7.3 Amortization of Intangibles

Amortization of intangibles is a key aspect of tax planning for businesses. It allows companies to recover the costs of valuable non-physical assets over time, impacting their taxable income and overall financial strategy.

Section 197 governs the tax treatment of many intangibles, mandating a 15-year amortization period. This standardized approach simplifies calculations but may not align with an asset's actual economic life, creating potential tax planning opportunities and challenges for businesses.

Intangible assets for tax purposes

Characteristics and tax treatment

• Non-physical assets providing long-term economic benefits to businesses (patents, copyrights, trademarks, goodwill)
• Must have determinable useful life and be used in trade or business or held for income production
• IRC Section 197 outlines guidelines for intangibles acquired after August 10, 1993
• Capitalized rather than expensed, with costs recovered through amortization over time
• Tax basis typically acquisition cost, including legal and registration fees
• Self-created intangibles generally not amortizable unless specifically allowed by IRC

Types of intangible assets

• Section 197 intangibles encompass goodwill, going concern value, workforce in place, business records, patents, copyrights, formulas, franchises, trademarks, trade names
• Computer software treated as Section 197 intangible when acquired with a business
• Non-Section 197 intangibles may be amortizable under other IRC provisions (research and experimental expenditures under Section 174)
• Covenants not to compete considered Section 197 intangibles when acquired as part of business acquisition
• Customer-based intangibles (customer lists, relationships) amortizable under Section 197
• Supplier-based intangibles (favorable supplier contracts) subject to Section 197 amortization

Amortization of intangible assets

Section 197 intangibles

• Amortized ratably over 15-year period, regardless of actual useful life or agreement terms
• Amortization period begins on first day of month of acquisition
• Partial year amortization prorated based on months held during tax year
• Annual amortization deduction calculated by dividing adjusted basis by 15 years

Non-Section 197 intangibles

• May have different amortization periods based on estimated useful lives or specific IRC provisions
• Special rules apply for disposition of Section 197 intangibles
  • Potential recapture of amortization deductions
  • Impact on tax basis and gain/loss calculations

Examples and applications

• Patent acquired for $300,000: Annual amortization deduction of$20,000 ($300,000 / 15 years)
• Trademark purchased midyear for $150,000: First-year deduction prorated for 6 months,$5,000 ($150,000 / 15 years * 6/12)
• Software developed internally for $500,000: May be amortized over 36 months under Section 167 instead of 15 years

Amortization deduction calculation

Calculation methods

• Divide adjusted basis of intangible asset by 15 years for Section 197 intangibles
• Use straight-line method over estimated useful life for non-Section 197 intangibles
• Prorate deduction for partial years based on number of months held

Factors affecting calculation

• Acquisition cost and any capitalized expenses form the initial tax basis
• Adjustments to basis may occur due to improvements or partial dispositions
• Mid-month convention applies for determining the start of the amortization period

Practical examples

• Goodwill acquired for $1,500,000: Annual amortization deduction of$100,000 ($1,500,000 / 15)
• Customer list purchased for $600,000 in July: First-year deduction of$20,000 ($600,000 / 15 * 6/12)
• Research costs of $900,000 amortized over 5 years: Annual deduction of$180,000 ($900,000 / 5)

Goodwill tax treatment and amortization

Definition and recognition

• Excess of purchase price over fair market value of identifiable assets acquired in business combination
• Prior to Section 197, goodwill not amortizable for tax purposes
• Now treated as 15-year amortizable intangible under Section 197
• Self-created goodwill not amortizable, only acquired goodwill qualifies

Amortization rules

• Entire amount allocated to goodwill in business acquisition amortizable
• 15-year amortization period applies regardless of actual value decline rate
• Partial business disposition requires proportionate allocation of goodwill to assets sold

Special considerations

• Creates book-tax difference due to financial accounting rules requiring impairment testing
• Special rules for allocating purchase price to goodwill in asset acquisitions
  • Impacts amount subject to amortization
  • Requires careful documentation and valuation
• Recapture rules may apply upon disposition of business or goodwill