sec. 197 amortization to the extent of the adjusted basis received from the transferor. This exchange treatment applies to the following IRC transactions:
* Sec. 332, liquidation of a controlled subsidiary;
* Sec. 351, nontaxable incorporation;
* Sec. 361, nontaxable reorganizations;
* Sec. 721, nontaxable partnership formation;
* Sec. 731, nontaxable partnership distribution;
* Sec. 1031, like-kind exchanges; and
* Sec. 1033, involuntary conversions.
Also, transfers within an affiliated group for which a consolidated return is filed receive exchange treatment.
Special Rule For Franchises and Franchise Renewals
The term "franchise" also includes trademarks and trade names. A franchise is any agreement that provides one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area. According to the committee reports, the acquisition of a franchise is deemed to be the acquisition of a business. Therefore, franchise acquisition costs must be capitalized and amortized under IRC Sec. 197.
Formerly, amortization of franchises occurred over either 10 years (franchise acquisitions of less than $100,000) or 25 years (franchise acquisitions of $100,000 or more and certain contingent payments). Now, the costs of franchises are amortizable under the IRC Sec. 197 15-year rules. However, IRC Sec. 1253 continues to allow a current deduction for contingent amounts paid based on productivity, use, or disposition of the franchise. The contingent amounts are currently deductible only if they are paid as part of a series of amounts payable at least annually throughout the term of the franchise agreement, and the payments are substantially equal in amount or payable under a fixed formula.
Example: Suds, Inc. is a franchisor of dog washes. On January 1, 1994, Pups, Inc. acquires a Suds franchise for the island of Oahu. The franchise is for 20 years and Pups pays a lump sum of $24,000 plus $2,000 per year for the second through sixth years. Also, Pups must pay 6.5% of its gross monthly revenue to Suds.
The 6.5% of monthly revenue is not capitalizable and is deductible when accrued (if Pups is an accrual-basis taxpayer) or paid (if Pups is a cash-basis taxpayer).
The $24,000 franchise acquisition cost is amortizable over 15 years. If Pups is a cash-basis taxpayer, each year when the additional $2,000 payment is made, the payment is added to Pups' adjusted basis for the franchise. The new adjusted basis is amortized over the remaining months in the 15-year amortization period. If Pups is an accrual-basis taxpayer, the basis of the franchise is initially $34,000 $24,000 + (5 X $2,000) because the liability for the second through sixth payments of $2,000 each is fixed.
Renewals. When the franchise is renewed, the costs of renewal are capitalized and amortized over a new 15-year period.
Other Special Rules
Reinsurance Contracts. If the IRC Sec. 197 intangible arises from an assumption reinsurance transaction, the intangible's adjusted basis is the amount paid less the amount required to be capitalized under IRC Sec. 848. IRC Sec. 848 requires capitalization and allows 5-year amortization of certain policy acquisition expenses.
Subleases. A sublease is treated in the same manner as a lease of the underlying property. Consequently, subleases of tangible property are not IRC Sec. 197 intangibles because they are specifically excluded by IRC Sec. 197(e)(5)(A).
IRC Sec. 197 Amortization Is Depreciation. Any amortizable IRC Sec. 197 intangible is treated as property depreciable under IRC Sec. 167.
Anti-Churning Rules. To prevent abuse, IRC Sec. 197(f)(9) contains rules that make IRC Sec. 197 inapplicable when the transfer occurs after July 25, 1991, and does not involve a change in the user of the property. User is defined in two ways--when a related taxpayer becomes the user or the actual user does not change.
A related taxpayer is defined broadly and uses a 20% control test. However, if the IRC Sec. 197 intangible acquisition was from a decedent, the anti-churning rules do not apply, and IRC Sec. 197 amortization may be available. Also, when the transfer involves a partnership and transactions under IRC Secs. 732, 734, or 743, the anti-churning provisions are applied at the partner level. Each partner is treated as having owned and used their proportionate share of each partnership asset.
Anti-Abuse Rule. The term "amortizable IRC Sec. 197 intangible" does not include any IRC Sec. 197 intangible acquired in a transaction that occurred after August 10, 1993 and had as a principal purpose avoiding the applicability of IRC Sec. 197 by backdating the transaction or deliberately avoiding the anti-churning rules.
Treasury Guidance Critical
IRC Sec. 197 provides a sensible framework that seeks to end the uncertainties and disputes that existed with purchased intangibles prior to its enactment. Although the statute is long and detailed, the result is administrative simplification for taxpayers and the IRS. As is common with many recent simplification efforts, however, there are significant grants of authority to the Treasury Department, including the power to include and exclude certain assets. Treasury guidance will be critical to maintaining the simplification sought by Congress.
EXHIBIT 1 CLASSES FOR ALLOCATION OF PURCHASE PRICE UNDER IRC SEC. 338
Class I: Cash, demand deposits and similar accounts in depository institutions, and other similar items designated by the IRS.
Class II: Certificates of deposit, U.S. Government securities, readily marketable securities Reg. 1.351-1 (c)(3) foreign currency, and other similar items designated by the IRS.
Class III: All assets other than Classes I, II, and IV. This includes both intangible and tangible assets without regard to whether they are depreciable, depletable, or amortizable.
Class IV: Intangible assets in the nature of goodwill and going-concern value.
Steven C. Dilley, PhD, CPA, is a professor at Michigan State University, East Lansing, MI. James C. Young, PhD, CPA, is an assistant professor at George Mason University, Fairfax, VA.
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