Section 197: Congress and the IRS attempt to settle disputes involving amortization of intangibles.

• Author: Antognini, Walter G.

As part of the Omnibus Budget Reconciliation Act of 1993,(1)(*) Congress added section 197 to the Internal Revenue Code, which allows taxpayers to amortize most intangible assets ratably over a period of 15 years.(2) The enactment of section 197 represents a legislative effort to resolve a wide range of disputes between taxpayers and the Internal Revenue Service on the proper tax treatment of intangibles and to bring some measure of certainty to the area.

Before the enactment of section 197, taxpayers and the IRS fought over the legitimacy of amortization deductions for intangibles such as customer lists, covenants not to compete, goodwill and going concern value. Taxpayers sought to establish that the intangibles had an ascertainable cost basis separate and distinct from goodwill and going concern value and that intangibles had a limited useful life, the length of which could be ascertained with reasonable accuracy. The IRS attempted to refute these contentions, by arguing (among other things) that the intangibles were indistinguishable from goodwill and going concern value.

By allowing one standard amortization deduction for an expansive list of intangibles--so-called amortizable section 197 intangibles(3)--Congress sought to settle a heavily litigated area of tax law. The IRS can no longer deny deductions for assets in the nature of goodwill and going concern value, and taxpayers must accept an amortization period of 15 years for most intangibles, notwithstanding a possibly shorter economic life. Questions remain, however, whether section 197 will operate to eliminate controversies concerning intangibles.

The legislative history of section 197 calls upon the IRS to settle existing intangible amortization controversies (even though the provision itself is generally prospective). Pursuant to this mandate, the IRS has established settlement offer guidelines for pre-section 197 cases and, as of April 1, 1994, has started to contact taxpayers offering to settle. Although the settlement guidelines are not unduly generous, they do allow taxpayers to resolve thorny issues and salvage some tax benefits.

Background

Congress was driven to enact section 197 because of the substantial issues--in terms of numbers and dollar value--arising with respect to intangible assets.(4) Treas. Reg. [sections] 1.167(a)-3, establishing guidelines for the amortization of intangibles, was at the heart of the controversy. This regulation allows depreciation of an intangible that is used in business or in the production of income for only a limited period, the length of which can be estimated with reasonable accuracy. No depreciation is allowed for an intangible that does not have a limited useful life. In addition, the regulation specifically precludes depreciation of goodwill.

In 1993, the Supreme Court opined on the amortization of intangibles in Newark Morning Ledger Co. v. United States.(5) In interpreting the language of Treas. Reg. [sections] 1.167(a)-3, the Court concluded that "[t]he entire justification for refusing to permit the depreciation of goodwill evaporates ... when the taxpayer demonstrates that the asset in question wastes over an ascertainable period of time."(6) Thus, while accepting "expectancy of continued patronage" as a useful definition of goodwill, the Court cautioned that the definition only serves to describe an intangible asset that has no useful life and no ascertainable value.(7) If a taxpayer can establish that an intangible asset has a limited useful life and can be valued, then the taxpayer may depreciate the asset's value over its useful life, regardless of how much the asset appears to reflect the expectancy of continued patronage.(8)

The Supreme Court's decision in Newark Morning Ledger removed the requirement to distinguish an intangible from goodwill, but it also underscored the magnitude of the taxpayer's evidentiary burden in establishing an asset's useful life.(9) By allowing amortization ratably over 15 years, Congress has attempted to strike a balance between taxpayers and the IRS--allowing taxpayers to amortize previously nonamortizable intangibles while preventing taxpayers from amortizing "provable" intangibles over periods shorter than 15 years.

Operation of Section 197

Effectively, section 197 allows the amortization of most types of goodwill and other intangibles that are purchased (not created) by the taxpayer. Taxpayers are allowed the deduction for "amortizable section 197 intangibles."(10) The taxpayer determines the amount of the deduction by amortizing an intangible's adjusted basis ratably over the 15-year period beginning with the month that the taxpayer acquired the intangible. Under Newark Morning Ledger and pre-section 197 law, the assets would have been amortized based on their useful lives. Currently, all assets covered by section 197 are amortized on a straight-line basis over a 15-year period--no flexibility exists.(11) Section 197(b) states that if an asset is defined by section 197, then the amortization rules of section 197 must be followed.

Section 197(c) states that, for an asset to be amortizable under the statute, it must generally (i) be acquired on or after August 10, 1993, (ii) not be created by the taxpayer, and (iii) be used in the taxpayer's trade or business or for the production of income. The provisions of section 197 might otherwise suggest an advantage to the taxpayer to take assets created by the taxpayer or acquired by the taxpayer prior to August 10, 1993, and have them transferred and then reacquired in order to be able to amortize them under section 197. Section 197(f)(9), however, effectively prevents such churning of the assets.(12)

Businesses that made acquisitions after July 25 and before August 10, 1993, may, however, elect to apply the Act retroactively.(13) If the election is made, section 197 must be applied retroactively to all transactions that occurred after July 25, 1991. Temp. Reg. [sections] 1.197-1T outlines the requirements and consequences of making the election, including the requirement to file amended returns.(14)

The certainty afforded by applying the Act retroactively has great merit. When litigation costs and the uncertainty factor are taken into consideration, it is possible that--despite the shorter amortization available prior to the Act--retroactive application would be beneficial.

Section 197 Intangibles

Section 197 intangibles generally include the following:(15)

* Goodwill

* Going concern value

* Workforce in place

* Business books and records, operating systems, or

any other information base

* Patent, copyright, formula, process, design, pattern, knowhow, format, or similar item * Customer-based intangible(16) * Supplier-based intangible * "[A]ny other similar item"(17) * Governmental license, grant, permit, or other rights * Covenant not to compete acquired as part of the acquisition of a business(18) * Franchise, trademark, or tradename

Section 197 also prescribes certain exceptions that remove certain intangibles from the scope of the statute.(19) Section 197 intangibles do not include any of the following:

* Interests in a corporation, partnership, trust or

estate, or futures contracts, foreign currency contracts,

notional principal contracts, or other similar

contracts.(20)

* Interests in land.(21)

* Computer software, if it is not purchased in connection

with the acquisition of a trade or business.(22)

(Software excluded from section 197 amortization

is instead amortized over 36 months.(23)

* Unless acquired in a transaction (or series of related

transactions) involving the acquisition of assets

constituting a trade or business or substantial portion

thereof(24)--

* an interest in a film, sound recording, video

tape, book, or similar property,(25)

* the right to receive tangible property or services

under a contract or any right to receive tangible

property or services granted by a government

or government agency,(26)

* any interest in a patent or copyright,(27) and

* to the extent provided in regulations, contract

rights (or rights under governmental grant) that

either have a fixed duration of less than 15

years or are fixed in amount and would otherwise

be recoverable under a method similar to

unit-of-production.(28)

* An existing lease in tangible property and any existing

indebtedness (except for bank deposits).(29)

* Professional sports franchises and any item acquired

in connection with the acquisition of such a

franchise.(30)

* Rights to service residential mortgages, unless acquired

as part of a trade or business.(31) (The taxpayer

instead must amortize these rights straight line

over 108 months.(32))

* Transaction costs incurred in nonrecognition transactions

under part III of Subchapter C.(33) (Hence,

the Act leaves intact the principles of INDOPCO,

Inc. v. Commissioner.(34))

Basis of Intangibles and Interplay of Sections 197, 338 and 1060

While section 197 allows a taxpayer to amortize a wide variety of intangibles over 15 years, the section provides scant guidance on determining the basis of intangibles. The determination of basis is important because the taxpayer cannot amortize an intangible unless the taxpayer carries its burden of proof on the basis of the intangible. Section 197 does not change this. The determination of basis would typically be straightforward in the acquisition of an isolated intangible: basis would equal the amount paid.(35) If the cost of acquisition includes contingent amounts, the taxpayer generally increases basis as of the beginning of the month that the contingent amount is paid or incurred, with the additional amount amortized ratably over the months remaining in the original 15-year period.(36)

When a taxpayer acquires a trade or business, the taxpayer must allocate purchase price among all the assets acquired, including intangibles. The legislative history of section 197 provides helpful guidance on allocating purchase price.

If a taxpayer acquires an...