What Is the Character of Pre-Sec. 197 Goodwill?

In Letter Ruling 200243002, the IRS held that pre-Sec. 197 (nonamortizable) goodwill is a capital asset. While this may be the right answer, there is more to the analysis than meets the eye.

Facts

The taxpayer is the parent of a consolidated group for Federal income tax purposes. In numerous transactions, it disposed of two divisions that it operated with its subsidiaries. Each transaction was structured as an asset sale or as a stock sale with a Sec. 338(h)(10) election; thus, all the transactions were treated as taxable asset sales for Federal income tax purposes.

For each transaction, the parent allocated the sales price using the residual allocation method under Secs. 1060(a) and 338(b)(5), allocating the sales price in excess of the fair market value of all other assets to goodwill and going-concern value (collectively, goodwill).

All of the goodwill was either (1) acquired before Aug. 11, 1993 (without a retroactive election under Temp. Regs. Sec. 1.197-1T) or (2) self-created. Thus, it was not amortizable.

The IRS held that the goodwill was a Sec. 1221 capital asset.

IRS Analysis

At issue was whether the goodwill was excluded from the definition of a capital asset under Sec. 1221(a)(2), which excludes property held by a taxpayer (whether or not connected with the taxpayers trade or business) that is [u]sed in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167

The Service acknowledged that under Sec. 197(f)(7), any amortizable Sec. 197 intangible is property that is of a character subject to the allowance for depreciation provided in Section 167. It noted that the goodwill was not subject to amortization under Sec. 197, because it was either (1) self-created or (2) acquired before Aug. 11, 1993 (the Sec. 197 effective date). Thus, because the goodwill was not amortizable, it was not subject to depreciation under Sec. 167. The IRS thus concluded that the goodwill qualified as a Sec. 1221 capital asset (i.e., the Sec. 1221(a)(2) exclusion did not apply).

Determination of Character?

The question is whether the Services analysis is oversimplified. What does the phrase of a character subject to mean? If Congress had merely intended to refer to depreciable (and amortizable) property, the phrase would have been unnecessary. How does the phrase broaden the scope of Sec. 1221(a)(2)?

It can be argued that a propertys character is a trait distinguishable from the timing of its purchase. For example, in 512 West Fifty-Sixth St. Corp., 4 TCM 53 (1945), affd, 151 F2d 942 (2d Cir. 1945), the Second Circuit held that a fully depreciated property was of a charactersubject to depreciation, even though it could not generate depreciation. The Tax Court had stated [t]he fact that depreciation has not been taken or that the[property] has been fully depreciated is immaterial as long as the property is of a character subject to depreciation. It held that because the property in question (a building) was of a character subject to depreciation, it met an exception to the definition of a capital asset contained in then-Sec. 117(a)(1).

In Twentieth Century Fox Corp., 45 TC 137 (1975), the court held that a taxpayers realized gain from the sale of all its rights in a motion picture film to its controlling shareholder was ordinary income under Sec. 1239 (i.e., the property was of a character subject to depreciation). Depreciation was not available on the film rights, because the taxpayer had adopted the income-forecast method for computing depreciation. Nonetheless, the court held that the property was of a character subject to depreciation, because depreciation would have been allowed under the Sec. 167(b)(1) straight-line method.

By analogy, it could be argued that the enactment of Sec. 197 changed the basic character of goodwill from a nonamortizable to an amortizable asset. Thus, the goodwill (or a portion thereof) was nonamortizable merely due to the timing of its purchase. Like the building described above, it would have been amortizable had it been acquired by the taxpayer at a later date. Although the goodwill was not amortizable on the sale date, it was of a character such that it could have been (and, presumably, it became amortizable immediately after the sale).

Faced with this argument, the IRS could assert that the character of pre-Sec. 197 goodwill relates directly to (and, thus, is not separable from) the propertys purchase date. In such case, the goodwills character is pre-Sec. 197 and, hence, nonamortizable. This assertion is supported by Lan Jen Chu, 486 F2d 696 (1st Cir. 1973), affg 58 TC 598 (1973), in which the court held that Sec. 1239(a) applies only to depreciable property and, thus, was inapplicable to a patent application.

Sec. 1239s language is similar to that of Sec. 1221(a)(2). Sec. 1239(a) treats a taxpayers gain on a sale of property to a related person as ordinary income if the property is, in the hands of the transferee, of a character which is subject todepreciation provided in section 167.

In Lan Jen Chu, the IRS attempted to treat a patent application as if it were a patent (an amortizable asset) in anticipation of the day it would probably become a patent. The application alone could not generate depreciation (or amortization). The court concluded that the patent application was not of a character subject to amortization.

Perhaps goodwill is distinguishable from the patent application in Lan Jen Chu. If purchased after the Sec. 197 effective date, the goodwill would have been amortizable. Thus, it could be argued that this amortizable character is inherent in the goodwill; no alteration, development or government approval is required for it to attain this character.

On the other hand, prior to the enactment of Sec. 197, goodwill was a capital asset; see, e.g., Patterson, 810 F2d 562 (6th Cir. 1987). Thus, the essential issue is whether the enactment of Sec. 197 altered the character of nonamortizable goodwill.

Until further guidance is available, taxpayers should carefully consider whether alternative tax positions are available for characterizing pre-Sec. 197 goodwill.

From Andrew Cordonnier, Washington, DC