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Amortizing intangible assets.

The present tax law, like any other code of law, only provides "black and white" guidelines and statutory requirements for various tax issues. Therefore, the courts have had to interpret the "gray" areas, including those associated with amortizing intangible assets. In some court cases an allowance for an intangible asset has been allowed, whereas in other cases a deduction has been denied for similar assets.

This article describes the structure of the present tax law and analyzes

interpretation by the court system, the IRS and the taxpayers. In addition, inconsistencies in the treatment of such intangible assets as customer lists, subscription lists, bank core deposits and covenants not to compete is illustrated through case analysis. Pending house bills and proposal by the General Accounting Office are discussed as they relate to the present problems in the treatment of amortizing intangible assets. Finally a planning technique checklist is provided to aid the taxpayers in structuring future acquisitions.


It is the taxpayers' responsibility to adequately support deductions of intangible assets. The present tax structure does not provide a listing of allowable and unallowable intangible assets other than patents and copyrights. The Internal Revenue Code section 167 states:

If an intangible asset is known

from experience or other factors

to be of use in the business or in

the production of income for only

a limited period, the length of

which can be estimated with reasonable

accuracy, such an intangible

asset may be the subject of

a depreciation allowance... No

allowance will be permitted

merely because, in the unsupported

opinion of the taxpayer,

the intangible asset has a limited

useful life.(1)

If the deduction for amortization is to be allowed, the taxpayer must first determine if the intangible asset is separate and distinct from goodwill, then determine whether the asset has an ascertainable basis and a definite life.

When a taxpayer acquires either a business or part of an entity, allocation of the consideration paid to identifiable tangible and intangible assets reduces the residual amount to be assigned to goodwill. The IRS has set guidelines, effective May 6, 1986, entitled "Special Allocation Rules For Certain Asset Acquisition," which states:

... the consideration received for

such assets shall be allocated

among such assets acquired in

such acquisition ... If in connection

with an applicable asset acquisition,

transferee and

transferor agree in writing as to

the allocation of any consideration,

or as to the fair market

value of any of the assets, such

agreement shall be binding on

both the transferee and transferor

unless the Secretary determines

that such allocation is not appropriate.(2)

There are four asset classes to allocate consideration paid. In general, allocation of the purchase price to an asset is not to exceed the fair market value of the asset. The first two classes include items such as cash, demand deposits, certificates of deposits and U.S. Government securities as well as tangible assets. Class III encompasses all identified intangible assets. Finally, Class IV represents the residual or premium to be assigned to goodwill. It is to the benefit of the taxpayer at the time of purchase to identify, determine a definite life of and fair market value for, all intangibles assets so that their values can be assigned to Class III, which can be amortized. To facilitate the assignment, to be performed by both buyer and seller, the IRS requires Form 8594 "Asset Acquisition Statement" to be filed when a group of assets constituting a trade or business is sold. This requirement became effective October 9, 1990.(3) Taxpayers are subject to penalties if Form 8594 is neglected. Penalties will be based on failure to file and failure to include all required information. The latter penalty relates to any contracts omitted by the taxpayer, such as a covenant not to compete, which are required to be listed.

Internal Revenue Service


Intangible Assets

Generally the IRS takes the position that customer base assets are "indistinguishable from goodwill possessing no determinable useful life."(4) If intangible assets are classified as a component of goodwill then these assets are not amortizable under the current tax law, based on the "Mass Asset Rule."


Unlike financial accounting, which defines goodwill as "the residual or the excess of the cost over the fair value of the identifiable net assets acquired,"(5) the tax law only specifies goodwill as being unallowable. Thus, through numerous cases, the courts have incorporated their own interpretation of goodwill. Goodwill has generally been defined as being the "expectancy that the old customers will resort to the old place."(6) This is where the question of fact is relevant and where inconsistencies arise.

Large amounts of both taxpayers and Government money and time have been spent litigating deductions based on facts and circumstances. For example, a 1991 GAO study on "Issues and Policy Proposals Regarding Tax Treatment of Intangible Assets," found that the IRS is currently involved in over 1500 open issues, with a potential $8 billion in tax adjustments. Of these issues, 70% are attributed to interpretation of goodwill, while the other 30% pertains to how intangible assets were valued and/or how the life was determined.(7)

Case Analysis

Customer Lists

A customer list provides information such as name, address and billing history. Generally, a taxpayer can amortize a customer list as an intangible asset if a basis and life have been determined with reasonable accuracy. Nonetheless, the IRS has challenged such deductions, claiming that the asset is indistinguishable from goodwill.

In the case General Television. Inc. v. U.S,.(8) the taxpayer attempted a deduction regarding customer lists obtained through two acquisitions. The lists were service contract which were terminable at will. The IRS contended that the subscribers were not obligated for a definite period of time since the contracts were terminable at will. Thus, the customer lists had an indefinite life which made the lists a component of goodwill - "the expectancy of continued patronage." The taxpayer was denied a deduction on the grounds that goodwill is not amortizable.

In Metro Auto Auction of Kansas City, Inc. v. Commissioner,(9) the taxpayer amortized a customer card file obtained through a corporate liquidation. The taxpayer valued the asset at the direct labor cost of compiling the information on the files. The taxpayer demonstrated to the court that the life of the customer file was five years, based on the fact that certain cards would become obsolete due to dealerships going out of business and customers resorting to other auctions. Furthermore, the taxpayer showed the court that the cards were a factor in producing income, thus having value to the business. The courts accepted most of the taxpayer's claim, but the original basis in the card file was reduced by one-third due to its characteristic of goodwill since the taxpayer testified that about one-third of his customers would return to the auction whether or not the customer file existed.

In Panichi v. U.S.,(10) the taxpayer amortized his trash collection customer list. The District court allowed the deduction, but the IRS appealed based on the argument "that, as a matter of law, the value of the customer list is inseparable from goodwill." The Appeals court granted the taxpayer a deduction because the court felt that the list had a "discrete value" and a definite life.

Subscription Lists

A subscription list, like a customer list, is an intangible asset which shows names and other information about individuals who have, for example, paid for newspaper home delivery. Attempts to amortize this intangible asset by taxpayers have likewise resulted in the IRS challenging the deductions.

In the case National Weeklies, Inc. v. Commissioner,(11) the taxpayer sought a depreciation allowance based on a percentage of lost clients over a period of two to three years. Evidence supporting the life of the list was based on historical data from previous years that showed that such lists were "subject to a constant loss of subscribers, without any opportunity for commercial replacement and as a capital asset, are therefore definitely limited as to time in their use." Furthermore, a determinable basis for the subscription list was assigned by the taxpayer in proportion to the purchase price at the time when three companies had merged. The court denied deductions taken by the taxpayer on the grounds that the life of a subscription list is "not ordinarily limited as to the time in its use." In addition, the assigned basis was declared invalid because it failed to provide a basis to its transferors.

In Donrey, Inc. v. U.S.,(12) the taxpayer also sought to amortize a subscription list. Evidence provided by Donrey appears to have been more involved and specific, unlike the evidence provided by National Weeklies. The taxpayers provided experts who testified that Donrey's subscription list had a 23-year life - based on a similar study which revealed the limited life of its subscription list. The taxpayers showed the court that 80% of the newspaper's revenue came from advertising. They also showed that the subscription list was "an indispensable tool in selling advertising and is not simply a list but instead used much as a machine to generate advertising revenue." The taxpayers argued the determinable basis for such a list is the difference in advertising revenues generated by the subscription list as compared to the revenues of an equivalent paper without a subscription list." The court, with a dissenting opinion, granted an allowance, even though the Internal Revenue Service disagreed with the verdict. The court's decision was similar to Houston Chronicle Publishing Co. v. U.S., which allowed a depreciation allowance because the taxpayer sustained his burden of proving that the lists: 1. Had an ascertainable value separate

and distinct from goodwill;

and 2. Had a limited useful life, the

duration of which could be ascertained

with reasonable accuracy.(13)

In a more recent case, Newark Morning Ledger,(14) assigned life to their subscription list as the result of a statistical analysis performed by an independent entity. instead of combining Ledger to another newspaper, a consultant was hired by the taxpayer to develop a "mortality table of subscribers at a particular address" to determine a useful life. Valuing the basis of the list was then determined by using the income method. Such an approach determined the net realizable value of income over the life of the intangible asset. The Internal Revenue Service position was that the acquisition was of a going concern and that the income approach to value the list represents "expectancy that those customers will continue their patronage -i.e., the goodwill of the acquired concern." Although the Tax Court ruled for the taxpayer, the Appeals Court reversed the decision and denied a deduction.

These three cases are similar in that each deals with a newspaper company with a subscription list to be amortized, yet only Donrey was found to be entitled to a deduction. Basically, the valuation in Donrey was performed by an expert, who valued the asset by determining the replacement cost.

It seems that the courts favor an independent valuation like the one conducted by National Weeklies, even if an in-house valuation is performed. In Newark Morning Ledger an independent valuation was performed, but the income approach used to value the asset was perceived by both the IRS and the Appeals Court to be faulty. Had Newark Morning Ledger applied the cost approach in valuing the list, then the deduction would have been allowed because the Internal Revenue Service had acknowledged the list had a value, although much lower than that claimed under the income approach.

Core Deposit Base

A core deposit base is an intangible asset of an acquired bank that represents the present value of income to be received from investing the core deposit. Usually this intangible asset represents savings accounts, time deposits and various counts, time deposits and various other types of deposit accounts. Some banks have contended that the deposit base contributes to the production of income and is an amortizable capital asset.

In AmSouth Bancorporation v. U.S.,(15) the taxpayer sought to amortize the bank core deposit of an acquired bank even though there had been no allocation of consideration paid to the intangible asset at the time of closing. The taxpayer attempted to illustrate that such an asset was separate and distinct from goodwill. The estimated expenses for marketing and business development which could be eliminated by acquiring the existing customer base were used as the basis.

In addition, the taxpayer hired two consultants to determine the assignable basis for its acquired core deposits. The result of the valuations were $3.1 million and $3 million, respectively, by each consultant. The life was determined by the consultants as being 40 years for business accounts and 25 years for individuals. The courts questioned the validity of the consultants' valuation, since it appeared that there was no consideration given to the probability that the bank would draw in and acquire new customers. The courts denied a deduction on the grounds that the taxpayer had not proven the asset to be separate and distinct from goodwill, thus did not need to rule on the validity of the determined basis and life of the bank core deposit.

In the case Citizens & Southern Corp. v. Commissioner,(16) the taxpayer attempted to amortize a deduction for the core deposit base of acquired banks. In general, the taxpayer performed an analysis that compared consideration allocated to the core deposit in relation to a more expensive source of revenue. The taxpayer's study resulted in allocation of an identifiable value to the core deposit. The taxpayer also testified that if the core deposit had no value, then the price paid for the acquired bank would have been less. Experts were hired to determine the present value at the date of acquisition and the value of income attributed to the core deposits This process involved constructing "monthly runoff tables" which would determine survival factors. The IRS opposed, on the grounds that intangible assets were "inextricably linked to goodwill" and "that old customers will resort to old places." The courts, in ruling for the taxpayer, felt the assets were distinguishable from goodwill, and the valuation adequately justified the deduction.

Covenants Not To Compete

A covenant not to compete is a contract between the buyer and seller in which the seller agrees not to enter into a competing business for a defined time period. A bona fide "covenant not to compete" is subject to an amortization allowance. Taxpayers have abused the use of covenants not to compete, sometimes referred to as "buried treasures," by assigning part of the premium paid for a business to a covenant, even when such a contract lacks economic substance.

In the case Theophelis v. U.S.,(17) the taxpayer sought a deduction for a two year covenant not to compete, which arose from purchasing a retail store. The taxpayer's deduction was based on a value assigned to the covenant of $75,000, which represented the premium paid over identifiable assets. The court's position was that since the contract had not been separately bargained for, nor had any part of the consideration paid been allocated to the contract, the taxpayer's deduction would be denied.

In another case, John Sadler v. Commissioner,(18) the taxpayer sought a deduction for a covenant not to compete for a period of five years within a five mile radius of the restaurant purchased. Sadler had been able to acquire the restaurant because the seller needed a quick closing in order to move from Alaska to Oregon. When documents were drafted regarding the sale of the restaurant, they did not address the specifics of the covenant not to compete, although negotiations had taken place.

It was not until the following tax period that the purchase price was allocated to the tangible and intangible properties acquired. The basis assigned to the covenant was the difference in the fair market value of the tangible assets and the consideration paid. There was no allocation to goodwill. The courts denied a deduction because the taxpayer had no written documentation for the discussed covenant. Furthermore, with the seller having moved out of state, the contract seemed to lack economic substance as there was little danger of competition.

In, Wilson Athletic Goods Mfg. Co. v. Commissioner,(19) the taxpayer amortized a covenant not to compete. The sales contract did not specify the value of this ten year covenant, but $132,000 of the premium was allocated to the contract at the time the entity was acquired. Evidence supporting the allocated amount to the covenant was the testimony of the president of Wilson Athletic who told the court that the purchase would not have taken place or the price paid would have been lower if the covenant not to compete had not been negotiated. Furthermore, the main reason for the purchase was to buy out the competition. As a result, the court allowed a deduction to the taxpayer.

Pending Resolutions and

GAO Recommendations

Since the beginning of 1991, three bills have been introduced (and remain in the introductory stages) that will possibly eliminate the inconsistent treatment of amortizing intangible assets. On January 18, 1991, Rep. Brian Donnelly (D- MA) introduced the bill H.R. 563 which would provide statutory nondeductible treatment for customer base intangibles and similar items as having an indefinite life. Unlike Donnelly's bill, Rep. Vander Jagt (R- MI) introduced the bill H.R. 1456 on March 18, 1991, which favors the present tax law. Under Jagt's bill, customer based intangibles "shall be amortizable" if taxpayer provides reasonable evidence of a definite life, and a distinct and separate value from goodwill. The question of fact would remain and inconsistencies regarding reasonableness would persist. The third bill, H.R. 3035, introduced by Rep. Dan Rostenkowski (D- IL) on September 20, 1991, would provide for customer based and some other intangible assets, including goodwill, to be amortizable over a fixed 14-year life. This would obviously eliminate any controversy regarding amortizing intangibles.

The GAO made three possible recommendations which are somewhat similar to Rep. Rostenkowski's proposed bill. One recommendation was to expand the rules regarding amortization on purchased intangible assets that waste over time, sometimes including goodwill. The GAO suggests the use of cost recovery periods similar to MACRS for tangible property. The intent is to accurately identify, value, and amortize each intangible asset under a specified cost recovery system. There will be deviation from the matching principle, but the burden on the taxpayer and the inconsistencies of allowable deductions are likely to diminish.

This proposal would prevent taxpayers from accelerating the life of an asset. It would also allow taxpayers to amortize intangibles including goodwill, thus enhancing the competitiveness of American businesses in International markets, by improving after-tax cash flow.(20) On the other hand, such a proposal would require guidelines on how certain costs, i.e., advertising and other development expenses, should be treated as either a capital expenditures or period expenses.

Planning Techniques

This checklist is provided as a planning tool in structuring and documenting acquired intangible asset. 1. Identify all assets during negotiations

and document the intent

regarding all intangible assets. 2. Use Form 8594 - Asset Acquisition

Statement, at the time of the

acquisition and file it with the

IRS in a timely fashion. 3. For purposes of allocating consideration,

if the intangible asset

has not been separately negotiated,

obtain a third party expert

to value and determine the life of

this asset. The unsupported opinion

of the taxpayer may not be

adequate to prevail in litigation. 4. In order to distinguish the asset

from goodwill, document how

the intangible asset contributes

to income production. 5. Any contract, such as a covenant

not to compete, should be negotiated

and valued prior to the

final sale. 6. Consider the effect of structuring

an acquisition under the

present tax law. If intangibles

are determined to have a shorter

life than 14 years, then it may be

to the advantage of the taxpayer

to structure an acquisition prior

to a change in the tax law. 7. The GAO identified approximately

175 intangible assets. To

identify unknown intangibles the

taxpayer could interview employees,

review contractual agreements

and analyze the general

business environment of the entity

to be acquired to determine

if any unknown intangibles exist. 8. Consider the effect of structuring

an acquisition under Rep.

Rostenkowski's bill. If intangibles

are not easily identifiable,

then being able to amortize goodwill

over a 14-year life may be

advantageous, whereas under the

present law, goodwill is not

amortizable. Therefore, a taxpayer

may want to delay an acquisition

and follow the development

of Rostenkowski's bill.

Successful litigating of intangible amortization cases requires careful planning. Amortizing intangible assets involves preliminary valuations, which, if structured correctly, will provide a strong foundation for a defense if challenged by the IRS. The planning techniques listed above will aid in preparing documented support regarding the asset basis and life. Furthermore, pending legislation have influential impact in clarifying the present tax structure and reducing future inconsistent case rulings. Taxpayers who may be affected by such changes are strongly encouraged to follow future developments.


(1) IRC [section] 1.167(a)-3 (2) IRC [section] 1060(a)-2 (3) IRC [section] 1.1060-1T(b)(4) (4) Revenue Ruling 74- 56, 1974-2 CB 65 (5) Intermediate Accounting, Kieso and Weygandt, 6th ed., pg. 545. (6) Netwark Morning Ledger Co. v. U. S., 90-1 USTC 50193. These two concepts of goodwill have been the result of various cases of litigation and their interpretation by the courts provides the present views of goodwill. (7) GAO/GGD-91-88 Tax Policy - "Issues and Policy Proposals Regarding Tax Treatment of Intangible Asset," pp. 29-30. report was response to the joint Committee on Taxation charged to evaluate and provide proposals regarding the amortization of intangible assets. (8) General Television, Inc. v. U.S. 79-2 USTC, 9411. (9) Metro Auto Action v. Commissioner 48 TCM, 41428(MO. (10) Panichi v. U.S. 87-2 USTC, 9652 (11) National Weekies, Inc., v. Commissioner 43-2 USTC 9547, 1943 (12) Donrey, Inc, v. U.S. 87-1 USTC 9143 (13) Houston Chronicle Publishing v. U.S. 3-2 USTC, 9537 (14) Newark Morning Ledger v. U.S. 91 USTC, 50451 & 90-1 USTC. 50193 (15) AmSouth Bancorporation v. U.S. 88-1 USTC, 9232 (16) Citizens & Southern Corp. v. Commissioner 91 TC, 463 (17) Theophelis v. U.S. 85-1 USTC, 9105 (18) John Sadler v. Commissioner 41 TCM 2298-80 (19) Wilson Athletic Goods Mfg. Co. v. Commissioner 55-1 USTC, 9442 (20) GAO/GGD-91-88 "Tax Policy - Isues and Policy Proposals Regarding Tax Treatment of Intangible Asset," pp. 32-35

Don F. Farineau is an auditor with the Department of Commerce, Office of Inspector General. He received a BBA in accounting from West Georgia College. He is a member of the Association of Government Accountants and is associated with the Institute Of Management Accountants. In addition, he has participated as a Voluntary Income Tax Assistant (VITA) and has received scholarships from both professional and fraternal organizations.

Royce E. Chaffin, CPA, MBA, is an assistant professor of accounting at West Georgia College. He received his MBA from Golden Gate University. He is associated with the American Accounting Association, the American Institute of CPAs and the Georgia Society of CPAs. A former Revenue Agent with the IRS, he is active as a consultant for tax planning and in taxpayer disputes with the Service. He has published tax articles in a number of professional publications.
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Author:Farineau, Don F.; Chaffin, Royce E.
Publication:The National Public Accountant
Date:Aug 1, 1992
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