Amortization of intangibles: IRS prevails.

Currently, a taxpayer that acquires a business may not amortize the portion of the purchase price allocable to goodwill and going concern value. In an effort to maximize tax benefits, buyers often assign values to specific intangible assets (such as favorable leases, noncompetition agreements, customer lists and contract rights) that may qualify for more favorable treatment. Amortization deductions are allowed for such items if it can be established that the intangible (1) has a value separate and distinct from goodwill and (2) has a limited useful life, the duration of which can be estimated with reasonable accuracy.

Whether an intangible can satisfy these two tests has increasingly become a source of controversy between taxpayers and the IRS, particularly since the advent of Form 8594, Asset Acquisition Statement Under Section 1060, and the closing of the gap between regular tax rates and capital gains rates (which has limited the instances in which buyers and sellers are truly at odds in negotiating purchase price allocations). In an effort to stem the tide of controversy in this area, there are no less than three legislative proposals under consideration by Congress, each of which attempts to create more objective standards for determining the amortization of intangibles.

According to reports prepared by the General Accounting Office and the Joint Committee of Taxation, permitting taxpayers to amortize substantially all intangible assets could result in a better matching of income and expense than under current tax rules, and would also provide taxpayers and the IRS with an element of certainty that should substantially reduce the number of disputes. In the meantime, as this legislation works its way through Congress, two recent cases provide the Service with significantly more ammunition in its battle against purchase price allocations that it views as questionable.

In Ithaca Industries, Inc., 97 TC No. 16 (1991), a taxpayer acquired a clothing manufacturer in a leveraged buy-out, and allocated a portion of the purchase price to the manufacturer's "assembled work force." It assigned an average per capita amount to each of its hourly and production work force and staff employees and then deducted that amount when an employee terminated his employment. The IRS disallowed the deductions, claiming that an assembled work force represents an element of going concern value, since this asset merely enables the business to continue operating without interruption. The taxpayer argued that the life of the work force was limited, since employees would on average terminate their employment within a statistically determined period of 6.8 years.

The court agreed with the Service, concluding that the work force, as an assembled entity, does not diminish in value by reason of an employee leaving; the assembled work force might be subject to temporary attrition and expansion (through departures and hirings), but it is not depleted due to the passage of time or as a result of use. The court noted that if the useful life of those employed on the acquisition date was the same as the useful life of the assembled work force, at the end of 6.8 years the taxpayer would no longer have an assembled work force; this was clearly not the case. The court concluded that Ithaca's assembled work force was not a "wasting asset" and, thus, there was no reduction in its value allocable to a particular tax period. Consequently, the assembled work force was not separate and distinct from going concern value and, therefore, the taxpayer could generally recover the cost of the work force only when it disposed of the business.

In Newark Morning Ledger Co., 3d Cir., 1991, rev'g 734 F Supp 176 (DC N.J. 1990), the taxpayer acquired a company that owned eight newspapers. In allocating its purchase price, the taxpayer relied on sophisticated financial analysis to determine that it acquired $26 million of goodwill and going concern value and $67 million of an intangible asset designated "paid subscribers." This intangible represented an estimate of the future profits to be derived from the newspapers' 460,000 at-will subscribers. The taxpayer established that the newspapers' "paid subscribers" had an ascertainable value ($67 million) and limited useful lives (from 14.7 to 23.4 years) that could be estimated with reasonable accuracy. Nevertheless, the Third Circuit, reversing the district court, concluded that the taxpayer did not show that these customer lists were separate and distinct from goodwill.

The district court had found that once a value and limited useful life was established for an intangible asset, the intangible by definition is separate and distinct from goodwill. The IRS, on the other hand, believed that even if (as the taxpayer had proven) an intangible asset has an ascertainable value and a limited useful life, the taxpayer still had to demonstrate that the intangible was separate and distinct from goodwill. The Third Circuit agreed with the Service. The income to be generated by a list of customers acquired in connection with the acquisition of a going concern was by its very nature goodwill (defined by the court as the "expectation of continued patronage"). Accordingly, the taxpayer was not entitled to amortize the $67 million value attributable to its paid subscribers. The court acknowledged that the cost of generating a list of potential customers (which in this case the IRS estimated to be $3 million) might be amortizable, but since the taxpayer relied solely on the income method for valuing its customer list, the availability of the cost method to amortize the customer lists was not at issue.

The results of these and similar cases could result in a substantial tax burden for a taxpayer that has allocated a considerable portion of the purchase price of an acquired business to intangible assets that the IRS subsequently determines to be nonamortizable. The escalating burden of proving that specific intangible assets are separate and distinct from goodwill and going concern value appears to be approaching an insurmountable level. In light of cases such as Ithaca Industries and Newark Morning Ledger, an increasing number of taxpayers and tax professionals can be expected to support legislation such as that proposed by Rep. Rostenkowski (generally providing a 14-year write-off for most intangible assets, including goodwill), which will eliminate the cost and uncertainty of attempted purchase price allocations, and the cost of defending those allocations.