Avoiding Ordinary Income Recapture on the Sale of Certain §197 Intangibles (article)
In the past, we have addressed the difficulties of writing off IRC §197 intangible assets before the end of their 15-year amortization period. Conversely, what happens when §197 intangible assets are sold at a gain? An unpleasant surprise awaits the taxpayer because the amortization deductions that were taken on these intangible assets must be recaptured as ordinary income. If these intangible assets are sold in an installment sale, the ordinary income recapture is reported in the year of sale. Effectively, this portion of the gain is not eligible for deferral under the installment sale rules.
Section 197 intangible assets are "acquired intangible assets" as opposed to "self-created intangible assets". These assets are most commonly acquired as part of the acquisition of the assets comprising a trade or business. Intangible assets are defined as: goodwill, going-concern value, workforce in place, business records and systems, patents and know-how, customer based intangibles, supplier-based intangibles, certain computer software, licenses and permits, covenants not to compete, franchises, trademarks and trade names. "Self-created intangible assets" are those intangible assets that are created as a result of ongoing business operations and do not result in the creation of a distinct asset being recorded and amortized on the taxpayers books and records.
The purchase price of the assets of an acquired trade or business must be allocated among various classes of assets. Under the residual method, the excess of purchase price over the fair value of the recorded assets is allocated to §197 intangible assets, which must be amortized over a 15-year period.
Taxpayers may be able to avoid the ordinary income recapture on certain intangible assets. In PLR 201016053, the Internal Revenue Service allowed the taxpayer to bifurcate its customer-based intangibles between acquired customer-based intangibles (a §197 asset) and self-created intangibles (a non-§197 asset). By allowing the taxpayer to bifurcate the customer-based intangible assets, the taxpayer only had to recapture the amortization on the acquired customer-based intangibles. The self-created intangibles were not subject to the ordinary income rates.
Under the facts of this ruling, the taxpayer made several acquisitions in which it recorded customer-based intangibles (along with other types of §197 intangible assets). However, the taxpayer also built its own customer base over time through its regular business operations. In this case, the taxpayer was able to prove to the IRS that it could differentiate which customers were acquired through acquisition (the §197 intangibles) and which customers resulted from its own internal efforts (the self-created intangibles). The taxpayer also was able to show that the customer-based assets had an ascertainable value and a determinable life. These were critical factors in determining that the §197 intangible assets were separate and distinct from the self-created intangible assets.
The opportunities provided in this ruling can be beneficial for taxpayers that sell older, acquired customer-based intangibles. Although the older intangible asset likely has been significantly amortized and therefore the amount of potential ordinary income recapture could be significant, it may be worth less because many of the acquired customers may no longer be customers of the taxpayer. Therefore, a smaller amount of the sales price allocated to all customer-based intangibles could be allocated to the older, acquired intangible, and a correspondingly larger amount could be allocated to the more recent self-created customer-based intangible. This would minimize the ordinary income recapture. A valuation study and strong record-keeping are essential to making this allocation.
While this PLR deals only with "customer-based intangibles," a similar argument can be made for other types of intangibles such as "workforce in place" and "supplier-based intangibles." The potential for later tax savings reinforces the need for a detailed valuation of the acquired intangibles made at the time of the original purchase. If these intangibles are sold at a later date, it would be much easier to support the position that the intangibles sold are no longer the same as the intangibles originally acquired. Taxpayers interested in using the reasoning of this PLR should consider seeking their own rulings from the IRS to protect their tax treatment.
Keep in mind that a PLR applies only to the specific taxpayer addressed in the ruling. Therefore, the IRS is not bound by the ruling as it applies to other taxpayers. The PLR does give a sense of the IRS's position and allows taxpayers to carefully plan so that their facts can be similar to those provided in the PLR.
Your local CBIZ tax professional can assist you in analyzing the tax issues when disposing of §197 intangible assets. In addition, CBIZ can provide the valuation experts to determine the value of various intangible assets.
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