What is the character of Pre-Sec. 197 goodwill? .

• Author: Ochsenschlager, Thomas P.
• Position: Nonamortizable goodwill

In Letter Ruling 200243002, the IRS held that pre-Sec. 197 (nonamortizable) goodwill is a capital asset. While this may be the right answer, there is more to the analysis than meets the eye.

Facts

The taxpayer is the parent of a consolidated group for Federal income tax purposes. In numerous transactions, it disposed of two divisions that it operated with its subsidiaries. Each transaction was structured as an asset sale or as a stock sale with a Sec. 338(h)(10) election; thus, all the transactions were treated as taxable asset sales for Federal income tax purposes.

For each transaction, the parent allocated the sales price using the residual allocation method under Secs. 1060(a) and 338(b)(5), allocating the sales price in excess of the fair market value of all other assets to goodwill and going-concern value (collectively, "goodwill").

All of the goodwill was either (1) acquired before Aug. 11,1993 (without a retroactive election under Temp. Regs. Sec. 1.197-1T) or (2) self-created. Thus, it was not amortizable.

The IRS held that the goodwill was a Sec. 1221 capital asset.

IRS Analysis

At issue was whether the goodwill was excluded from the definition of a capital asset under Sec. 1221(a)(2), which excludes property held by a taxpayer (whether or not connected with the taxpayer's trade or business) that is "[u]sed in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167 ..."

The Service acknowledged that under Sec. 197 (f) (7), any amortizable Sec. 197 intangible is "property that is of a character subject to the allowance for depreciation provided in Section 167." It noted that the goodwill was not subject to amortization under Sec. 197, because it was either (1) self-created or (2) acquired before Aug. 11,1993 (the Sec. 197 effective date). Thus, because the goodwill was not amortizable, it was not subject to depreciation under Sec. 167. The IRS thus concluded that the goodwill qualified as a Sec. 1221 capital asset (i.e., the Sec. 1221(a)(2) exclusion did not apply).

Determination of Character?

The question is whether the Service's analysis is oversimplified. What does the phrase "of a character subject to" mean? If Congress had merely intended to refer to depreciable (and amortizable) property, the phrase would have been unnecessary. How does the phrase broaden the scope of Sec. 1221(a)(2)?

It can be argued that a property's "character" is a trait distinguishable from the...