Reducing losses disallowed by sec. 197.

Since its enactment in 1993, Sec. 197 has reduced significantly the level of uncertainty associated with amortization deductions for acquired intangibles. While the provision has helped decrease administrative burdens and costs to taxpayers and the IRS, not all issues arising under Sec. 197 have been identified or resolved. One such issue is the application of the loss disallowance rules in Sec. 197(f), which affects taxpayers as they dispose of acquired intangibles. These rules may have particular application to companies in the entertainment and media industry because of the significant amount of intangibles that comprise underlying business assets and the heightened level of merger and acquisition activity in this industry in recent years.

Loss Disallowance

Under Sec. 197(f) (1) (A) (i), no loss shall be recognized on a disposition (or worthlessness) of any "amortizable section 197 intangible" if (1) the intangible was acquired in a transaction or series of related transactions and (2) one or more of other such intangibles are retained. Instead, Sec. 197(f) (1) (A) (ii) requires the adjusted bases of the retained intangibles to be increased on a pro rata basis for any loss not recognized. In the case of a loss from disposition of a covenant not to compete, Sec. 197(f) (1) (B) precludes recognition of such loss by treating the convenant as disposed of only on disposition of the taxpayer's entire interest in the assets for which the covenant was created.

The term "amortizable section 197 intangible" is defined by Sec. 197(c) (1) as any Sec. 197 intangible intangible acquired by the taxpayer after the date of enactment of Sec. 197 and held in connection with the conduct of a trade or business or Sec. 212 activity. Sec. 197(d) specifically identifies the following as Sec. 197 intangibles:

* Goodwill and going concern value.

* Intangible property generally related to work force, information base, know-how, customers, suppliers or other similar items.

* Any license, permit or other right granted by a governmental unit or agency.

* Any convenant not to compete (or similar arrangement) entered into in connection with the direct or indirect acquisition of an interest in a trade or business.

* Any franchise, trademark or trade name.

Although sometimes referred to as a loss disallowance provision, Sec. 197(f) operates as a mechanism for loss deferral; that is, the effects of Sec. 197(f) are not permanent. The underlying purpose of Sec. 197(f) was to address concerns that taxpayers would seek to accelerate deductions for intangibles by claiming loss deductions for intangibles that are "sold" or become worthless, thereby circumventing the required 15-year amortization period. For example, prior to the enactment of Sec. 197, some taxpayers had sought to claim loss deductions for amounts allocated to customer lists when customers were lost.

Example 1: On Jan. 1, 1996, ABC Corp. acquires business assets for $1,000 from XYZ Corp. The purchase price is allocated to the underlying assets as follows, based on their fair market values at the date of acquisition.

                       Allocated
                     purchase price
   Description           1/1/96

Tangible assets          $ 100
Customer list A
  (product line A)        200
Customer list B
  (product line B)        200
Trademark                 200
Goodwill                  300

Total                  $1,000

Pursuant to Sec. 197, the intangibles are amortized on a straight-line basis over a 15-year life. On Mar. 31, 1998, ABC sells customer list A for $100. The tax basis of the list to ABC on the date of sale is $170 ($200 cost -- $30 amortization from Jan. 1, 1996 through Mar. 31, 1998). Therefore, ABC realizes a loss of $70 as a result of the sale. However, because list A was acquired from XYZ as part of a larger asset acquisition, the loss of $70 is deferred under Sec. 197(f). The adjusted bases of list B, the trademark and goodwill are increased by $70 on a pro rata basis. The $70 loss on the sale of list A is recognized as additional amortization over the remainder of the 15-year amortization period for the retained intangibles.

Segregating Intangibles on Disposition

The application of the statutory definition of "amortizable section 197 intangible" on a sale is not clear. Specifically, there is no clear guidance as to whether similar intangibles acquired in one transaction should be aggregated into one group, or whether such intangibles should be segregated, perhaps by the business line or product to which they relate or some other basis. Absent clear guidance in this area, different results may be reached when applying Sec. 197(f).

Aggregation suggests that all intangible assets acquired in one transaction should be grouped by the categories listed in Sec. 197(d), without regard to the specified use of each intangible. That is, if two or more acquired intangibles have the same definition under Sec. 197(d), the cost of all such intangibles should be aggregated into one category. On the other hand, segregation suggests that a business acquisition could consist of more than one intangible with the same definition representing separate and distinct intangibles within one Sec. 197(d) category. Either approach might be appropriate, depending on the particular facts and circumstances. For example, if a transaction represents the acquisition of more than one trade or business, segregation of the acquired assets between each business might be appropriate.

Example 2: Assume the same facts as in Example 1, except that ABC Corp. sells customer lists A and B in the same transaction, as follows:

Intangible    3/31/98      3/31/98     Gain/
  asset      tax basis   sales price   (loss)

Customer
  list A       $170         $100       $(70)
Customer
  list B       $170         $250        $ 80

If each customer list is treated as a distinct intangible, ABC would have a recognized gain of $80 on the sale of list B, and a disallowed loss of $70 on the sale of list A that could only be deducted ratably over the remaining 12 years and nine months of the original 15-year life. Alternatively, if the customer lists are considered one intangible asset category in the aggregate, the disposal of the customer lists would result in a gain of $10, and no loss would be deferred on the disposal--clearly a preferable outcome to the taxpayer.

Conclusion

The enactment of Sec. 197 significantly relieved previous tension between taxpayers and the Service over the amortization of intangibles. However, uncertainty as to the application of the loss disallowance rules under Sec. 197(f) among a group of similar intangibles, as illustrated, may continue to prove to be a point of controversy. FROM ANTHONY R. CASTELLANOS, CPA, AND JOHN J. LYNCH, CPA, NEW YORK, N.Y.