Depreciation of customer-based intangibles confirmed by Supreme Court in Newark Morning Ledger.

• Author: Persellin, Mark B.

The Supreme Court of the United States recently held in Newark Morning Ledger Co. v. United States(1) that customer-based intangible assets, such as newspaper subscription lists, can be depreciated for federal tax purposes.(2) In a 5-4 decision, the Court held that an intangible asset is depreciable if two conditions are met: (i) the asset has a limited life that can be reasonably estimated; and (ii) the asset can be valued. This decision thus rejects the Internal Revenue Service's per se rule that customerbased intangibles acquired in the purchase of a going concern are indistinct from (non-depreciable) goodwill. The decision in Newark Morning Ledger will directly affect the disposition of many intangible asset disputes currently under audit or in litigation. According to a recent General Accounting Office report, in 1989 the IRS's open cases on customer-based intangibles alone accounted for proposed adjustments of more than $4 billion.(3) Newark Morning Ledger, however, will not summarily resolve these disputes. Indeed, the Court's opinion emphasizes the heavy burden a taxpayer must carry in establishing that the two-part test for depreciation is satisfied.

When the assets of a going concern are acquired by purchase (either outright or by way of a stock acquisition followed by liquidation), the "residual method" is used to allocate the purchase price to the various acquired assets.(4) Under this method, the total purchase price is allocated to assets other than goodwill to the extent of their fair market values and any residual cost basis is allocated to goodwill. In an effort to allocate as little cost basis as possible to the residual goodwill, purchasing companies have argued for the existence of various acquired (non-goodwill) intangible assets to which a portion of the purchase price can be allocated and recovered through depreciation. The GAO report indicated that the value of non-goodwill intangibles reported by taxpayers increased from $45 billion in 1980 to $262 billion in 1987. To support both an limited life and ascertainable value of these acquired intangibles, taxpayers have made extensive use of modern statistical methodologies. Customer-based intangibles (e.g., customer lists, newspaper and magazine subscription lists, and bank core deposits) have attracted much of the attention surrounding the issue of intangible asset depreciation, but taxpayers' overall ingenuity in this area has been impressive. Exhibit I illustrates this ingenuity by reproducing the GAO's listing of the nongoodwill intangible assets claimed by taxpayers.

By eliminating the IRS's blanket argument that customer-based intangibles acquired as part of a going concern are per se indistinct from goodwill, Newark Morning Ledger represents a dear taxpayer victory. The decision offers benefits not only to those taxpayers that participated in the acquisition frenzy of recent years, but also to the financial and statistical experts who are called upon to establish the necessary useful lives and values. At the same time, the decision confirms the factual nature of the intangibles inquiry and the taxpayer's heavy burden of proof.

This article examines the issue of customer-based intangible asset depreciation in light of the Supreme Court's decision in Newark Morning Ledger. After examining the statutory and regulatory requirements for depreciation, the article reviews the results of pre-Newark customer-based intangibles litigation. Newark Morning Ledger is then discussed and analyzed at length. The article concludes with an examination of that decision's implications for taxpayers, including the prospects for legislative action to resolve much of the uncertainty still surrounding the intangible issue.

The Statute and the Regulations

Section 167 provides for a depreciation deduction of "a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)" in the case of business property or property held for the production of income. While tangible property is subject to the cost recovery rules of section 168 (i.e., MACRS), depreciation of intangible property continues to be governed under section 167. Treas. Reg. (section) 1.167(a)-3 provides that a depreciation allowance is permitted for intangible assets with a limited useful life that can be estimated with reasonable accuracy.

Patents and copyrights are the only examples in the regulations of intangibles offered as being depreciable. The provision specifically prohibits a depreciation deduction with respect to goodwill and other intangibles having indeterminate lives. "Goodwill" is not defined in the regulations; instead, that chore has been left to the courts. That intangible assets, other than goodwill,(5) are depreciable has been a longstanding position of Treasury as evidenced by regulatory pronouncements dating back to the early 1900s.(6)

Goodwill, Customer-Based Intangibles, and the Courts

Customer-based intangibles--such as customer lists, subscription lists, client records, bank core deposits, and insurance expirations--have been the source of much litigation over the years. The IRS's position is that these intangibles represent the customer structure of a business and are in the nature of goodwill or otherwise have indeterminate lives. The question whether customer-based intangibles are depreciable thereby is grounded in the definition of goodwill. Goodwill is frequently defined as "the expectancy of continued patronage, for whatever reason."(7)

Prior to 1973, courts had frequently found customerbased intangibles to be indistinct from goodwill, generally by applying the "mass asset" doctrine. Under that rule, an asset that is self-regenerating (i.e., non-fluctuating in value because the loss of some customers was offset by the addition of other customers) provides a non-diminishing benefit for an indeterminate life and, therefore, is non-depreciable.(8) The courts routinely applied the mass-asset rule in rejecting depreciation deductions on customer-based intangibles acquired in the purchase of a going concern? In 1973, however, the United States Court of Appeals for the Fifth Circuit ruled in Houston Chronicle Publishing Co. v. United States,(10) that the mass-asset doctrine did not serve as aper se rule for the non-depreciation of customer-based intangibles. In that landmark case, the taxpayer had acquired a subscribers list for a newspaper that had ceased publication. The court ruled that a depreciation deduction was allowable upon a determination that the intangible had an ascertainable value and a useful life that could be reasonably determined. A jury had concluded that the taxpayer had satisfied its burden of proof in meeting that two-part test in the case of the subscription list; thus, the customer-based intangible was held to be depreciable.

The IRS's response to Houston Chronicle was Rev. Rul. 74-456,(11) which declared customer-based intangibles to be generally indistinct from goodwill and non-depreciable. The IRS did concede, however, that "if in an unusual case the asset . . . is suspectable of valuation, and is of use to the taxpayer... for only a limited period of time, a depreciation deduction is allowable-(12) In the aftermath of Houston Chronicle, the IRS abandoned the "mass asset" doctrine as support for a per se rule against the depreciation of customer-based intangibles, and publicly adopted the...