Section 197: Congress and the IRS attempt to settle disputes involving amortization of intangibles.

As part of the Omnibus Budget Reconciliation Act of 1993,(1)(*) Congress added section 197 to the Internal Revenue Code, which allows taxpayers to amortize most intangible assets ratably over a period of 15 years.(2) The enactment of section 197 represents a legislative effort to resolve a wide range of disputes between taxpayers and the Internal Revenue Service on the proper tax treatment of intangibles and to bring some measure of certainty to the area.

Before the enactment of section 197, taxpayers and the IRS fought over the legitimacy of amortization deductions for intangibles such as customer lists, covenants not to compete, goodwill and going concern value. Taxpayers sought to establish that the intangibles had an ascertainable cost basis separate and distinct from goodwill and going concern value and that intangibles had a limited useful life, the length of which could be ascertained with reasonable accuracy. The IRS attempted to refute these contentions, by arguing (among other things) that the intangibles were indistinguishable from goodwill and going concern value.

By allowing one standard amortization deduction for an expansive list of intangibles--so-called amortizable section 197 intangibles(3)--Congress sought to settle a heavily litigated area of tax law. The IRS can no longer deny deductions for assets in the nature of goodwill and going concern value, and taxpayers must accept an amortization period of 15 years for most intangibles, notwithstanding a possibly shorter economic life. Questions remain, however, whether section 197 will operate to eliminate controversies concerning intangibles.

The legislative history of section 197 calls upon the IRS to settle existing intangible amortization controversies (even though the provision itself is generally prospective). Pursuant to this mandate, the IRS has established settlement offer guidelines for pre-section 197 cases and, as of April 1, 1994, has started to contact taxpayers offering to settle. Although the settlement guidelines are not unduly generous, they do allow taxpayers to resolve thorny issues and salvage some tax benefits.

Background

Congress was driven to enact section 197 because of the substantial issues--in terms of numbers and dollar value--arising with respect to intangible assets.(4) Treas. Reg. [sections] 1.167(a)-3, establishing guidelines for the amortization of intangibles, was at the heart of the controversy. This regulation allows depreciation of an intangible that is used in business or in the production of income for only a limited period, the length of which can be estimated with reasonable accuracy. No depreciation is allowed for an intangible that does not have a limited useful life. In addition, the regulation specifically precludes depreciation of goodwill.

In 1993, the Supreme Court opined on the amortization of intangibles in Newark Morning Ledger Co. v. United States.(5) In interpreting the language of Treas. Reg. [sections] 1.167(a)-3, the Court concluded that "[t]he entire justification for refusing to permit the depreciation of goodwill evaporates ... when the taxpayer demonstrates that the asset in question wastes over an ascertainable period of time."(6) Thus, while accepting "expectancy of continued patronage" as a useful definition of goodwill, the Court cautioned that the definition only serves to describe an intangible asset that has no useful life and no ascertainable value.(7) If a taxpayer can establish that an intangible asset has a limited useful life and can be valued, then the taxpayer may depreciate the asset's value over its useful life, regardless of how much the asset appears to reflect the expectancy of continued patronage.(8)

The Supreme Court's decision in Newark Morning Ledger removed the requirement to distinguish an intangible from goodwill, but it also underscored the magnitude of the taxpayer's evidentiary burden in establishing an asset's useful life.(9) By allowing amortization ratably over 15 years, Congress has attempted to strike a balance between taxpayers and the IRS--allowing taxpayers to amortize previously nonamortizable intangibles while preventing taxpayers from amortizing "provable" intangibles over periods shorter than 15 years.

Operation of Section 197

Effectively, section 197 allows the amortization of most types of goodwill and other intangibles that are purchased (not created) by the taxpayer. Taxpayers are allowed the deduction for "amortizable section 197 intangibles."(10) The taxpayer determines the amount of the deduction by amortizing an intangible's adjusted basis ratably over the 15-year period beginning with the month that the taxpayer acquired the intangible. Under Newark Morning Ledger and pre-section 197 law, the assets would have been amortized based on their useful lives. Currently, all assets covered by section 197 are amortized on a straight-line basis over a 15-year period--no flexibility exists.(11) Section 197(b) states that if an asset is defined by section 197, then the amortization rules of section 197 must be followed.

Section 197(c) states that, for an asset to be amortizable under the statute, it must generally (i) be acquired on or after August 10, 1993, (ii) not be created by the taxpayer, and (iii) be used in the taxpayer's trade or business or for the production of income. The provisions of section 197 might otherwise suggest an advantage to the taxpayer to take assets created by the taxpayer or acquired by the taxpayer prior to August 10, 1993, and have them transferred and then reacquired in order to be able to amortize them under section 197. Section 197(f)(9), however, effectively prevents such churning of the assets.(12)

Businesses that made acquisitions after July 25 and before August 10, 1993, may, however, elect to apply the Act retroactively.(13) If the election is made, section 197 must be applied retroactively to all transactions that occurred after July 25, 1991. Temp. Reg. [sections] 1.197-1T outlines the requirements and consequences of making the election, including the requirement to file amended returns.(14)

The certainty afforded by applying the Act retroactively has great merit. When litigation costs and the uncertainty factor are taken into consideration, it is possible that--despite the shorter amortization available prior to the Act--retroactive application would be beneficial.

Section 197 Intangibles

Section 197 intangibles generally include the following:(15)

* Goodwill

* Going concern value

* Workforce in place

* Business books and records, operating systems, or

any other information base

* Patent, copyright, formula, process, design, pattern, knowhow, format, or similar item * Customer-based intangible(16) * Supplier-based intangible * "[A]ny other similar item"(17) * Governmental license, grant, permit, or other rights * Covenant not to compete acquired as part of the acquisition of a business(18) * Franchise, trademark, or tradename

Section 197 also prescribes certain exceptions that remove certain intangibles from the scope of the statute.(19) Section 197 intangibles do not include any of the following:

* Interests in a corporation, partnership, trust or

estate, or futures contracts, foreign currency contracts,

notional principal contracts, or other similar

contracts.(20)

* Interests in land.(21)

* Computer software, if it is not purchased in connection

with the acquisition of a trade or business.(22)

(Software excluded from section 197 amortization

is instead amortized over 36 months.(23)

* Unless acquired in a transaction (or series of related

transactions) involving the acquisition of assets

constituting a trade or business or substantial portion

thereof(24)--

* an interest in a film, sound recording, video

tape, book, or similar property,(25)

* the right to receive tangible property or services

under a contract or any right to receive tangible

property or services granted by a government

or government agency,(26)

* any interest in a patent or copyright,(27) and

* to the extent provided in regulations, contract

rights (or rights under governmental grant) that

either have a fixed duration of less than 15

years or are fixed in amount and would otherwise

be recoverable under a method similar to

unit-of-production.(28)

* An existing lease in tangible property and any existing

indebtedness (except for bank deposits).(29)

* Professional sports franchises and any item acquired

in connection with the acquisition of such a

franchise.(30)

* Rights to service residential mortgages, unless acquired

as part of a trade or business.(31) (The taxpayer

instead must amortize these rights straight line

over 108 months.(32))

* Transaction costs incurred in nonrecognition transactions

under part III of Subchapter C.(33) (Hence,

the Act leaves intact the principles of INDOPCO,

Inc. v. Commissioner.(34))

Basis of Intangibles and Interplay of Sections 197, 338 and 1060

While section 197 allows a taxpayer to amortize a wide variety of intangibles over 15 years, the section provides scant guidance on determining the basis of intangibles. The determination of basis is important because the taxpayer cannot amortize an intangible unless the taxpayer carries its burden of proof on the basis of the intangible. Section 197 does not change this. The determination of basis would typically be straightforward in the acquisition of an isolated intangible: basis would equal the amount paid.(35) If the cost of acquisition includes contingent amounts, the taxpayer generally increases basis as of the beginning of the month that the contingent amount is paid or incurred, with the additional amount amortized ratably over the months remaining in the original 15-year period.(36)

When a taxpayer acquires a trade or business, the taxpayer must allocate purchase price among all the assets acquired, including intangibles. The legislative history of section 197 provides helpful guidance on allocating purchase price.

If a taxpayer acquires an interest in a partnership, the taxpayer is not treated as acquiring a new section 197 intangible unless the taxpayer obtains an increased basis in the intangible.(37) The new partner will step into the shoes of the selling partner to the extent of any existing basis in section 197 intangibles. If a section 754 election is in effect, the new partner could be treated as having an increased basis in the section 197 intangibles of the partnership. The new partner would in effect determine income or loss from the partnership as if the partnership had two intangibles. To the extent of existing partnership basis in section 197 intangibles, the new partner would step into the shoes of the selling partner, and to the extent of any increased basis in partnership section 197 intangibles, the partner's income would reflect amortization of the increased basis over the 15 years starting with the month the new partner acquires the partnership interest.

Sections 338 and 1060 pertain to determining the basis of assets acquired as part of the acquisition of a trade or business.(38) Section 1060 applies to an outright acquisition of a trade or business, and section 338 applies to an acquisition of a target company's stock treated as an asset acquisition for tax purposes. In both cases, the rules of section 338(b)(5) govern the allocation of overall basis(39) to the individual assets acquired.(40) The regulations under section 338(b)(5) require allocation of overall basis to four classes of assets (cash, marketable securities, other assets and, historically, goodwill/going concern value).(41)

Section 197 does not specifically address the interplay of sections 197, 338, and 1060.(42) The legislative history does.(43) After explaining the current mechanics of the residual method of section 338(b)(5), the Conference Report on the 1993 Act states:

It is expected that the present Treasury regulations

which provide for the allocation of purchase

price in the case of certain asset acquisitions will

be amended to reflect the fact that the bill allows

an amortization deduction with respect to intangible

assets in the nature of goodwill and going concern

value. It is anticipated that the residual method

specified in the regulations will be modified to

treat all amortizable section 197 intangibles as

Class IV assets and that this modification will

apply to any acquisition of property to which the

bill applies.(44) Thus, acquirers should, in theory, allocate to amortizable section 197 intangibles any residual of purchase price not allocated to other assets.

For a variety of reasons, it is unclear whether the express congressional intent that the enactment of section 197 minimize, if not eliminate, conflicts between the IRS and taxpayers will materialize. First, section 197 does not alter the burden of proof on the basis of any asset, including intangibles; that burden remains with the taxpayer. Second, while section 197 has broad application to intangibles, the statute allows 15-year amortization only for enumerated intangibles, and expressly excludes some intangibles from its application.

Several issues linger. Could an argument be made that the congressional desire to modify the existing residual method by treating all amortizable section 197 intangibles as Class IV assets implies a rejection of the residual method in favor of a system that attaches a value to each asset to be proven by the taxpayer? Will the courts tolerate a taxpayer that fails to adequately establish the values of assets because the taxpayer views 15-year amortization as a fallback position or because the taxpayer prefers 15-year amortization over what might otherwise result? Might the courts in those situations simply disallow amortization deductions, citing the taxpayer's failure to carry its burden? Or, might the IRS prevail in allocating basis to assets other than intangibles that have a recovery period in excess of 15 years because the taxpayer fails to carry its burden?

Perhaps most troubling, to what extent will the Supreme Court's INDOPCO decision factor into the allocation of basis to amortizable section 197 intangibles?(45) The Court held in INDOPCO that expenses incurred as part of a friendly takeover were not deductible under section 162 as ordinary and necessary business expenses. The exact principles to be gleamed from the case and, therefore, the effect on the future, remains uncertain. But the Court's decision did provide some guidance. An expenditure's giving future benefit to a taxpayer, for example, is "undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization."(46) Moreover, the Court confirmed that certain expenses incurred to change the corporate structure for the benefit of future operations are not ordinary and necessary business expenses and are therefore nondeductible.(47) And, "[t]he fact that the expenditures do not create or enhance a separate and distinct additional asset is not controlling; the acquisition-related expenses bear the indicia of capital expenditures and are to be treated as such."(48)

There are at least two possible ways in which INDOPCO could be invoked to defeat deductions for intangibles under section 197. First, if the taxpayer fails to establish values for assets (including amortizable section 197 intangibles) equal to the purchase price, the IRS might argue that the excess is not deductible because the expenditure creates a future benefit even though not attributable to a separate and distinct asset. Second, the IRS could argue that, while the cost of acquiring an intangible might be amortizable, future expenses that enhance that intangible give rise to a long-term benefit that must be capitalized rather than deducted.

Except perhaps where the taxpayer abandons or all but abandons its burden of proof on the values of assets and except in respect of post-acquisition expenditures primarily intended for future benefit, neither of the foregoing arguments should succeed. Congress was clearly concerned about the backlog of audits and litigation produced by the amortization-of-intangibles issue and just as clearly intended that section 197 simplify the law and reduce confrontation.(49) In addition, Congress provided ample language calling for the treatment of any residual purchase price as an asset amortizable over 15 years, a period intended to strike a balance between the IRS's and taxpayers' positions. Accordingly, the law should be construed to minimize the possibility of nonamortizable nondeductible expenditures.

Settlement of Existing Intangible Amortization Disputes

Congress did not limit its focus to amortization of intangibles acquired after the passage of the 1993 Act. It also expressly called upon the IRS to resolve existing controversies.(50) The IRS has responded with global settlement guidelines.(51) As of April 1, 1994, the IRS is contacting taxpayers offering to settle consistent with these guidelines. These guidelines apply in respect of acquisitions made before July 26, 1991, if intangibles issues from the acquisitions are under audit by April 1, 1994.(52) The offer will be available to most, but not all, taxpayers.(53) Once the IRS and taxpayer agree on a computation of the settlement, the parties will execute a specific item closing agreement.

Subject to a possible exception, the essence of the proposed guidelines is to allow a taxpayer to amortize some but not all of what the taxpayer claims as amortizable intangibles. The guidelines generally require taxpayers to reclassify from amortizable intangibles to nonamortizable goodwill/going concern value the greater of two computed amounts:

* 15 percent of claimed amortizable intangibles,

* an amount based on a present value analysis of

intangibles cost recovery. The guidelines thus offer tax benefits somewhere between what the taxpayer claimed on its tax return and no deduction at all. The guidelines are less favorable than section 197 itself.

The IRS settlement offer guidelines provide a four-step process to determine the reclassification from amortizable intangibles to nonamortizable intangibles. This process must be applied separately to each acquisition.

Step 1. Multiply the claimed basis of amortized intangibles

shown on the tax return by 15%.(54)

Step 2. Compute the 50% cost recovery adjustment:

(a) Compute the weighted average useful life for

amortized intangibles. This is accomplished by multiplying

the claimed basis of each amortized intangible

by its claimed useful life, adding the results for each

intangible, and then dividing that total by the total

basis claimed for all amortized intangibles.(55)

(b) Determine the nonamortizable intangible basis

necessary to achieve an overall cost recovery of 50%.

This step is accomplished by multiplying the aggregate

value of all intangibles (amortizable and nonamortizable)

by the nonamortizable percentage of total intangible

value, a percentage derived from a table provided

by the IRS in its settlement guidelines. The table provides

percentages that differ based on the weighted

average useful lives of amortized intangibles (from Step

1). The purpose of the table is to limit the present

value of a taxpayer's amortization deductions. Hence,

as the weighted average useful life increases, the basis

that can be amortized increases.(56)

(c) Subtract the goodwill/going concern value (i.e.,

the nonamortizable intangibles) claimed on the tax

return from the amount computed in Step 2(b). This

remainder is called the "50% cost recovery adjustment."

Step 3. Determine the larger of amounts derived in

Steps 1 and 2(c) and reclassify that amount from amortizable

intangibles to nonamortizable intangible

Step 4. Recompute the basis of each intangible acquired

in the transaction. The basis of goodwill/going

concern value increases by the Step 3 amount. The

basis of amortizable intangible assets is decreased by a

pro rata portion of the Step 3 amount, with the proration

based on the assets' respective values claimed on

the tax return. The taxpayer then recomputes amortization

deductions based on these revised bases, and

based on the lives and methods used in the tax return.

If the recomputation of amortization deductions includes

closed years, the taxpayer must make further

adjustments the essence of which requires the taxpayer

to forgo amortization deductions in the earliest open

years to the extent of excessive deductions in closed

years.(57) (The operation of these guidelines is illustrated in Example 2.

Although the IRS settlement guidelines generally require taxpayers to reclassify basis from amortizable intangibles to nonamortizable intangibles, the IRS will allow taxpayers to extend the lives of amortizable intangible assets rather than lose amortizable basis. The IRS has established an eight-step process determining the extended lives such that the present value of increased tax benefits over an extended period equals the present value of tax benefits under the general approach outlined above. (This process is illustrated in Example 3.

The decision to settle based on the guidelines may not be an easy one. The starting point in the analysis should be a numerical comparison--the present value of tax savings based on deductions as claimed on the return with the present value of tax savings based on accepting a settlement. The legal, accounting, and time costs of pursuing a defense should also be factored in. Consideration should also be given to the following observations.

The guidelines do not distinguish between industries; service companies would receive the same treatment as manufacturers even though service companies have a greater proportion of their assets in intangibles and therefore stand to lose a great deal more. If the guidelines are unattractive to this segment of businesses, the congressional intent to encourage settlement would be undermined. The IRS has responded that a distinction based on industry would be improper because Congress did not suggest any such distinction and because service providers face the same hazards of litigation as manufacturers.

A decision to settle must be considered in light of the alternative--fighting the issue through the IRS's administrative process and the courts. Ultimate disposition should depend on the nature of the intangibles, not the nature of the industry. Nonetheless, several factors might make service companies less attracted to the settlement offer. Service companies have a greater proportion of intangible assets and therefore have more to lose by settling, and the cost of litigation would be relatively less expensive. Service companies would more likely have intangibles that would withstand a court challenge--customer lists, core deposits, etc. On the whole, taxpayers should not place too much emphasis on their industry in determining whether to accept the settlement offer. Rather, taxpayers should look primarily to the merits of their particular circumstances.

The settlement guidelines are the same for all taxpayers regardless of a taxpayer's likelihood of ultimate success. The guidelines require the taxpayer to give up amortization based on uniform formulae that are ultimately a function of the proportion of intangibles that are amortized and the useful lives claimed. The offer does not vary based on the type of intangibles a taxpayer has claimed or based on the aggressiveness of the taxpayer or based on the taxpayer's diligence in documenting the amortization deduction. In a sense, then, the settlement guidelines may actually reward taxpayer aggressiveness because the more aggressive the taxpayer has been in claiming amortizable intangibles, the more amortizable intangibles the taxpayer will have following acceptance of the settlement offer. Taxpayers should make their decision with these considerations in mind. The more aggressive a taxpayer has been in claiming amortizable intangibles out of what would otherwise be nonamortizable, the less evidence the taxpayer has to support the intangibles, and the more questionable the nature of the intangibles claimed, the more willing the taxpayer should be to accept the offer.

The settlement guidelines assume an interest rate that may now be unrealistically low. The interest rate is 5.5 percent (approximately 8.5 percent pre-tax, assuming a 35 percent tax rate), applied to essentially long-term computations. If the interest rate used in discounting computations is too low, the present value of future amounts is too high, and given the 50-percent present value standard of the guidelines, the percentage of intangibles that may be amortized will be too low and the amount that must be reclassified to nonamortizable assets too high. While a long-term interest rate of 5.5 percent may have been realistic when the IRS issued the guidelines on February 10, market forces have since increased interest rates substantially, making the settlement offer less attractive.

A taxpayer should consider both the tax and financial accounting consequences of settling. The financial accounting aspects of the decision are especially important in light of the possibility of amortizing 100 percent of the amortizable intangible basis claimed on the return by agreeing to extend the period for amortization. The general approach would presumably create differences between tax basis and financial accounting carrying amounts for amortizable intangible assets. The alternative would not. Moreover, whereas the general approach requires a discounting of future tax consequences, Statement of Financial Accounting Standards No. 109, which addresses accounting for deferred taxes, does not now require discounting. Hence, while the alternative would theoretically produce a comparable present value (assuming market rates of interest), the deferred taxes could be substantially less.

Conclusion

Section 197 allows taxpayers to amortize most intangibles ratably over 15 years. Taxpayers should identify and value all assets, including amortizable section 197 assets, acquired as part of the acquisition of a trade or business or as part of the acquisition of stock of a company treated as an acquisition of assets. If the overall purchase price exceeds the fair market value of identified assets, the taxpayer should allocate that excess to amortizable section 197 intangibles, together with amounts already allocated to those intangibles. The taxpayer should then amortize the entire amount over 15 years.

Although the provisions of section 197 are available for acquisitions after July 25, 1991, IRS settlement guidelines offer most taxpayers an opportunity to settle outstanding cases. The offer is clearly not as generous as section 197, but the taxpayer should nonetheless compare the settlement offer with the expected outcome of continued litigation together with the associated time, expense,y and other hazards of litigation. The taxpayer should also consider whether financial accounting results or some other rationale justifies extending the tax lives of assets acquired in transactions before July 25, 1991, rather than reclassifying basis from amortizable assets to nonamortizable assets. Example 1: X Corp. acquires 100% of the stock of Y Corp. for cash of $1 million, X elects section 33 acquisition of Y. Y has no liabilities before or as a result of the transaction. Under two alternati establish assets with the following apprised values:

                              Alternative 1       Alternative 2
     Cash                        $50,000            $50,000
     I.B.M. stock                100,000            100,000
     Equipment                   650,000            350,000
     Customer list               100,000            100,000
     Goodwill                    200,000            200,000
     Going concern value         100,000            100,000
                              $1,200,000           $900,000

Y is able to establish that the customer list has a value of $100,000 and a useful life of 7 years. basis of $1 million. That allocation with and without application of section 197 should be, as follo

                                              Alternative 1
         Alternative
                              Before [sections]197   After [sections]197   Befor
e [sections]197   Af
     Class I (cash)              $50,000                $50,000               $5
0,000
     Class II (I.B.M. stock)     100,000                100,000               10
0,000

Class III:

     Equipment                   650,000                650,000               35
0,000
     Customer list               100,000                      0               10
0,000
     Class IV                    100,000                200,000               40
0,000
                              $1,000,000             $1,000,000            $1,00
0,000             $1

Both alternatives represent circumstances where the amount paid ($1 million) does not equal the aggr values of acquired assets. The taxpayer would still allocate total basis of $1 million, and any resi allocations to Classes I, II, and III-should go to Class IV, both before and after section 197. Example 2:(58) P Corp. acquires the assets of Target for $2 million. The assets have

Tangible assets:

    Inventory                          $200,000
    Machinery and equipment             400,000
    Accounts receivable                 100,000
    Land and building                   300,000
                                     $1,000,000

Intangible assets:

    Goodwill/going concern value       $200,000
    Customer list                       700,000
    Trade name and trademark            100,000
                                     $1,000,000

P amortizes the customer list straight line over 4 years, the tradename/trademark over 10 years. Step 1. The minimum concession amount equals $120,000, computed as 15 percent of $800,000, the amoun amortized intangibles (i.e., the customer list and trade name/trademark). Step 2(a). The weighted average useful life for amortized intangibles equals 4.75 years, computed as

    Intangible                           Value     Life         Total
    Customer list:                    $700,000        4    $2,800,000
    Trademark/tradename                100,000       10     1,000,000
    Total                             $800,000       14    $3,800,000

3,800,000/800,000 = 4.75 years Step 2(b). The nonamortizable intangible basis necessary to achieve an overall cost recovery of 50 p $418,300:

    $1,000,000        values of all intangibles
     x 41.83%         the nonamortizable percentage (derived from the IRS table)

$418,300 Step 2(c). The 50-percent cost recovery adjustment is $218,300:

    $418,300        Step 2(b) amount
    (200,000)       less goodwill/going concern value

$218,300 Step 3. The larger of Steps 1 and 2 is Step 2, $218,300. Step 4. Adjust the bases of the intangibles:

    Intangible            Basis of Return   Adjustment         Revised Basis
    Goodwill/GCV                 $200,000     +218,300              $418,300
    Customer list                 700,000     -191,012 (7/8)         508,988
    Trademark/tradename           100,000      -27,288 (1/8)          72,712
                               $1,000,000            0            $1,000,000

P would amortize the revised bases of the customer list and trademark/tradename, $508,988 and $72,71 over their useful lives, 4 years and 10 years. Example 3:(59) Assume the same facts as in Example 2 above. Step 1. Compute the weighted average useful life of amortized intangibles on the return:

    Customer list                    $700,000  x   4 years  =  $2,800,000
    Trademark/tradename               100,000  x  10 years  =  $1.000.000
    Total                            $800,000                  $3,800,000

3,800,000/800,000 = 4.75 years Step 2. Determine the "recovery timing percentage." This is done by finding the weighted average use on an IRS provided Straight Line Conversion Table. In the case of 4.75 years, the recovery timing pe 86%. Step 3. Compute the 15% minimum recovery timing percentage by multiplying the recovery timing percen 2) by 85%:

86% x 85% = 73.1

Step 4. Compute the "recovery amount percentage" claimed on the return by dividing the amount of amo intangible assets on the return by the total intangibles from the acquisition:

800,000/1,000,000 = 80%

Step 5. Determine the "required recovery timing" percentage by dividing 50% by the recovery amount p (Step 4):

50%/80% = 62.5%

Step 6. Determine the extended recovery timing percentage by determining the lower of Steps 3 and 5. 62.5% of Step 5 is lower than the 73.1% of Step 3. Step 7.(60) Determine the extended useful life for each specific asset by applying the following 4 s

a. For each amortized intangible, find the asset's useful life on the Straight Line Conversion

the corresponding cost recovery percentage:

          Customer list (4 years)    = 87.6%
          Tradename (10 years)       = 75.4%

b. Compute the recovery timing percentage reduction factor for the whole acquisition by dividi

extended recovery timing percentage (Step 6) by the recovery timing percentage (Step 2):

62.5%/86% = 72.7%

c. Multiply the recovery timing percentage reduction factor (Substep 7b) by the Substep 7a per

each asset:

          Customer list          87.6% x 72.7% = 63.7%
          Tradename              75.4% x 72.7% = 54.8%

d. Determine the extended useful life for each asset by finding the corresponding Substep 7c p

the Straight Line Conversion Table:

          Customer list              = 17.25 years
          Tradename                  =    24 years

Step 8. Recompute the amortization deductions by dividing each asset's basis claimed on the return b extended useful life (Substep 7d):

          Customer list     $700,000/17.25 years = $40,580/year
          Tradename         $100,000/24 years = $4,167/year

(*) Footnotes are printed on page 288.

--Notes--

(1) Pub. L. No. 103-66 (1993). (2) I.R.C. [sections] 197(a). (3) I.R.C. [sections] 197(c). (4) See H.R. Rep. No. 103-213, 103d Cong., 1st Sess. 696 (1993) (OBRA Conference Report). (5) 61 U.S.L.W. 4313 (U.S. April 20, 1993). For a further analysis of Newark Morning Ledger, see Persellin, Depreciation of Customer-Based Intangibles Confirmed by Supreme Court in Newark Morning Ledger, 45 Tax Executive 211 (May-June 1993). (6) 61 U.S.L.W. at 4318. (7) Id. at 4316 n.9. (8) Id. at 4319. The Court did not minimize the taxpayer's burden of proof. The taxpayer must establish the value of the distinct intangible, the fact that the asset has a limited useful life, and a determination of that useful life. The Court acknowledged that the taxpayer's burden would often prove too great to bear. Id. (9) Some courts have considered the amortization of intangibles in light of Newark Morning Ledger. For example, in Ithaca Industries Inc. v. Commissioner, 17 F.3d 684 (4th Cir. 1994), the court disallowed amortization for an assembled workforce acquired in a merger. In Meredith Corp. v. Commissioner, 102 T.C. 15 (1994), the acquirer of a magazine was not allowed to amortize the editor-in-chief's employment contract or additional amounts allocated to non-competition agreements but was allowed to amortize the subscriber relationships based on agreed useful lives and determined basis. In Trustmark Corp. v. Commissioner, T.C. Memo 1994-184 (1994), a bank was allowed to amortize core deposits purchased. (10) I.R.C. [sections] 197(a). See also I.R.C. [sections] 197(f)(7) (treating amortizable section 197 intangibles as property of a character subject to the allowance for depreciation under section 167). (11) I.R.C. [sections] 197(b). (12) I.R.C. [subsections] 197(c)(3) & (f)(9). Churning generally occurs when the intangible was held or used at any time on or before the date of enactment by the taxpayer or a related person, the intangible was acquired from a person who held such intangible at any time on or before such date of enactment and, as part of the transaction, the user of such intangible does not change or the taxpayer grants the right to use such intangible to a person (or a person related to such person) who held or used such intangible at any time on or before such date of enactment. I.R.C. [sections] 197(f)(9)(A). (13) Omnibus Budget Reconciliation Act of 1993, Pub. L. No. 103-66, [sections] 13261(g)(2); Temp. Reg. [sections] 1.197-1T. (14) Temp. Reg. [sections] 1.197-1T(c)(4). The temporary regulation also addresses the requirement that all taxpayers under common control elect, the effect of the election on former consolidated group members, the effect of the election on taxpayers involved in certain nonrecognition transactions, the interplay of the election with sections 734(b) and 743(b), and the binding contract election. (15) I.R.C. [sections] 197(d)(1). (16) This category includes many of those intangibles that have been so heavily litigated in the past, including the intangibles at issue in the landmark Newark Morning Ledger and Houston Chronicle cases. See Newark Morning Ledger v. United States, 61 U.S.L.W. 4313 (U.S. April 20, 1993), and Houston Chronicle Publishing Co. v. United States, 481 F.2d 1240, (5th Cir. 1973), cert. denied, 414 U.S. 1129. Clearly, a core of customers represents one of the primary assets included in the acquisition of most trades or businesses. (17) I.R.C. [sections] 197(d)(1)(C)(vi). (18) The purchase of the stock of a corporation does not result in the purchase of its assets for tax purposes unless the acquirer so elects pursuant to section 338. Based upon this, there would be no new amortization of any assets of the acquired corporation in a simple stock purchase transaction. If a covenant not to compete is negotiated as part of the stock purchase, however, the covenant not to compete is an amortizable section 197 intangible, even if section 338 is not elected. See I.R.C. [subsections] 197(d)(1)(E) & (f)(3); OBRA Conference Report at 677.

Fifteen-year amortization for covenants not to compete presents significant problems. Courts are hostile to covenants not to compete even when they have been freely negotiated with both sides represented by counsel. It is almost certain that a covenant not to compete in excess of five years will be struck down. Most covenants not to compete are for a maximum of three years.

Since most covenants not to compete are for a maximum of three years and they will be amortized under the Act over a period of fifteen years, a purchaser will want to allocate as little cost as possible to the asset. This will obviously create tensions with the Internal Revenue Service over the amount of cost allocated to the covenant not to compete. For example, the acquirer of the target company may prefer to enter into a contract for the performance of consulting services by the former owner. The government can recast an amount paid under this contract into a section 197 intangible required to be amortized over 15 years, to the extent the amount paid exceeds reasonable compensation. See OBRA Conference Report at 677. (19) I.R.C. [sections] 197(e). (20) I.R.C. [sections] 197(e)(1). As discussed more fully in the text that follows, a partnership can have section 197 intangibles and can pass the amortization of those intangibles through to the partners. In addition, although a partnership interest may not be a section 197 intangible, that acquisition could give rise to an increase in basis in section 197 intangibles for measuring that partner's income or loss from the partnership. (21) I.R.C. [sections] 197(e)(2). Airport landing rights, however, are section 197 intangibles. OBRA Conference Report at 679. (22) I.R.C. [sections] 197(e)(3). Moreover, even if computer software is acquired in connection with the acquisition of a trade or business, it is excluded from 15-year amortization if it is readily available for purchase by the general public, is subject to a non-exclusive license, and has not been substantially modified. For example, the Wordperfect software used to write this article would be excluded from section 197 amortization. (23) I.R.C. [sections] 167(f)(1). (24) I.R.C. [sections] 197(e)(4). (25) I.R.C. [sections] 197(e)(4)(A). (26) I.R.C. [sections] 197(e)(4)(B). See also OBRA Conference Report at 680. Taxpayers will instead determine the depreciation deduction pursuant to regulations to be written. I.R.C. [sections] 167(f)(2). (27) I.R.C. [sections] 197(e)(4)(C). If depreciation is allowable, but not under section 197, regulations will provide the manner of depreciation. I.R.C. [sections] 167(f)(2). The regulations should provide that if the purchase price is payable on an annual basis as a fixed percentage of revenue derived from a patent, the depreciation deduction equals the royalty paid or incurred. OBRA Conference Report at 681. (28) I.R.C. [sections] 197(e)(4)(D). Taxpayers would instead amortize these intangibles pursuant to regulations to be written. I.R.C. [sections] 167(f)(2). Regulations should address the extent to which renewal rights or opportunities will impact the determination of a contract's fixed duration or amount. (29) I.R.C. [sections] 197(e)(5). See also I.R.C. [sections] 197(f)(6) (treating a sublease in the same manner as a lease). (30) I.R.C. [sections] 197(e)(6). (31) I.R.C. [sections] 197(e)(7). (32) I.R.C. [sections] 167(f)(3). (33) I.R.C. [sections] 197(e)(8). (34) 112 S. Ct. 1039 (1992). (35) See OBRA Conference Report at 685, indicating that the adjusted basis of an intangible acquired from another taxpayer is generally determined under existing principles of tax law applicable to acquisitions of tangible property. (36) Id. Congress expects some limited regulatory exceptions to this general proposition. For example, certain amounts paid for a franchise, trademark, or tradename that is contingent on productivity, use, or disposition would be deductible. Id. at 678. (37) OBRA Conference Report at 686-87. (38) I.R.C. [subsections] 338(b)(5) & 1060(a). Section 197 provides many distinct rules for assets that are acquired as part of an acquisition of assets that constitute "a trade or business or substantial portion thereof." See, e.g., I.R.C. [subsections] 197(c)(2) & (d)(1)(E). This concept for purposes of section 197 is intended to include, but not be limited to, an asset acquisition defined in section 1060. Hence, the acquisition of a trade or business (or substantial portion thereof) for purposes of section 197 can occur even if such an acquisition does not occur for purposes of section 1060. See OBRA Conference Report at 678. (39) Sections 338 and 1060 and the applicable regulations provide rules to determine the overall basis to allocate. The overall basis is primarily a function of the purchase price of the trade or business or stock of the target. See I.R.C. [subsections] 338(b) & 1060(a). (40) See I.R.C. [sections] 1060(a), referring to I.R.C. [sections] 338(b)(5). (41) Temp. Reg. [subsections] 1.338(b)-2T & 1.1060-1T(d) & (e). Taxpayers must identify assets acquired and place the assets within one of the four classes:

Class I, cash and cash equivalents,

Class II, CD's, Treasury securities, foreign currency, and marketable

stock or securities,

Class III, all assets not in the other three categories,

Class IV, goodwill/going concern value. Having identified the class for each asset, the acquirer allocates overall basis first to Class I, then to Class II, then to Class III, up to the fair market value of each class. The acquirer allocates remaining overall basis (i.e., overall basis in excess of the aggregate fair market value of classes I, II, and III) to Class IV, not limited to the fair market value of Class IV Thus, while Class III is the catchall in terms of placing assets in categories, any residual of purchase price goes to Class IV. (42) The 1993 Act did, however, make two changes to section 1060. Section 1060(b)(1) granted regulatory authority to require the buyer and seller of a business to provide to the IRS information on the amount of consideration received (and paid) for goodwill and going concern value. Section 1060(d)(1) applied the rules of section 1060(a) in the case of a distribution of partnership property or a transfer of a partnership interest but only for purposes of determining the value of goodwill or going concern value for purposes of applying section 755, which provides rules for allocation of basis. Both provisions have been modified by substituting section 197 intangibles for goodwill and going concern value. (43) OBRA Conference Report at 688-89. (44) Id. at 689. (45) INDOPCO v. Commissioner, 112 S. Ct. 1039 (1992). (46) Id. at 1044-45. (47) Id. at 1045. (48) Id. at 1046. (49) See OBRA Conference Report at 696. A similar purpose underlay the enactment of section 1060 which imposed the residual method of allocating basis. See S. Rep. No. 99-313, 99th Cong., 2d Sess. 253 (1986), H.R. Rep. No. 99-841, 99th Cong., 2d Sess. 208 (1986) (Conference Report on Tax Reform Act of 1986) and Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (the Blue Book), 99th Cong., 2d Sess. 355-360 (1987). The abundance of litigation targeted by the 1993 law apparently occurred notwithstanding congressional intent in earlier legislation to minimize confrontation. (50) See OBRA Conference Report at 696. The Conference Report indicates, "[i]n considering settlements and establishing procedures for handling existing controversies in an expedited and balanced manner, the conferees strongly encourage the Internal Revenue Service to take into account the principles of the bill so as to produce consistent results for similarly situated taxpayers. However, no inference is intended that any deduction should be allowed in these cases for assets that are not amortizable under present law." Id. (51) The settlement offer guidelines were released as press briefing materials. They are reprinted in the Bureau of National Affairs' Daily Tax Report (1994-27), at L-7 (February 10, 1994). (52) See IRS Press Release IR-94-29 (March 29, 1994). As discussed earlier, taxpayers may elect section 197 for acquisitions made between July 26, 1991, and August 9, 1993 (inclusive), hence making settlement offers unnecessary for these later acquisitions. (53) The offer is not available for cases approved by a National IRS cross-functional committee consisting of representatives from Appeals, Counsel, and Examination. Also, the offer is not available for refund claims based on increased deductions (relative to the original return filed) from the amortization of intangibles. (54) If the taxpayer has claimed a second-tier allocation, the taxpayer must first reallocate the second-tier adjustment made to tangible assets over to goodwill. (55) If the taxpayer claims accelerated amortization on an intangible, a further adjustment must be made. The settlement offer guidelines provide a table for making this adjustment. (56) For example, if the taxpayer determines that the amortizable intangible assets from an acquisition have a weighted average useful life of 4.75 years, the table provides that 58.17 percent of total intangible value is allowed to be amortized and 41.83 percent of the total value is nonamortizable. If, alternatively, the amortizable intangibles have a weighted average useful life of 6.25 years, 60.43 percent of total intangible value can be amortized and 39.57 percent is nonamortizable. (57) The IRS has provided the procedures for making the adjustment together with an example in a document issued March 29, 1994. See BNA Daily Tax Report (1994-60), at L-9 (March 30, 1994). (58) Adopted from an example provided in the settlement offer guidelines. (59) Adopted from an example issued by the IRS on March 29, 1994. See BNA Daily Tax Report (1994-60), at L-15 (March 30, 1994). (60) Step 7 would differ if Step 3 were less than Step 5. The first and last substeps would remain the same but Substeps 7b and 7c would be replaced with the following substep: Multiply the recovery timing percentage for each asset (Substep 7a) by 85 percent.

WALTER G. ANTOGNINI is an Associate Professor of Taxation and MITCHELL K. KASSOFF is an Assistant Professor of Taxation of the Lubin School of Business, Pace University, New York. Both authors are attorneys in New York, and Mr. Antognini is also a certified public accountant. The authors thank Joan M/ Stout, an associate with the law firm of Debevoise & Plimpton, New York, for her assistance in the preparation of this article.