Deducting the cost of intangibles.

Distinguishing the intangible asset from goodwill is only one hurdle a taxpayer must overcome to obtain a deduction.

The tax treatments of tangible and intangible assets differ. Tangible assets are presumed to waste away, so only the length of the asset's life is a tax issue. Expenditures relating to certain intangibles must be permanently capitalized and are deductible only on disposing of the asset. To obtain a tax deduction for amortizing an intangible, a taxpayer must prove the asset is not goodwill, which is nondeductible. This creates a heavy burden of proof.

To avoid the nondeductible category, taxpayers also must prove the asset has a limited and determinable useful life. The facts and circumstances of the acquisition and the nature of the intangible asset govern this determination. The tax treatment of certain intangibles (such as research and development expenditures) is specifically prescribed by statute. For most intangibles, however, taxpayers must rely on case law and administrative rulings to determine the tax treatment.

Acquisition of multiple assets, such as purchase of a business enterprise, is particularly troublesome. Case law supports the notion some goodwill is present in almost every business acquisition. Since it's likely some portion of the purchase price must be allocated to goodwill, accurate appraisals of both tangible and intangible assets are essential to obtaining a tax deduction for the cost of intangibles.

The statutory and administrative tax treatments of intangibles often are vague and inconsistent, leaving taxpayers little guidance on when to take a deduction. This article discusses tax laws relevant to deducting the cost of intangibles and explores the problems practitioners may encounter in seeking deductions.

APPLICABLE TAX LAW

Most intangible assets are expected to benefit more than one year, so their cost is a capital expenditure under Internal Revenue Code section 167 (depreciation), the primary authority for deducting intangibles. However, section 167 is a catchall for the tax treatment of intangibles not specifically covered elsewhere and offers little guidance on whether or when a deduction is available. The section 167(a) general rule allows a depreciation deduction for the wear and tear, exhaustion and obsolescence of property used in a trade or business or in the production of income.

Other IRC sections deal with specific intangibles, including section 174 (research and experimental expenditures) and section 195 (start-up expenditures). Authority and limited guidance for deducting the costs of most intangibles are found in Treasury regulations.

Section 167(a) implies that "property" includes both tangible and intangible assets, but the regulations contain restrictive language on depreciating intangibles. Regulations section 1.167(a)-3 excludes goodwill by saying "no deduction for depreciation is allowable" for it and also says no deduction is permitted merely because the taxpayer believes the intangible asset has a limited life. Thus, the regulation forces the taxpayer to prove an intangible asset is not goodwill and has a limited life before section 167(a) can be considered.

The regulation requires that an asset's estimated useful life be determinable with reasonable accuracy. Unfortunately, this complicates tax deductions for amortizing intangibles. The Internal Revenue Service commonly argues certain intangibles such as customer lists and human resources have indefinite or indeterminable lives. Before the determinable useful life of an asset can be considered, however, the taxpayer must prove an identifiable intangible exists. Exhibit 1, page 87, lists court cases that have focused on the separability of the intangible from goodwill.

ESTABLISHING AN IDENTIFIABLE INTANGIBLE ASSET

To deduct an intangible asset's cost, a taxpayer must demonstrate the amount paid relates specifically and only to the asset. The simplest case is acquiring a single intangible asset for a specific price from an unrelated party. In Western Mortgage v. U.S., the taxpayer acquired the right to service mortgage loans and was allowed a deduction because the right had a determinable life that was known from the taxpayer's experience.

Many acquisitions include multiple assets (tangible and intangible) for a single purchase price, creating identification and valuation problems among the assets. In First National Bank of Omaha v. Commissioner, the taxpayer allocated the purchase price to the cost of the right to service mortgage loans, but the Tax Court allocated some of the purchase price to nondeductible goodwill and going concern value.

Regulations section 1.338 requires taxpayers to allocate a business's total purchase price among identifiable tangible and intangible assets based on their relative fair market values (FMVs). Any purchase price remaining after this allocation is made is recorded as goodwill [Treasury regulation 1.338(b)-2T(b)]. But IRC section 1012 makes it clear the depreciable basis is cost--not value. In Winn-Dixie Montgomery, Inc. v. U.S., the Fifth Circuit Court of Appeals said, "Cost is what the buyer paid for the asset, not what the buyer thought it was worth."

The Ninth Circuit Court of Appeals developed an economic reality test in Schulz v. Commissioner to determine if covenants not to compete were separate from goodwill. The test focused on the independent value of an intangible asset that reasonable buyers would bargain to acquire. Covenants not to compete pose unique adverse interests. Buyers prefer the asset be classified as a covenant not to compete, not goodwill, because goodwill is not deductible. Sellers prefer the asset be classified as goodwill to receive capital gain treatment after the basis is recovered. Buyers generally can amortize the cost of a covenant not to compete, but the seller must include gains on the sale of the covenant in ordinary income.

Several bank acquisition cases (see exhibit 1, item 3) have examined the cost of the core deposit intangible asset, which arises from the value of customer deposits acquired. To date, only Citizens and Southern Corporation (C&S) and Colorado National Bankshares (CNB) have convinced the Tax Court the core deposit intangible is depreciable. To prove it is separate from goodwill, a bank's aggregate purchase price must be allocated among tangible assets, specifically identifiable intangibles and goodwill (if any), based on their respective FMVs.

The Schulz economic reality test applies only when buyers and sellers have adverse interests and bargain at arm's length. Yet, the seller usually is indifferent to an intangible asset's classification because the seller receives capital gain treatment regardless of the specific assets sold. This lack of conflicting interests weakens the economic reality test's usefulness in allocating a portion of the purchase price to intangible assets. Further, in most multiple asset acquisitions, such as the purchase of a business, it is impractical to develop detailed allocation agreements; purchasers are buying an economic enterprise, not a pool of individual assets. Tax law is inconclusive, giving taxpayers some latitude in allocating cost to the assets acquired.

MASS ASSET THEORY

The mass asset theory's logic is that individual components, such as subscriptions, may expire or terminate, but the entire entity shows only minimal fluctuations in value as replacements are added (see the article by Martin J. Gregorcich in the Winter 1975 issue of the Tax Lawyer). The mass asset theory prevailed in Sunset Fuel Co. v. U.S., in which the taxpayer acquired a customer list and other assets. The Ninth Circuit Court ruled the list was part of a single indivisible capital asset and not deductible, since termination of individual accounts merely represented a decline in the larger asset's value.

In PLR 8817002, the IRS applied the mass asset theory to deny an amortization deduction for human resources costs-an asset the IRS believes is closely related to goodwill. This ruling addressed whether values attributable to human resources acquired by a brokerage firm are distinguishable from goodwill. Acquiring a going business enabled the taxpayer to avoid the expense of training a work force and developing a clientele. The IRS contended the taxpayer was maintaining customer patronage, which the IRS views as a key element of goodwill.

The mass asset theory has not always been successful for the IRS. In Super Food Services, Inc. v. U.S., the IRS argued franchise contracts are part of a unitary asset with lost contracts replaced by new ones, so a franchise taken as a whole has an indefinite life similar to goodwill. The Seventh Circuit Court of Appeals ruled, however, that each franchise contract represented an individual relationship separate from goodwill.

ASSETS RELATING TO CUSTOMER STRUCTURE

Revenue ruling 74-456 (1974-2 C.B. 65) precludes a depreciation deduction for intangible assets representing customer structure because they are in the nature of goodwill or have indeterminable lives. Intangible assets cited include location contracts and insurance expirations. This ruling modified earlier rulings and removed the implication such intangibles are, as a matter of law, indistinguishable from goodwill with no determinable useful life. However, the taxpayer bears the burden of proving the intangible asset has an ascertainable value separate from goodwill and a limited useful life determinable with reasonable accuracy.

If an intangible asset is related to customer structure, the IRS or the courts are likely to allocate at least part of the aggregate purchase price to goodwill. In Abco Oil Corp. v. Commissioner, the taxpayer acquired customer lists and covenants not to compete from two competitors. The Tax Court found the lists had an independent value. However, the court also believed the taxpayer desired to preserve customer patronage, which, the court said, is the essence of goodwill. Thus, they reclassified 25% of the amount allocated to the customer list as goodwill.

Acquiring a specific intangible avoids the problem of allocating cost to a variety of assets after the fact. In Panichi v. Commissioner, the taxpayer acquired a list of trash-collection customers, but not the entire company, from a sanitation company. The Second Circuit Court of Appeals upheld the district court decision the customer list had a discrete value that could be depreciated when acquired separate 'from a going concern.

A similar result occurred in Midlantic National Bank v. Commissioner, in which the taxpayer acquired the right to solicit a failed bank's deposits. The IRS argued the amount allocated to the solicitation right should be attributed to goodwill. The Tax Court held the solicitation right was in the nature of a customer list, distinct from goodwill. The court also said an asset that will attract customers is not goodwill.

Other cases (exhibit 1, item 3) have addressed whether the core deposit intangible asset is so inextricably linked to customer structure as to be indistinguishable from goodwill. In Citizens and Southern Corporation and Subsidaries v. Commissioner, the taxpayer purchased nine going concern banks and allocated $41.8 million of the $461.6 million price to the core deposit intangible asset.

The IRS argued the core deposit base was goodwill because it was a component of each acquired bank's customer relationship. The IRS applied the mass asset theory in an attempt to prevent C&S from fragmenting goodwill into depreciable and nondepreciable components. In response, the Tax Court said the mass asset theory did not prevent C&S from taking an amortization deduction because it proved the intangible asset had an ascertainable value separate from goodwill and a limited useful life that could be reasonably measured. Colorado National Bankshares v. Commissioner resulted in a similar conclusion.

To the IRS, a critical issue related to customer-structure assets is whether the acquired asset is part of an ongoing business. The IRS's 1990 Coordinated Issues paper concludes that when acquired businesses possess goodwill characteristics, customer-structure related assets are inseparable from goodwill and nonamortizable as a matter of law. The IRS drew its conclusion from analysis of the cases in exhibit 2, above. In general, customer-structure intangibles acquired apart from going concerns were amortizable, whereas intangibles acquired as part of a going business were not. Three exceptions to the IRS position include Citizens and Southern Corporation and Colorado National Bankshares, previously mentioned, and Donrey, Inc. v.U.S. Thus it appears the going-concern barrier can be overcome.

THE LIMITED LIFE REQUIREMENT

Distinguishing the intangible asset from goodwill is only one hurdle a taxpayer must overcome to obtain a deduction. The intangible asset also must have a reasonably ascertainable limited useful life. Regulations section 1.167(a)-1 provides the following criteria:

* The life is the period over which the asset may reasonably be expected to be useful to the taxpayer in his or her trade or business or in the production of income.

* The period of time is determined by reference to the taxpayer's own experience with similar property.

* If the taxpayer's own experience is inadequate, the general experience of the industry may be used until the taxpayer forms an adequate basis for making a determination.

These requirements do not mean the life must be determined with absolute certainty. In Selig v.U.S., the taxpayer was allowed to depreciate baseball player contracts. The Seventh Circuit Court said clubs know from experience that baseball player contracts are useful for only a limited period that can be estimated with reasonable accuracy. Exhibit 3, page 90, lists the cases in which the intangible's life has been a key issue.

Determining the asset's useful life as specified in criterion 1 may be difficult. In Indiana Broadcasting Corp. v. Commissioner, the Tax Court approved the taxpayer's use of statistical computations from industry experience to determine the useful life of network affiliation contracts. However, the Seventh Circuit Court overruled the Tax Court, saying the evidence in the case refuted the statistical method's basic premise.

Intangible assets may have innate characteristics contributing to the difficulty of determining whether their lives are limited. An asset may have a fixed life that can be extended by automatic renewals. Meredith Broadcasting acquired adver.tising contracts with myriad terms remaininmg. The high probability of renewal caused the court to rule the contracts had an indeterminable useful life.

Birmingham News faced a similar problem when it acquired the rights to print, sell and distribute newspapers that were published by the Birmingham Post. The 30year contract could be renewed automatically unless either of the parties objected. Ruling in the taxpayer's favor, the court said that future renewal was a question of fact because of the taxpayer's circumstances at the time.

The terminable-at-will problem arises with intangible assets that rely on the actions of independent parties, such as customers, to establish the asset's life. For example, a customer list is an intangible asset because a price is paid for access to customers who may patronize the acquiring business. Such customers can terminate their patronage at will, depreciating the customer lists' value. With Citizens and Southern, the IRS argued that since customer patronage is unenforceable, the life is indeterminate.

GOODWILL--THE CATCH-ALL INTANGIBLE TO AVOID

Some courts have distinguished between goodwill and the characteristics contributing to it. In Indiana Broadcasting Corp. v. Commissioner, goodwill was not construed to include network affiliation contracts because the court believed the contracts attracted customers, similar to a neon sign. Part of the problem in separating identifiable intangible assets from goodwill arises because imprecise tax definitions of goodwill focus on customer patronage, which can include almost anything related to acquiring and keeping customers.

Even if the acquired intangible merely contributes to goodwill, it likely will be classified as goodwill if it's useful to a customer market. This was the ruling in United States Industrial Alcohol Co. v. U.S., in which the taxpayer acquired contracts to deliver industrial alcohol. The Second Circuit Court determined the primary purpose of the acquisition was to ensure a market for future sales, not to make a profit. In the court's opinion, the purpose of acquiring the contracts was to augment goodwill.

Excess earnings are one of the most important aspects of goodwill from an accounting perspective. Arguably, if a company has no excess earnings, it has no goodwill. The difficulty lies in defining the base for computing excess earnings. Is the base the normal industry return on tangible assets, the normal return on tangible and identifiable intangible, the normal return on tangible and identifiable intangibles excluding return on unrecorded goodwill, or some other base earnings?

Banc One Corporation faced this problem when it acquired a failed bank and argued it had purchased no goodwill because the bank had no excess earnings over the industry's normal return on total assets. The court held goodwill could exist in the absence of excess earnings; the benchmark industry return on total assets likely included a return on unrecorded goodwill. Even though Banc One's return had not exceeded the industry average, its return also could have included a return on goodwill. The court effectively negated reliance on excess earnings as an indication of goodwill.

LOOKING AHEAD

Deducting the cost of an intangible requires several steps. The taxpayer first must circumvent the mass asset theory and establish that a separable asset exists. Intangibles related to customer structure are the most problematic because of their relationship to goodwill. The asset must have a measurable cost. Finally, its limited life must be predictable with reasonable accuracy.

A recent case demonstrates the difficulty of the separability hurdle. Newark Morning Ledger Co. attempted to amortize $67 million of paid subscribers as part of the acquisition of Booth Newspapers, a going concern. The district court agreed the paid subscriber asset had a measurable life separable from goodwill. In September 1991, the Third Circuit Court of Appeals reversed the decision, finding the value of a list is intertwined with goodwill in a case of going concern. A final decision on the issue is forthcoming; in April, the U.S. Supreme Court agreed to hear the Newark Morning Ledger case.

EXECUTIVE SUMMARY

* LITTLE TAXPAYER GUIDANCE is available on when and how the cost of intangibles can be deducted. Practitioners seeking deductions on clients' behalf may encounter considerable difficulties.

* GENERALLY, TAXPAYERS must prove an intangible asset is not goodwill and has a limited life before a deduction is available. In multiple asset acquisitions, taxpayers also must demonstrate the amount paid relates specifically to the intangible asset alone.

* SEVERAL RECENT COURT cases have examined the cost of banks' core deposit intangible assets, arising from the value of acquired customer deposits. Some banks have convinced the Tax Court the core deposit intangible is a depreciable asset separate from goodwill.

* CUSTOMER-STRUCTURE intangible assets--customer and subscription lists, location contracts and insurance expirations--are not depreciable because they are in the nature of goodwill or have indeterminable lives.

* DISTINGUISHING THE intangible asset from goodwill is only one hurdle taxpayers must overcome. The asset also must have a reasonably ascertainable useful life.

* CASE LAW SUPPORTS the contention some goodwill is present in almost every business acquisition. Since some portion of the purchase price must be allocated to goodwill, accurate appraisals of both tangible and intangible assets are essential to obtaining a deduction for the cost of intangibles.

EXHIBIT 1

DEDUCTING THE COST OF INTANGIBLES SELECTED CASES

Goodwill or another asset?

1. Right to service mortgage loans: Western Mortgage v. U.S., 308 F.Supp. 333 (C.D. Cal. 1969); First National Bank of Omaha v. Commissioner, T.C. Memo. 1975-67)

2. Covenants not to compete: Schulz v. Commissioner, 294 F.2d 52 (9th Cir. 1961); Abco Oil Corp. v. Commissioner, T.C. Memo. 1990-40

3. Core deposit intangibles: MidAtlantic National Bank v. Commissioner, 52 T.C.M. (CCH) 2368 (1983); Southern Bancorporation v.U.S., 732 F.2d 374 (4th Cir. 1984); Banc One Corp. v. Commissioner, 84 T.C. 476 (1985), aff'd 815 F.2d 75 (61h Cir. 1987); AmSouth Bancorporation V.U.S., 681 F. Supp. 698 (N.D. Ala. 1988); Citizens and Southern Corporation and Subsidiaries v. Commissioner, 91 T.C. 463 (1988); Colorado National Bankshares v. Commissioner, T.C. Memo. 1990-495

4. Customer lists: Sunset Fuel Co. v.U.S., 519 F.2d 781 (gth C r 1975); Abco Oil Corp. v. Commissioner; Panichi v.U.S., 834 F.2d 300 (2nd Cir. 1987)

5. Individual or mass asset: Super Food Serv/ces v.U.S., 416 F.2d 1236 (7th Cir. 1969); First Northwest v. Commissioner, 70 T.C. 817 (1978)

6. Right to solicit bank customers: MidAtlantic National Bank v. Commissioner

7. Excess earnings an index of goodwill: Banc One v. Commissioner; Citizens and Southern Corporation and Subsidiaries v. Commissioner

8. Contract to deliver a product: United States Industrial Alcohol Co. v. U.S., 137 F.2d 511 (2d Cir. 1943)

EXHIBIT 2

DEDUCTING THE COST OF INTANGIBLES: SELECTED CASES

Ongoing business or discontinued?

1. Customer structure, not mere subscriber list: General Television, Inc. v.U.S., 449 F. Supp. 609 (D, Minn. 1978), aff'd per curiam, 598 F. 2d 1148 (8th Cir. 1979); Finoli v. Commissioner, 86 T.C. 697 (1986); Manhattan Company of Virginia, Inc. v. Commissioner, 50 T.C. 78 (1968), acq ,, 1974-2 C.B. 3; Holden Fuel Oil Co. v. Commissioner, T.C. Memo 1972-45, aft'd, 479 F. 2d 613 (6th Cir. 1973)

2. Credit information: Computing & Software, Inc. v. Commissioner, 64 T.C. 233 (1975)

3. Insurance expirations: Decker v. Commissioner, 864 F, 2d 51 (7th Cir. 1988) aff'g T.C. Memo 1987-332; Richard S. Miller & Sons, Inc. v.U.S,, 537 F, 2d 446 (Ct. CI. 1976)

4. Subscription list: Houston Chronicle Publishing Co. v. U,S., 481 F. 2d 1240 (Sth Cir. 1973), cert. denied, 414 U.S. 1129 (1974); Donrey, Inc. v, U,S., 809 F. 2d534 (8th Cir. 1987)

EXHIBIT 3

DEDUCTING THE COST OF INTANGIBLES:

SELECTING CASES

Limited or indefinite life?

1. Customer lists: Golden State Towel and Linen Serv/ce v.U.S., 373 F.2d 938 (1967)

2. Network affiliation contracts: Indiana Broadcasting Corp. v. Commissioner, 41 T.C. 493 (1964), rev'd 350 F.2d580 (7th Cir. 1965)

3. Franchises: Dunn v.U.S., 259 F. Supp. 828 (W.D. Okla. 1966), aft'd, 400 F.2d 679 (lOth Cir. 1968); Super Food Services, Inc. v.U.S.

4. Use of hindsight: Southern Bancorporation v.U.S.; Banc One Corp. v. Commissioner

5. Advertising renewal contract: Meredith Broadcasting v.U.S., 405 F.2d 1214 (Ct. CI. 1969); Birmingham News v.U.S., 224 F. Supp. 670 (N.D. Ala. 1963)

6. Terrainable-at-will contracts: Super Food Services, Inc. v.U.S.

7. Self-regenerating asset: Banc One Corp. v. Commissioner; AmSouth Bancorporation v.U.S.

8. Leaseholds: Winn-Dixie Montgomery, Inc. v.U.S., 444 F.2d 677 (Sth Cir. 1971)

9. Baseball player contracts: Selig v.U.S., 565 F. Supp. 524 (E.D. Wis. 1983), aft'd, 740 F2d 572 (7th Cir. 1984)