Separately identifiable intangible assets: tax opportunities and traps.

• Author: Gruidl, Nick

In Letter Ruling 201016053, (1) the IRS ruled that where a taxpayer could separately identify and distinguish acquired customer-based intangibles from self-created customer-based intangibles, the taxpayer could separately calculate gains on the sale of each, thereby avoiding Sec. 1245 ordinary income recapture on the sale of the self-created customer-based intangibles. The ruling is consistent with a recent Chief Counsel Advice (CCA) (2) holding that customer-based intangibles (among others) "can be separately described and valued apart from goodwill" and thus qualify as like-kind property under Sec. 1031. The underlying technical analysis of the ruling, albeit not groundbreaking, is significant to taxpayers in a variety of transactions outside of Sec. 1245 recapture, such as the application of the Sec. 197 antichurning provisions and the Sec. 1374 built-in gain (BIG) tax.

Simplified Ruling and Fact Pattern

The ruling appears to involve the sale of certain partnership interests held by an S corporation following the implementation of an Up-C (3) initial public offering (IPO) transaction. Simplifying the facts in the ruling, shareholder SH owns S, a subchapter S corporation, which in turn owns an interest in the operating LLC (taxed as a partnership for federal tax purposes). The remainder of the LLC interest is owned by P, which prior to the IPO was controlled by SH. Following the IPO, P acquired LLC interests from 5. The acquisition by P was presumably eligible for an election under Sec. 754 and asset basis adjustments under Sec. 743. The exhibit shows a simplified structure that differs from the actual structure in the ruling.

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The LLC owned both self-created and acquired customer-based intangibles. The acquired intangibles were customer relationships with terminable-at-will written service contracts. The LLC acquired the intangibles while it was primarily engaged in the provision of Service A. The LLC took a cost basis in the assets and began amortizing them over 15 years. Following the acquisition, the LLC expended significant capital to expand its service offerings to include Service B and develop the capability to service customers it previously was unable to serve. The LLC operates in a competitive industry that requires continued capital investment, which the taxpayer (P) claimed was necessary to keep customers from choosing competitors. As a result, the LLC held x number of acquired customer relationships that were different from y number of self-created customer relationships.

Gain on the sale of the customer-based intangibles, presumably as a result of the application of Sec. 751, would generate ordinary income recapture under Sec. 1245 up to the amount of amortization deductions claimed on the intangibles. However, if the LLC could establish that rather than being a single intangible asset, the self-created customer-based intangibles were separate from the acquired customer-based intangibles, ordinary income recapture on the sale would be limited to gain on the acquired intangibles. (4)

Example: LLC pays $45 million for customer-based intangibles and also creates customer-based intangibles in the ordinary course of business. LLC disposes of the business assets in a taxable transaction. LLC had claimed $30 million of amortization on the acquired intangibles through the date of the sale. The total purchase price allocated to customer-based...