Treatment of capitalized costs of intangible assets: this two-part article provides an overview of cost recovery for intangible asset expenditures. Part 2 covers the income-forecast and units-of-production methods, computer software, transaction costs and sec. 195 deductions.

• Author: Witner, Larry
• Position: Part 2

EXECUTIVE SUMMARY

* In many cases, taxpayers may be eligible to accelerate amortization deductions using the income-forecast or units-of-production methods.

* Transaction costs are added to the basis of acquired intangible assets, acquired stock or, in the case of a tax-free reorganization, a separate intangible asset.

* When acquiring a business, investigatory costs are amortized over 15 years, but facilitative costs may not be amortized.

This two-part article examines how capitalized costs of intangible assets are recovered. Part I, in the April 2007 issue, explained the INDOPCO regulations (17) and capitalization and amortization in the context of Sees. 197 and 167 (the useful-life method and 15-year amortization safe harbor). Part II, below, continues the discussion of capitalizing and amortizing intangible assets in the context of Sec. 167 (e.g., units-of-production method), computer software, transaction costs and certain Sec. 195 start-up costs.

Sec. 167

Units-of-Production Method

The cost of certain intangible assets can be recovered using the units-of-production method described in Regs. Sec. 1.167(a)-14. Example 1 below illustrates this method with a forward contract that, according to Regs. Sec. 1.263(a)-4(d) (2) (vi), includes an agreement under which a taxpayer has the right and obligation to provide or acquire property.

Example 1--units-of-production method: (18) S paid $1 million to B in exchange for a promise to purchase 1,000 units of S's product within the next three years (year 1-year 3). In year 1, B purchases 300 of the 1,000 units.

In essence, S gave B a sales discount in advance. Because S has the right and obligation to provide property,, the arrangement is a forward contract (category 1 intangible asset). According to the INDOPCO regulations, S must capitalize the $1 million sales discount. As for recovering it, neither Sec. 197 15-year amortization nor the 15-year amortization safe harbor of Sec. 167(a)-(3)(b) is appropriate. According to the units-of-production method under Regs. Sec. 1.167(a)-14(c)(2)(i), S's cost recovery deduction equals S's basis in the right ($1 million) times a fraction, the numerator of which is the number of units purchased this year (300), and the denominator of which is the total number to be purchased (1,000). Thus, for year 1, S's amortization deduction would be $300,000 ($1,000,000 x (300/1,000)).

Example 2--units-of-production method: The facts are the same as in Example 1, except no quantity is specified. Thus, B is given a sales discount on all purchases for the next three years, with no quantity specified.

According to Regs. Sec. 1.167(a)-14(c)(2)(ii), the capitalized amount ($1 million) would be recovered ratably over the three-year period. For all three years, S's amortization deduction would be $333,333 ($1,000,000/3).

Income-Forecast Method

Under the Sec. 167(g) income-forecast method, taxpayers can depreciate certain property on the basis of anticipated income. Specifically, a property's cost recovery deduction for a year is determined by multiplying its adjusted basis by a fraction, the numerator of which is current-year income, and the denominator of which is forecasted total income. Forecasted total income is that income expected to be generated prior to the close of the tenth year after the year the property is placed in service. Any costs not recovered by the end of the tenth year are deducted in that year.

The income-forecast method may be used to calculate cost recovery on copyrights, books, patents, motion picture films, theatrical productions, videotapes, sound recordings and similar property, under Sec. 167(g)(6). The following examples, dealing with patents, provide a good overview of the cost recovery possibilities for such assets.

Example 3--patents: A, an inventor, procured a patent and used it for eight years in his business. (In general, a patent has a legal life of 20 years.) (19) On Oct. 1, year 1, with 12 years (144 months) remaining on the patent's legal life, R Co. paid $48,000 for A's patent.

Under the INDOPCO regulations, R must capitalize the $48,000, because the patent is a category 1 intangible asset.

Example 4--patents: R from Example 3 obtained the patent as part of acquiring A's business.

The patent would be an amortizable Sec. 197 intangible. In year 1, R's amortization deduction would be $800 (($48,000/180 (months in 15 years)) x 3 (months in year 1)).

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