Intangibles - amortization recapture and allocation of sales price.

Tax practitioners should exercise diligence when advising clients on dispositions of Sec. 197 intangibles. The rules regarding the character of income recognized on such dispositions require detailed analysis, especially in light of the Energy Tax Act of 2005 (ETA).

Amortizable Sec. 197 Intangibles

Sec. 197(a) entitles taxpayers to a deduction on amortizable Sec. 197 intangibles, determined by amortizing the intangible's adjusted basis over 15 years, beginning with the month it was acquired. Sec. 197(c) defines "amortizable Sec. 197 intangible" as any "Sec. 197 intangible" held in connection with the conduct of a trade or business or an activity described in Sec. 212. Sec. 197(d) and (e) define "197 intangible" and exceptions. The term "amortizable Sec. 197 intangible" does not include intangibles created by a taxpayer; see Sec. 197(c)(2)(B). Thus, for a taxpayer to be entitled to an amortization deduction on an amortizable Sec. 197 intangible, generally, it must have purchased the intangible. Further, amortization deductions are precluded under some circumstances by Sec. 197(f)(9)'s anti-churning rules.

Ordinary Income Recapture 

When a taxpayer disposes of an amortizable Sec. 197 intangible, recapture rules may require treating any resulting gain as ordinary income. Sec. 1245(a)(1) provides that if Sec. 1245 property is disposed of at a gain, the transaction may result in ordinary income. Sec. 1245(a)(3) describes Sec. 1245 property, in part, as personal property, used in a trade or business, which is, or has been, subject to a depreciation allowance under Sec. 167. Under Sec. 197(f)(7), an amortizable Sec. 197 intangible is treated as property subject to the allowance for depreciation under Sec. 167. Regs. Sec. 1.197-2(g)(8) further clarifies that an amortizable Sec. 197 intangible is Sec. 1245 property.

In most transactions, the amount of ordinary income recognized under Sec. 1245 for an item of property equals the lesser of the gain on the particular item of Sec. 1245 property or the amount previously allowed (or allowable) as depreciation or amortization deductions on the property being disposed. Sec. 1245 applies to property disposed of at a gain, but not at a loss. According to Regs. Sec. 1.1245-1 (a), the "... amount of such gain shall be determined separately for each item of Sec. 1245 property." Thus, even if the sale of multiple items of Sec. 1245 property, as a whole, yields no gain (or even a loss), the operation of Sec. 1245 on a property-by-property basis still may result in ordinary income recognition.

Example 1: Taxpayer S sold two items of Sec. 1245 property. S's adjusted basis was $10 for asset A and $50 for asset B. S previously claimed $40 depreciation on A and $25 on B. The total consideration received in exchange for both items was $50, allocated $25 each to A and to B. Overall, S has a $10 loss on the transaction ($50-$10$50). However, on an item-by-item basis, S recognizes $15 of Sec. 1245 ordinary income recapture on A and has a $25 Sec. 1231 loss on B.

Importantly, Sec. 1221(a)(2) excludes Sec. 1245 property from the definition of a capital asset. Moreover, under Sec. 1231(b), an item of property used in a trade or business that is held more than one year, may qualify as Sec. 1231 property. Under Sec. 1231(a), if the property so qualifies, any net gain recognized on its sale is characterized as gain from the sale of a capital asset; any net loss is characterized as ordinary, subject to certain recapture provisions under Sec. 1231. The interaction of Secs. 1231 and 1245 require recognizing ordinary income recapture on Sec. 1245 property, even when such property is Sec. 1231 property otherwise entitled to capital gain treatment. When a taxpayer disposes of Sec. 1231 property at a gain, Sec. 1231 generally governs any portion of the gain not recaptured under Sec. 1245.

Dispositions

When a taxpayer disposes of an amortizable Sec. 197 intangible (or a group of such intangibles) in a transaction with an unrelated third party, it must determine whether the intangibles sold are Sec. 1245 property. As previously discussed, amortizable Sec. 197 intangible property is Sec. 1245 property. To the extent the intangible has been held and used in a trade or business for more than one year, the property generally also qualifies as Sec. 1231 property. Thus, a taxpayer that disposes of an amortizable Sec. 197 intangible at a gain is subject to the Sec. 1245 recapture provisions and may have to recognize ordinary income.

Computing Recapture on Disposition

Prior to the ETA, the Sec. 1245 recapture provisions applied to gains on dispositions of amortizable Sec. 197 intangibles in the same manner as to gains on any other property described in Sec. 1245. Sec. 1245 ordinary income recapture was calculated on an' item-by-item basis (i.e., determined separately for each item of property disposed of in the transaction). Thus, when a group of assets was sold (e.g., the sale of a group of assets comprising an entire business), the purchase price for the group was allocated among all the assets, and the gain or loss associated with each asset was calculated. To the extent an item of property described in Sec. 1245 was disposed of at a gain, the taxpayer was required to recognize ordinary income under Sec. 1245. The same held true for dispositions of amortizable Sec. 197 intangibles.

Example 2: In year 1, taxpayer X acquires two amortizable Sec. 197 intangible assets for $45. Asset A is assigned a $15 basis and asset B a $30 basis. For amortization purposes, X is entitled to $3 total depreciation per year ($45/15 years). In year 6, when A's adjusted basis is $10 and B's is $20, X sells A and B for $45, resulting in $15 gain ($45$10-$20).The amount of gain subject to recapture will depend on the relative allocation of sales price among the intangibles. X claimed $5 of amortization on A and, thus, has $5 recapture potential. X claimed $10 of amortization on B and, thus, has $10 recapture potential.

Prior to the ETA, if the sale proceeds were allocated $15 to A and $30 to B, the gain would be $5 and $10, respectively. These amounts match the recapture potential for each asset, so the full amount of the gain would have been recaptured as ordinary income. However, if the sale proceeds were instead allocated $25 to A and $20 to B, a $15 gain would have been recognized on A, but only $5 (full recapture potential) would have been recaptured as ordinary income; the remaining $10 gain attributable to A would have been capital gain. No gain would have been recognized on B, and only $5 of the total $15 recapture potential on both assets would have been recognized. Obviously, the latter result would have been desirable for X.

New law: ETA Section 1363(a) amended Sec. 1245 by adding Sec. 1245(b)(9), which provides that a taxpayer disposing of more than one amortizable Sec. 197 intangible in a transaction (or series of related transactions) has to treat all of the intangibles as one Sec. 1245 property for recapture purposes. This provision, which applies to dispositions of property after Aug. 8, 2005, aims to ensure that taxpayers are subject to ordinary income recapture on sales of multiple amortizable Sec. 197 intangibles. The provision intends to eliminate the shifting of purchase price allocations among multiple intangibles to eliminate or mitigate the recapture of ordinary income, as in Example 2 above.

Further, new Sec. 1245(b)(9)(B) provides an exception for amortizable intangibles with an adjusted basis that exceeds their fair market value (FMV). Such intangibles are not includible in the group of assets that have to be treated as one when calculating recapture. This provision essentially codifies, with respect to amortizable Sec. 197 intangibles, Kegs. Sec. 1.1245-1(d), which similarly provides that Sec. 1245 does not apply to property with an adjusted basis greater than its FMV.

Revisiting Example 2 above, it can be concluded that no matter how the proceeds are allocated among the amortizable Sec. 197 intangibles sold by X, X is now consigned to recapture under Sec. 1245(b)(9), regardless of the purchase price allocation. In light of this law change, taxpayers and practitioners alike should carefully consider the Sec. 1245 recapture provisions in any transaction involving the disposition of an amortizable Sec. 197 intangible asset.

FROM DAVID SITES, CPA, CHARLOTTE, NC

Editor: Stefan Gottschalk, J.D., LL.M., CPA Senior Manager Grant Thornton LLP Washington, DC