November 2010 -- In the September 2010 issue of InTouch we discussed how and when you can write off amortizable goodwill for tax purposes. This article will address the tax implications of writing off other types of intangible assets.
When acquiring the assets of a trade or business, purchase price is first assigned to tangible assets. The residual is assigned first to specifically identifiable intangible assets, such as customer lists, trademarks and covenants not to compete. The remaining purchase price (if any) is allocated to goodwill. These intangibles assets (including goodwill) are deemed to be Section 197 intangible assets for tax purposes and are amortized over a 15-year life. If a corporation is acquired by purchasing the ownership interests, e.g., purchasing the stock of a corporation, in most cases those intangibles are not Section 197 intangible assets and cannot be amortized for tax purposes, even if purchase accounting creates value for goodwill and other intangibles for financial statement purposes. Instead, the corporation continues to depreciate and amortize the same assets it had prior to the acquisition, and the entire purchase price is allocated to the basis in the buyers’ stock.
There are two key provisions that govern the ability to take deductions for an intangible asset – the loss regulations under Treas. Reg. §1.165-1 and the amortization rules under Code Section 197(f)(1).
Treas. Reg. §1.165-1 states that a loss on an asset is deductible to the extent the taxpayer has not been compensated by insurance or otherwise. The loss also must be evidenced by a closed and completed transaction. Although intangible assets are not capable of physical abandonment, the courts have concluded that intangibles may be treated as abandoned when the taxpayer demonstrates its intention to abandon the property, coupled with an act of abandonment. Generally, this means that intangibles either need to be sold or abandoned through a formal process such as a board resolution, withdrawal from participation in any activity involving the intangible, or cancellation of legal rights. Mere worthlessness is not enough. The taxpayer must have evidence to support the fact that the asset has been abandoned or sold.
Section 197(f)(1) denies any deduction for the abandonment of an intangible asset if other intangibles related to the original acquisition are retained by the taxpayer. Therefore, if multiple Section 197 intangibles were valued and recorded by the taxpayer at the time of the original purchase, the taxpayer cannot deduct the loss from the abandonment of only one of the intangible assets. Instead, Section 197(f) requires the taxpayer to increase the basis of the remaining Section 197 intangibles by the basis remaining in the abandoned asset. The increased basis is then recovered through amortization of the remaining Section 197 intangibles.
One of the biggest timing inequities of Section 197(f)(1) concerns covenants not to compete. Although the typical term for a covenant not to compete is much shorter than 15 years, the expiration of the term does not justify writing off the remaining tax basis of a Section 197 covenant not to compete. If the covenant was entered into in conjunction with a transaction in which other Section 197 intangibles were acquired, then the rules of Section 197(f)(1) require that any tax basis deemed to be written off will be applied to the basis of the remaining intangible assets acquired. In effect, there is no accelerated write off of the covenant not to compete.
In some circumstances a covenant not to compete is not a Section 197 intangible. For instance, if the covenant is entered into as part of a settlement or employment agreement that is not associated with the acquisition of substantially all of the assets of a trade or business, then the covenant not to compete generally is amortized over the term of the agreement. In addition, the loss disallowance rules of Section 197(f)(1) do not apply and, thus, do not prohibit the write off of any unamortized basis if the covenant becomes worthless before the end of its term.
If the loss on the Section 197 intangibles is allowed under the above rules, then the tax treatment of the loss is relatively straightforward. Section 197 intangibles are Section 1231 assets if held longer than 12 months. If the Section 197 intangibles are abandoned, the loss on the intangibles generally will be an ordinary loss. If the assets are sold, any long-term gain will be capital gain; however, in the case of a gain, Section 1245 requires the recapture of any amortization previously taken. Under Section 1245(b)(8) if a taxpayer disposes of more than one amortizable Section 197 intangible in a transaction or a series of related transactions, all such amortizable Section 197 intangibles shall be treated as one Section 1245 property for purposes of determining the Section 1245 recapture.
Writing off intangible assets requires careful analysis under a complicated series of tax provisions. If the assets are Section 197 intangible assets then the rules of Treas. Reg. §1.165-1 and Section 197(f)(1) need to be analyzed closely in order to determine the availability of any current losses. Contact your CBIZ MHM tax advisor for more information on how these rules impact your ability to deduct intangible assets.
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