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Supreme Court rules two-pronged test applicable when amortizing intangible assets.

The U.S. Supreme Court ruled in the Newark Morning Ledger case, 4/20/93, that if a taxpayer is able to prove that a particular asset can be valued and the asset has a limited useful life, 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." In other words, the taxpayer may depreciate an intangible asset when the asset's value is obviously dependent on the continued and voluntary patronage of customers (so-called "customer-based intangibles") by passing a two-pronged test, rather than the three-pronged test ("asset or a portion thereof does not possess the characteristics of goodwill, is susceptible of valuation, and is of use to the taxpayer in its trade or business for only a limited period of time") long espoused by the IRS in Rev. Rul. 74-456.

The Court did not overturn the "mass asset" rule, which prohibits the depreciation of certain intangible assets "because they constitute self-regenerating assets that may change but never waste." Rather, the Court found the taxpayer had shown that the "paid subscribers" acquired by the Newark Morning Ledger were not self-regenerating: "[T]here is no automatic replacement for a subscriber who terminates his or her subscription. Although the total number of subscribers may have or has remained relatively constant, the individual subscribers will not and have not remained the same, and those that may or have discontinued their subscriptions can be or have been replaced only through the substantial efforts of the [taxpayer]."

Finally, the Court recognized that the "paid subscribers" acquired by the Newark Morning Ledger were not merely a list of names and addresses. Once the taxpayer had shown the asset was not self-regenerating and had a limited useful life that could be estimated with reasonable accuracy, the correct method for valuing the "paid subscribers" was the "income approach." "The uncontroverted evidence presented at trial revealed that the "paid subscribers" had substantial value over and above that of a mere list of customers. App. 67 (Price Waterhouses's fair market value study of paid newspaper subscribers ... as of May 31, 1977). These subscribers were "seasoned'; they had subscribed to the paper for lengthy periods of time and represented a reliable and measurable source of revenue ... the |paid subscribers' at issue here provided a regular and predictable source of income over an estimable period of time. The cost of generating a list of new subscribers is irrelevant, for it represents the value of an entirely different asset." (Emphasis in original.)

As a result of this case, taxpayers will not automatically obtain depreciation deductions for customer-based intangibles. Appraisals prepared for taxpayers often fail to provide adequate evidence for the taxpayer to meet "its substantial burden of proving" that an intangible asset has "a limited useful life, the duration of which can be ascertained with reasonable accuracy."

Many appraisals rely on the unsubstantiated opinions of taxpayer employees or appraisers that an asset can be expected to be replaced in "X" years. Too often appraisers do not take sufficient time to thoroughly investigate and document the basis for useful life claims; many appraisal firms do not use statisticians while performing their appraisals. It is expected that the IRS will more thoroughly scrutinize appraisals, possibly by providing statisticians to assist the engineering agents typically assigned to audit these issues. Taxpayers might want to consider having their appraisals reviewed by appraisal firms with statisticians on staff.
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Author:Grabowski, Roger J.
Publication:The Tax Adviser
Date:Jul 1, 1993
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