When a business, trade, or practice is sold, the treatment of the consideration allocated to the businesses' intangible assets can be a complex matter, especially when a portion of those assets falls outside of Code Sec. 197. This article provides an overview of the key rules for how to handle the tax consequences for non- Code Sec. 197 intangibles.
Historical treatment of intangibles. Before the enactment of Code Sec. 197 9, many intangibles, including goodwill and going concern value, were treated as nondepreciable and nonamortizable because they had indeterminate useful lives. (Reg. §1.167(a)-3) These assets would essentially “sit” in the company's books until the company was sold. However, they were generally written off for accounting purposes—appearing to diminish a company's earnings without providing any corresponding tax relief. This led to a good deal of litigation over various taxpayers' attempts to construe goodwill as something that gave rise to deductions and produced a current tax benefit.
Similarly, IRS took the position that assets such as customer and subscription lists, insurance expirations, etc., generally had an indeterminate useful life and were therefore nondepreciable. However, these assets were occasionally depreciable in the unusual situation where a customer-based intangible (or portion thereof) didn't possess the characteristics of goodwill, was susceptible to valuation, and was useful to the business for only a limited period of time. (Rev Rul 75-456, 1974-2 CB 65)
For other intangibles with determinable lives, including patents and copyrights, a taxpayer could write off its adjusted basis (generally cost) in the intangible for its legal life or, if the taxpayer could prove a shorter period, its useful life. For a covenant not to compete, the cost could generally be amortized over the period of the agreement where the elimination or restraint of competition was for a definite and limited time. However, where the benefits of the restraint or elimination of competition were permanent or for an indefinite duration, no deduction was allowable.
Then, in the landmark’93 case of Newark Morning Ledger, 71 AFTR 2d 93-1380, which dealt with an asset called “paid subscribers,” the Supreme Court held that an asset could be depreciated, no matter how closely it resembled goodwill, if the taxpayer could value the asset and establish that it had a useful life. Code Sec. 197 was enacted later in ’93.
Background on Code Sec. 197. In response to the conflict between IRS and taxpayers regarding the treatment of goodwill, Congress enacted Code Sec. 197, which allows amortization of goodwill over 15 years. However, Code Sec. 197 also subjects other types of property acquired in connection with the goodwill, which a taxpayer could previously write off over shorter periods of time, to the same 15-year recovery period. For instance, a patent with five years remaining on it is written off over 15 years under Code Sec. 197, but under prior law it could have been written off over five years.
In general, an amortizable Code Sec. 197 intangible is an intangible of the type listed in Code Sec. 197(d)(1) acquired after Aug. 10,’93 (or July 25,’91, if the taxpayer made a valid retroactive election) and held in connection with the conduct of a trade or business or a Code Sec. 212 production-of-income activity.
Code Sec. 197 intangibles include assets such as goodwill and going concern value; workforce in place; information base; insurance policy expiration; know-how; customer-based intangibles; bank deposit bases; supplier-based intangibles; covenants not to compete; trademarks and trade names; contracts for the use of, and term interests in, other Code Sec. 197 intangibles; and certain similar items. The following are also treated as Code Sec. 197 intangibles if they were acquired in connection with the acquisition of assets constituting a trade or business or a substantial portion thereof: certain types of computer software (in general, software that is not readily available, is subject to an exclusive license, or has been significantly modified for the business); films, sound recordings, video tapes and books; copyrights and patents; and certain rights to receive tangible property or services under a contract granted by the government. The cost of these assets is amortized ratably over a 15-year period.
If a business owned intangible assets that it amortized under Code Sec. 197, these assets will be treated as Code Sec. 1231 assets when they are sold as part of the business and will generate Code Sec. 1245 recapture. (Code Sec. 197(f)(7); Code Sec. 1231(b); Code Sec. 1245(a)(2)(A))
However, the tax treatment of the part of the sales price allocable to intangible assets that aren't subject to Code Sec. 197 is more complicated. Such assets include:
... intangibles (such as goodwill and going concern value) acquired before the enactment of Code Sec. 197 (Aug. 11,’93; or July 26,’91 if a special retroactive transitional election was made) (Code Sec. 197(c)(1)(A));
... certain self-created intangibles (Code Sec. 197(c)(2)); and
... intangibles that were not purchased as part of a business acquisition. (Code Sec. 197(d)(1)(E); Code Sec. 197(e)(4))
Treatment of non- Code Sec. 197 intangibles. The tax treatment of many of these assets is determined largely with reference to pre- Code Sec. 197 law, and the treatment of others is examined under general capital gain provisions. For purposes of the following analysis, the business is presumed to be sold to an unrelated party.
...Goodwill and going concern value. The sales price of a business that's allocable to goodwill and going concern value acquired pre- Code Sec. 197 will be treated as an amount received for the sale of a capital asset. There won't be any Code Sec. 1231 gain or Code Sec. 1245 recapture income because these assets weren't depreciated or amortized.
...Customer-based intangibles. If the business that is being sold acquired its customer-based intangibles before the enactment of Code Sec. 197 and didn't claim depreciation deductions for them, these assets will be treated as capital assets for gain or loss purposes. However, if the business had depreciated a customer-based intangible, it will be treated as a Code Sec. 1231 asset triggering Code Sec. 1245 recapture. (Code Sec. 1245(a)(2)(A))
...Patents. A patent that was (i) created by the seller (or by someone else on the seller's behalf, unless in connection with a transaction involving the acquisition of assets constituting a trade or business, or a substantial portion thereof) (Code Sec. 197(c)(2)), (ii) acquired prior to Code Sec. 197, or (iii) acquired in a “one-off” transaction (i.e., purchased in a transaction that doesn't constitute the acquisition of a business or substantial portion thereof) (Code Sec. 197(e)(4)(C)), is excluded from Code Sec. 197. These patents may still be depreciable under Code Sec. 167 and written off over their “economically useful” lives—which can be, but are not necessarily the same as, the number of years remaining on the patent.
Assuming that the non- Code Sec. 197 patent isn't inventory in the hands of the seller, it's treated as the sale of a Code Sec. 1231 asset. Under Code Sec. 1245, however, gain will be treated as ordinary income to the extent of any depreciation claimed or allowable on the patent under Reg. §1.167(a)-3.
Observation: The sale of a patent may qualify for treatment as the sale of a capital asset held for more than one year under Code Sec. 1235 if: (i) the patent is sold by the individual inventor or an individual financial backer of the inventor (who is not an employer or related person); (ii) all substantial rights, or an undivided interest in all substantial rights, of the patent are transferred; and (iii) the transfer is not to a “related person” under Code Sec. 1235(d). Significantly, Code Sec. 1235 eliminates certain barriers that could otherwise prevent capital gain treatment—if the above requirements are met, it doesn't matter if the patent would otherwise constitute inventory in the hands of the holder, and it doesn't matter how long the holder held the patent prior to the sale. However, this provision is unlikely to be available in the context of the sale of a business.
...Franchise, trademark or tradename. In addition to acquisitions before Code Sec. 197’s enactment, Code Sec. 197 also excludes franchises, trademarks, or tradenames acquired in transactions where the transferor retained significant powers with regard to the intangible (Code Sec. 1253(a)), or transactions involving certain contingent payments.
If part of the sale price is contingent on the property's productivity or use, or if the seller retains any significant power, right, or continuing interest in the subject matter of the franchise, trademark, or trademark (e.g., the right to prescribe quality standards following the sale), then that part will be treated as an amount realized from the sale of a noncapital asset, and taxed as ordinary income to the seller under Code Sec. 1253. Additionally, if the seller claimed amortization deductions under former Code Sec. 1253(d)(2) or (d)(3) for a pre- Code Sec. 197 acquisition of a franchise, trademark or tradename, these amounts are subject to recapture under Code Sec. 1245.
...Covenant not to compete. If a portion of the proceeds from the sale of a business is allocable to a pre- Code Sec. 197 noncompete that was an asset of the business (e.g., one that was acquired by the now-seller when it initially bought the business from the previous owner), and no depreciation deductions were claimed, then this amount will be treated as an amount received for the sale of a capital asset. If the seller claimed amortization deductions, these amounts are subject to recapture under Code Sec. 1245.
Observation: If the seller of the business enters into an agreement not to compete with the buyer, payments under the covenant are taxable as ordinary income to the seller, and the non-compete covenant will be a Code Sec. 197 intangible in the hands of the buyer.
...Computer software. Computer software that was acquired by the now-seller in a one-off transaction, or that's readily available for purchase by the general public (otherwise known as “off the shelf”), subject to a non-exclusive license, or hasn't been substantially modified, is excluded from Code Sec. 197. Instead, it is generally depreciated under Code Sec. 167(f)(1) —i.e., straight line for 36 months. Thus, when the business is sold, any sale proceeds attributable to such non- Code Sec. 197 computer software is Code Sec. 1231 property, and prior depreciation deductions claimed will be recaptured under Code Sec. 1245. (A similar result would occur if the computer software had been expensed under Code Sec. 179.)
If the seller developed the computer software itself, or paid another to develop software on its behalf, then the seller likely elected to claim Code Sec. 174 research and development (R&D) deductions for such costs under Rev Proc 2000-50, 2000-2 CB 601. Although these deductions reduce the taxpayer's basis in the developed property, unlike depreciation, they don't trigger recapture income. Thus, any sale proceeds allocable to software developed by or for the taxpayer in excess of basis will be capital gain.
...Internet-based intangibles. Generally, the portions of a website's design that are produced from sophisticated programming languages (for example, the “C++” language widely used in website design) will qualify as “software” for Code Sec. 197 purposes. On the other hand, it is unclear whether the portions of a design produced from HTML (hypertext markup language) will qualify.
If the business developed its website itself (or had the website developed on its behalf), these costs may have been treated as deductible R&D under Code Sec. 174. However, the business may have amortized these costs over the three-year period beginning with the month in which the website is placed in service, or potentially expensed them under Code Sec. 179. In the end, the treatment of the portion of sale proceeds allocated to internet-based intangibles depends on how the seller treated these expenses.
Observation: Although the business use of websites is widespread, IRS guidance on the subject is extremely limited. The above standards are largely derived from established rules that apply to the deductibility of business costs in general and formal IRS guidance that applies to software costs in particular.
References: For treatment of goodwill and going-concern value that aren't amortizable Code Sec. 197 intangibles, see FTC 2d/FIN ¶L-8002; TaxDesk ¶229,500; United States Tax Reporter ¶1674.013; TG ¶14653. For Code Sec. 1245 recapture, see FTC 2d/FIN ¶I-10100; United States Tax Reporter ¶12,454; TaxDesk ¶223,100; TG ¶14725.