Antichurning and proposed sec. 197 regulations.

Prior to the enactment of Sec.197 in 1993, certain intangible assets -- including goodwill and going concern value -- were not amortizable. With Sec. 197, Congress provided antichurning rules to prevent situations in which taxpayers transferred nonamortizable intangible assets to related taxpayers for the purpose of turning nonamortizable goodwill or going concern value into amortizable Sec. 197 assets. There has been some uncertainty since Sec. 197 was added on the application of the antichurning rules. Prop. Regs. Sec. 1.197-2 provides guidance on the application of these rules, as well as clarifying certain definitions and exceptions to the rules.

Amortizable Sec. 197 Asset in the

Hands of the Seller

There are a few exceptions to the antichurning rules available to taxpayers.

Example: On July 25, 1991, J held nonamortizable intangible property (i.e., goodwill or going concern value). On Dec. 1, 1993, the property was sold in an arm's-length transaction to an unrelated third party with the expectation that J would never reacquire the property. The third party purchased a Sec. 197 asset, amortizable over 15 years. In mid-1996, J purchased the property back in an arm's-length transaction.

Under the antichurning rule provided in the Code, J would not be entitled to amortization, because he used the property on July 25, 1991. However, Prop. Regs. Sec. 1.197-2(h) provides that if property otherwise subject to antichurning is an amortizable Sec. 197 intangible asset in the hands of the seller, it is an amortizable Sec. 197 intangible asset in the buyer's hands as well.

Exception When Gain Is

Recognized

Another important exception to the antichurning rules is when an election is made to recognize gain under Sec. 197(f)(9)(B). To make this election, the taxpayer must agree to pay an amount that, when added to any other Federal income tax, equals the gain on the disposition multiplied by the highest marginal rate of tax imposed by Sec. 1 or Sec. 11 (whichever is applicable for the tax period in which the gain is realized by the seller).

Before the proposed regulations, there were many questions on how the "highest marginal rate of tax" was defined. Prop. Regs. Sec. 1.197-2(h)(9) sets forth the definition of the term for different types of taxpayers. In the case of a noncorporate taxpayer (i.e., individuals, trusts, estates), the highest marginal rate of tax is the highest marginal rate of tax in effect under Sec.1, determined without regard to Sec. 1 (h) (capital gains rates). This means that even though a taxpayer may be otherwise subject to the 28% capital gains rate, or in the 31% or 36% brackets, if an election is made to recognize gain, the gain will be paid at the highest marginal rate --currently 39.6%.

For corporations and tax-exempt entities, the highest marginal rate will be the highest marginal rate of tax in effect under Sec. 11, determined without regard to any rate that is added to the otherwise applicable rate in order to offset the effect of the graduated rate schedule. For example, the amount of gain shall not be reduced by any net operating loss (NOL) deduction under Sec. 172(a) or credits, although the NOL utilization in the year of sale is not delayed by the election.

For passthrough entities, the election will be made by the entity (rather than its owners or members), and will constitute an election by each of the owners or members to pay a tax at the highest marginal rate applicable to each owner or member (i.e., for an individual, 39.60%).

The regulations make it clear that there will be no reduction in the rates for any deductions, credits or losses in order to be exempt from the antichurning rules. This makes this exception to the antichurning provisions quite unattractive in most cases.