Maximizing Sec. 197 amortization in partnership transactions.

Sec. 197 generally allows for amortization of purchased intangibles (including goodwill and going-concern value) acquired after its Aug. 10, 1993 effective date. Sec. 197 and January 1997 proposed regulations contain rules that prevent taxpayers from converting pre-1993 goodwill and going-concern value (pre-1993 intangible assets) and self-created intangible assets into amortizable Sec. 197 intangibles, through the use of certain partnership transactions. These rules can prevent a taxpayer that acquires an interest in a partnership that holds these types of intangibles (the buyer) from claiming amortization deductions for his share of the partnership's intangibles, even when the buyer is unrelated to the taxpayer disposing of a portion of the pre-1993 goodwill or going-concern value or self-created intangible (the seller).

Three rules under Sec. 197 affect partners' ability to amortize pre-1993 and self-created goodwill.

"Step-into-the-shoes" rule. According to Sec. 197(f)(2), if a Sec. 197 intangible is contributed to a partnership in a Sec. 721 transaction, the partnership is treated as the contributing partner with respect to as much of the intangible as does not exceed the contributing partner's tax basis in the intangible. Thus, if the intangible is not amortizable in the contributing partner's hands, it is generally not amortizable in the partnership's hands.

Anti-churning rules. The anti-churning rules prohibit taxpayers from claiming amortization from intangibles that were not amortizable before the enactment of Sec. 197 (e.g., goodwill and going-concern value). The anti-churning rules apply if a taxpayer acquires pre-1993 intangibles and the taxpayer or a related person holds or uses the intangibles before Sec. 197's effective date. A partnership is considered related to any partner that owns 20% or more of the interests in partnership capital or profits. Thus, if a seller retains a 20% or greater interest in the partnership, the anti-churning rules apply.

Practitioners have questioned whether it is appropriate to bifurcate pre- and post-1993 intangibles for purposes of applying the anti-churning rules. The common concern is that if a small amount of pre-1993 goodwill taints all of the partnership's or seller's goodwill, application of the anti-churning rule will exceed statutory intent as more time passes after Sec. 197's effective date. The Service has informally expressed concerns over the ability to administer a rule allowing a bifurcation. It is unclear whether taxpayers can take this position without risking an IRS challenge.

Three exceptions to the anti-churning rules may apply to partnership formation transactions: (1) the Sec. 743 exception, (2) the unrelated transaction rule and (3) the gain recognition election. While the last exception is beyond the scope of this article, it generally allows a buyer to amortize a Sec. 197 intangible if the seller recognizes gain in the year of sale at the highest tax rate and the seller and buyer are not related by more than 50%.

Sec. 197(f)(9)(E) provides that an anti-churning rule applies at the partner level with respect to any increase in the partnership property basis under Sec. 743. For this purpose, each partner is treated as having owned and used a proportionate share of the partnership's assets. Thus, if a taxpayer acquires a partnership interest from an unrelated taxpayer, the basis step-up allocated to Sec. 197 intangibles is amortizable (regardless of whether the intangible is pre-1993 or self-generated) (Prop. Regs. Sec. 1. 197-2(h)(5)(i)).

Prop. Regs. Sec. 1.197-2(h)(4)(ii) contains a second exception to the anti-churning rule. This rule provides that the anti-churning rule does not apply to a taxpayer's Sec. 197 intangible acquisition if it was not part of a transaction or a series of related transactions in which the seller or transferor previously acquired the Sec. 197 intangible.

Sec. 704(c) rule. If an appreciated intangible is contributed to a partnership, Sec. 704(c) requires preferential allocations of income, gain, depreciation and loss to take into account the difference between the intangible's fair market value and tax basis at the time of contribution. Thus, if a taxpayer contributes an appreciated amortizable intangible asset, Sec. 704(c) requires preferential allocations of amortization to the noncontributing partners. Under the proposed regulations, however, a partnership cannot make curative or remedial allocations from a Sec. 197 intangible if it is not amortizable for tax purposes under the step-into-the-shoes rule or the anti-churning rules (Prop. Regs. Sec. 1.197-2(g)(2)(vi) and (h) (5) (ii)). Thus, if a contributed intangible is not an amortizable Sec. 197 intangible in the transferor's hands (either because the intangible is self-generated or pre-1993), any curative or remedial allocations of amortization made to a noncontributing partner with respect to the intangible are not amortizable under Sec. 197. This rule applies regardless of whether the contributing and noncontributing partners are related.

The Sec. 704(c) rules surprised most practitioners and have been widely criticized. Recently, the IRS informally announced that it was revisiting the Sec. 704(c) portions of the proposed regulations and considering whether to allow remedial allocations for self-created intangibles (and possibly pre-1993 intangibles) and whether, in any event, the Sec. 704(c) rules should apply prospectively only.

Partnership Formation Transactions

If a taxpayer holding pre-1993 or self-created intangibles wants to enter into a joint venture with an unrelated party without receiving any cash payments (i.e., there is no "sale" element to the transaction), the unrelated joint venture partner cannot amortize his share of the contributed intangibles. For example, in a 50/50 joint venture formation, the taxpayer contributes either pre-1993 or self-created intangibles and the buyer contributes cash for the partnership's business. The partnership cannot amortize the pre-1993 goodwill under either the step-into-the-shoes rule or the anti-churning rules. In addition, it may not make remedial or curative amortization allocations to the buyer under the Sec. 704(c) rule.

Three examples in the proposed regulations provide a road map for structuring partnership formation transactions to maximize the buyer's ability to amortize his share of the seller's pre-1993 and self-generated intangibles. In the first example, the seller contributes business assets to the partnership and the buyer contributes cash (Prop. Regs. Sec. 1.197-2(k), Example 15). The partnership thereafter distributes to the seller cash equal to the fair market value of the portion of the business assets sold. Pursuant to the Sec. 707 disguised sales rules, the seller is treated as selling a portion of the business assets to the partnership. The anti-churning rules apply and the partnership is treated as purchasing the business assets from a related party (the seller) (Prop. Regs. Sec. 1.197-2(h)(1) and (6)). Thus, even though the Sec. 197 intangible has tax basis and the seller recognized gain, the partnership (and, therefore, the buyer) cannot amortize the intangible.

In the second example, the seller sells an undivided interest in the business assets (including pre-1993 intangibles) to the buyer for cash; immediately thereafter, the seller and buyer contribute their respective undivided interests to the partnership. The anti-churning rules apply and the buyer is not allowed amortization, because the business assets acquired by the buyer and contributed to the partnership were held or used by the seller, a related party (Prop. Regs. Sec. 1.1972(h)(4)(ii)). In this example, the Sec. 197 intangibles are amortizable in the buyer's hands because the buyer and the seller are unrelated. Therefore, under the step-into-the-shoes rule, the partnership should be allowed to amortize the intangibles. However, in this example, the sale of business assets and contribution to the partnership are stepped together and the partnership is treated as acquiring the intangibles directly from the seller (a related party).

If the buyer and seller wait a sufficient amount of time to contribute their undivided interests in the business assets to the partnership (and they had no plans to do so at the time of the original asset sale), the partnership may be able to amortize a portion of the buyer's pre-1993 intangibles under the unrelated transaction exception to the anti-churning rules previously discussed. Nevertheless, under the Sec. 704(c) rules, the buyer is not allowed any amortization with respect to the seller's portion of pre-1993 intangibles contribution.

Unless and until the IRS amends the proposed regulations, the third example appears to provide the only mechanism to achieve amortization deductions for an unrelated buyer. In this example, the seller and a controlled entity form a partnership to hold the business assets (Prop. Regs. Sec. 1.1972(k), Example 17). Later, in an "unrelated transaction," the seller sells a portion of its partnership interest to the buyer. The partnership makes a Sec. 754 election, resulting in special basis creation in the Sec. 197 intangibles for the buyer. The example concludes that, provided the formation and the partnership interest sale are "unrelated," the buyer can amortize basis allocated to Sec. 197 intangibles under Secs. 754 and 743. The Service has informally acknowledged that the term "unrelated transaction" must be clarified and that it will do so in the final Sec. 197 regulations.

Conclusion

Until the proposed Sec. 197 regulations are finalized, practitioners have two choices in structuring partnership formation transactions involving pre-1993 or self-created intangibles: (1) rely on the statutory exception to the anti-churning rules and structure the transaction as a partnership interest acquisition or (2) structure the transaction as a straight contribution in anticipation that the IRS removes the Sec. 704(c) limitation (or at least applies the rule prospectively only).