The Ins and Outs of Sec. 197

Sec. 197 covers the proper tax treatment for most acquired intangible assets. Prior to its enactment in 1993, entities that acquired another trade or business faced the heavy burden of a two-pronged test to amortize acquired intangibles. The taxpayer had to estimate the intangible asset’s useful life and ascertain a value; see Newark Morning Ledger Co., 507 US 546 (1993). There was no concrete definition of an intangible asset, nor guidance on estimated useful life.

For intangibles assets acquired after Aug. 10, 1993, Sec. 197 removed the uncertainty, by promulgating a list of intangibles that can be amortized for tax purposes over a 15-year life. Certain intangibles are outside Sec. 197’s scope and are subject to pre-Sec. 197 treatment.

Inclusions

The following intangible assets are covered by Sec. 197:

• Goodwill and going-concern value (Sec. 197(d)(1)(A) and (B));

• Workforce in place (Sec. 197(d)(1) (C)(i));

• Customer-based intangibles (Sec. 197(d)(1)(C)(iv));

• Supplier-based intangibles (Sec. 197(d)(1)(C)(v));

• Information base, know-how, patents and copyrights, including the costs incurred in package design (Sec. 197(d)(1)(C)(iii));

• Other similar items (Sec. 197(d) (1)(C)(vi));

• Covenants not to compete and similar arrangements entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof (Sec. 197(d)(1)(E));

• Franchises, trademarks and tradenames (Sec. 197(d)(1)(F));

• Licenses and permits granted by governmental units (Sec. 197(d) (1)(D));

• Certain contracts for the use of, and term interests in, Sec. 197 intangibles (Sec. 197(e)(4)(D)); and

• Intangibles leased to tax-exempt entities (Sec. 197(f)(10)).

When to Use

In many instances, tax professionals mistakenly believe that all intangible assets fall under Sec. 197. However, a Sec. 197 intangible asset is only one that is acquired in connection with the taxpayer’s trade or business, not necessarily all intangibles newly acquired; see Sec. 197(c)(1).

Example 1: D Co. entered into a five-year noncompete agreement with a former employee. For D, the agreement is outside the ambit of Sec. 197, because it was not acquired as part of the acquisition of a trade or business or a substantial portion of one. Accordingly, D can amortize the agreement over its five-year life.

Example 2: R Co. acquires D’s assets, including the five-year noncompete agreement. The agreement is an intangible asset acquired by R in the transaction. Thus, R has newly acquired a Sec. 197 intangible asset as part of the acquisition of a trade or business. The noncompete agreement has a new value that must be amortized over 15 years, regardless of its actual remaining life.

R now has a potential economic problem. The noncompete agreement could be close to the end of its useful economic life. The 15-year amortization period produces a significant book-to-tax difference.

Dispositions

The disposition of a Sec. 197 intangible is sometimes tricky. It is conceivable that an intangible asset with virtually no value, which has been written off for book purposes, must continue to be amortized under Sec. 197. If a taxpayer disposes of a Sec. 197 intangible that was acquired in a transaction (or a series of related transactions) and other Sec. 197 intangible assets were acquired in the same transaction (or the same related series of transactions), no loss can be recognized, under Sec. 197(f)(1)(A)(i). Instead, the adjusted basis of the retained intangibles is increased by the unrecognized loss. Under Sec. 197(f)(1)(A)(ii), the adjusted basis of any retained Sec. 197 intangibles is increased by the product of:

1. The loss that is not recognized, multiplied by

2. A fraction, the numerator of which is the adjusted basis of the intangible as of the disposition date; the denominator is the total adjusted basis of all retained Sec. 197 intangibles as of that date.

Thus, for example, a loss would not be recognized by a corporation that disposed of a Sec. 197 intangible if it is a member of a controlled group in which another member retained Sec. 197 intangibles acquired in the same transaction (or series of related transactions).

However, this rule does not apply to a Sec. 197 intangible that is separately acquired. Consequently, a loss may be recognized on the disposition of a separately acquired Sec. 197 intangible. The intangible asset, as a whole, must be deemed worthless and disposed of; no portion can be retained. For example, the termination of one or more customers from an acquired customer list, when the list is the only intangible asset acquired in a business acquisition, or the worthlessness of some information from an acquired database, is not a disposition of a separately acquired Sec. 197 intangible. The entire list and database must be disposed of or deemed worthless to deduct the loss. The Service might take a position that other intangibles were acquired at the same time the customer list was acquired, even though no such assets were recorded, and force the taxpayer to recover the remaining unamortized basis over the remaining useful life of such other acquired intangibles.

Exclusions

Sec. 197 does not apply to all intangible assets acquired in connection with the acquisition of a trade or business. The following intangibles are not covered:

• Interests in a corporation, partnership, trust or estate (Sec. 197(e)(1) (A));

• Interests under certain financial contracts (Sec. 197(e)(1)(B));

• Land interests (Sec. 197(e)(2)); 

• Certain computer software (Sec. 197(e)(3)(A));

• Certain interests in films, sound recordings, videotapes, books or other similar property (Sec. 197(e) (4)(A));

• Certain rights to receive tangible property or services under a government contract (Sec. 197(e)(4) (B)); 

• Certain interests in patents or copyrights (Sec. 197(e)(4)(C));

• Interests under leases of tangible property (Sec. 197(e)(5)(A));

• Debt interests (Sec. 197(e)(5)(B));

• Certain transaction costs (Sec. 197(e)(7)); and

• Regulatory authority regarding rights of fixed term or duration (Sec. 197(e)(4)(D)).

The tax treatment of many of these intangible assets is covered by pre-Sec. 197 law. Also, there is a difference in character between these intangibles and the items covered by Sec. 197. Logically, goodwill would not fall into the same category as an interest in land. Accordingly, tax advisers must look to other Code sections (such as Sec. 167 or 168) for guidance on the tax treatment of items excluded from Sec. 197’s purview.

Conclusion

Historically, and even in the current economic environment, many businesses look to acquire others for economies of scale and synergistic reasons. During the 1980s and 1990s, mergers and acquisitions were common; until Sec. 197 was enacted, it was difficult for tax professionals to help these businesses plan and account for the treatment of acquired intangibles. Sec. 197 removed some of the ambiguity and helps to establish concrete tax treatment for intangible assets. Sec. 197 is often rigid and inflexible (certainly with respect to dispositions), but overall, it offers a great deal more guidance than was available before 1993.

From Paul Bayer, CPA, Aidman, Piser & Company, P.A., Tampa, FL