Regulations issued in 2004 require capitalization of six categories of intangible asset expenditures.
When Sec. 197 applies to intangible expenditures, 15-year amortization takes precedence over all other cost recovery rules
Intangible assets may be amortized under Sec. 167 when Sec. 197 does not apply and the asset has a limited useful life.
In 2004, the Service issued final regulations 1 under Sec. 263(a) on capitalizing the cost of intangible assets. While much has been written about this topic, 2 not much has been written about the aftermath of capitalization—i.e., once the cost of an intangible asset has been capitalized, how is that cost recovered? This two-part article:
Summarizes the new Sec. 263(a) regulations (as discussed below, otherwise known as the “INDOPCO regulations”);
Examines cost recovery possibilities, including, among other authority, Sec. 197 (amortizable Sec. 197 intangibles) and Sec. 167 (other intangibles); and
Examines how the INDOPCO regulations affect the treatment of certain start-up costs under Sec. 195.
Part I, below, summarizes the INDOPCO regulations, Sec. 197 cost recovery and general Sec. 167 amortization rules. Part II, in the May 2007 issue, will focus on the income-forecast method, lease acquisitions, options, computer software, and transaction and business acquisition costs.
In general, expenditures are deducted currently (expensed), capitalized and deducted over time or capitalized with no deduction. Under Sec. 162(a), expenditures are deducted currently if they are ordinary and necessary business expenses. Under Regs. Sec. 1.263(a)-2(a), expenditures are capitalized if they result in benefits that extend substantially beyond the end of the tax year. Under Regs. Sec. 1.263(a)-1(b), expenditures are capitalized if they result in permanent improvements or betterments, including materially increasing value, appreciably prolonging useful life or adapting an asset to a new or different use.
In 1992, the Supreme Court held in INDOPCO 3 that expenditures should be capitalized if they result in significant future benefits, whether or not they produce a separate and distinct asset. Unfortunately, the significant-future-benefits test raised more questions than it answered.
To clarify matters with regard to intangible assets, the IRS issued Regs. Sec. 1.263(a)-4 (acquiring or creating intangibles) and Regs. Sec. 1.263(a)-5 (facilitating the acquisition, restructuring or reorganization of a business). These regulations, commonly called the “INDOPCO regulations,” are effective for intangible asset costs paid or incurred after 2003. They are intended to provide bright-line rules 4 to make the INDOPCO-standards-based approach (significant future benefits) for capitalization more administrable.
The INDOPCO regulations 5 require capitalization of six categories 6 of expenditures relating to intangible assets; they are numbered and summarized in the exhibit. Of these six categories, four pertain to direct costs and two pertain to indirect costs (otherwise known as “transaction costs”). In this article, reference is made, for example, to “category 1, 2, 3 or 4 intangible assets” and “category 5 or 6 transaction costs.”
Regs. Sec. 1.263(a)-4(b)(4) provides that the INDOPCO regulations do not affect the treatment of amounts specifically provided for in Code sections (and regulations thereunder) other than Sec. 162 (ordinary and necessary business expenses) or 212 (expenses of producing income). For instance, the INDOPCO regulations do not apply to research and development costs, because Sec. 174 specifically applies.
If an expenditure does not fall into one of the six categories, or is not identified in subsequently published guidance, capitalizing is not required, and deducting is allowed. 7 In other words, under the INDOPCO regulations, listed categories of expenditures are to be capitalized; everything else is to be deducted. While this approach seems harmless, it reverses well-established principles. Before the INDOPCO regulations, capitalizing was the norm; deducting was the exception. After the INDOPCO regulations, at least with regard to intangible assets, deducting is the norm; capitalizing is the exception.
Cost Recovery (Amortization) in General
The INDOPCO regulations are capitalization provisions, not cost recovery provisions. For the latter, taxpayers should refer to:
Sec. 197 (15-year amortization);
Sec. 167, 8 in which the cost of an intangible asset is:
Amortized over the asset’s useful life; 9
Amortized over 15 years (safe harbor);
Not amortized; or
In some cases, amortized using the units-of-production method or the income-forecast method.
Sec. 178 (lease acquisition costs); and
Sec. 1234 (options).
Sec. 197 Amortization
For “amortizable Sec. 197 intangibles,” Sec. 197(a) allows amortization over 15 years (180 months), on a straight-line basis, with no salvage value, beginning in the month when such intangible assets are acquired. As described more fully below:
Some intangibles qualify as amortizable Sec. 197 intangibles only if obtained as part of acquiring a business;
Others qualify even though obtained separately;
Some intangible assets qualify only if purchased; and
Others qualify even though self-created.
Business-Acquisition Amortizable Sec. 197 Intangibles
The following intangible assets are amortizable Sec. 197 intangibles only if they are obtained as part of acquiring a business: goodwill, going-concern value, workforce in place, information base and know-how (including copyrights and patents), customer-based intangibles, supplier-based intangibles, interests in films, sound recordings, videotapes or books, and covenants not to compete.
Under Regs. Sec. 1.197-2(b)(4), “information base” includes, among other things, business books and records, technical manuals, training manuals and lists of current or prospective customers, subscribers and advertisers. Under Regs. Sec. 1.197-2(b)(5), “know-how” includes formulas, processes, designs, copyrights and patents. A “covenant not to compete” is a contract between, in general, a seller and a buyer, under which the seller agrees not to compete with the buyer for a certain period within a certain geographic area.
Example 1—goodwill: On April 1 of year 1, X Co. purchased all of the assets of Q Co., and paid $300,000 for goodwill.
Pursuant to the INDOPCO regulations, X must capitalize the $300,000, because the goodwill is a category 1 intangible asset. It is an amortizable Sec. 197 intangible, because it is goodwill obtained as part of acquiring a business. For year 1, X’s amortization deduction for goodwill would be $15,000 (($300,000/180 (months in 15 years)) × 9 (months in year 1)).
Example 2—customer lists: In year 1, Y Co. spent $60,000 to internally develop customer list #1. In the same year, Y purchased all of the assets of R Co., and paid $90,000 for customer list #2.
Pursuant to the INDOPCO regulations, Y must capitalize the $90,000 (customer list #2) because it is a category 1 intangible asset. Customer list #2 is an amortizable Sec. 197 intangible, subject to 15-year amortization, because it is a customer list obtained as part of acquiring a business. As for the $60,000 associated with self-created customer list #1, it is not a category 1 or 2 intangible asset. As long as it is not a category 3 intangible asset, 10 it would not be capitalized under the INDOPCO regulations. Consequently, for year 1, Y could deduct $60,000.
Separately Obtained Amortizable Sec. 197 Intangibles
The following intangible assets are amortizable Sec. 197 intangibles, even though they are obtained separately (i.e., not as part of acquiring a business): franchises and rights granted by a government (e.g., trademarks, tradenames, licenses, permits, liquor licenses, taxicab medallions, landing or takeoff rights, regulated airline routes and television and radio licenses). The cost to renew a franchise or a governmental right is treated as the acquisition of a new amortizable Sec. 197 intangible. Under Sec. 197(f)(4)(B), the renewal cost is amortized over a new 15-year period, beginning in the month of renewal.
Example 3—liquor license: For many years, A Co. did not serve alcohol in its restaurant. On May 1 of year 1, A paid $36,000 to local authorities for a five-year liquor license.
Under the INDOPCO regulations, A must capitalize the $36,000, because the liquor license is a category 2 intangible asset. Even though it is obtained separately, and not as part of acquiring a business, it is an amortizable Sec. 197 intangible, subject to 15-year amortization.
Example 4—license renewal: The facts are the same as in Example 3, except the date is May 1, year 5, four years after the five-year liquor license was purchased. A pays $27,000 to renew the liquor license for another three years, thereby extending its expiration date from April 30, year 6, to April 30, year 9.
Pursuant to the INDOPCO regulations, A must capitalize the $27,000, because the renegotiated or upgraded amount is a category 2 intangible asset. The cost to renew the liquor license is treated as a new amortizable Sec. 197 intangible, subject to 15-year amortization, beginning in May, year 5 (month of renewal). In addition, the cost of the original liquor license would continue to be amortized over its remaining 15-year period.
Self-Created Amortizable Sec. 197 Intangibles
The following intangible assets are amortizable Sec. 197 intangibles, even though they are self-created and not purchased: covenants not to compete and rights granted by a government (e.g., trademarks, tradenames, licenses, permits, etc.).
Example 5—trademark: V Co. pays $45,000 to develop and register a trademark.
Even though the trademark is self-created, it is an amortizable Sec. 197 intangible subject to 15-year amortization.
Sec. 167 Cost Recovery
Sec. 197(b) provides that when Sec. 197 applies, 15-year amortization takes precedence over all other cost recovery rules, including those under Sec. 167. If intangible assets are not amortizable Sec. 197 intangibles (because, for instance, they were not obtained as part of acquiring a business), they would be amortized (if at all) pursuant to other authority, including Sec. 167.
Numerous cost recovery rules are contained in Sec. 167. According to Regs. Sec. 1.167(a)-3(a), the cost of an intangible asset “known from experience or other factors to be of use…for only a limited period, the length of which can be estimated with reasonable accuracy,” is amortized over such period. Accordingly, with the exception of the 15-year amortization safe harbor discussed below, the cost of intangible assets is amortized under Sec. 167 only if taxpayers can show that such assets have limited useful lives that are reasonably ascertainable. Cost recovery is denied for intangible assets whose useful lives are not limited or cannot be estimated with reasonable accuracy. In such a case, the cost is recovered when the intangible asset is abandoned or otherwise disposed of, or when the enterprise that capitalized the expenditure ceases operation.
Example 6—covenants not to compete: In year 1, M Co. entered into two covenants not to compete (CNCs). In CNC #1, M purchased a bookkeeping practice from A; M paid $72,000 to A in exchange for A’s promise not to open a bookkeeping practice within a 50-mile radius for three years. In CNC #2, M terminated the employment of executive B, and as part of a severance package, M paid $360,000 in exchange for B’s promise not to work for certain competitors of M for three years.
Under the INDOPCO regulations, M must capitalize both payments ($72,000 and $360,000), because the CNCs are category 2 intangible assets. CNC #1 is an amortizable Sec. 197 intangible, because it was obtained as part of acquiring a business. Even though CNC #1 has a term of three years, it is amortized over 15 years. CNC #2 was not obtained as part of acquiring a business, so it is not an amortizable Sec. 197 intangible. Because the duration of CNC #2 can be estimated with reasonable accuracy (three years), the $360,000 would be amortized over that period.
Example 7—signing bonus: In year 1, Z Co. enters into a four-year employment contract with executive C. To induce C to leave his former employer, Z pays him a $240,000 signing bonus.
Under certain circumstances, 11 pursuant to the INDOPCO regulations, Z must capitalize the $240,000 because the contract right is a category 2 intangible asset. Because the duration of the employment contract can be estimated with reasonable accuracy (four years), the signing bonus would be amortized over that period.
Example 8—prepaid expenses: On Sept. 1, year 1, D Co. paid a $24,000 premium for a two-year insurance policy that will provide coverage from Sept. 1, year 1, to Aug. 31, year 3.
Under the INDOPCO regulations, D must capitalize the $24,000, because the insurance (prepaid expense) is a category 2 intangible asset. Because the duration of the insurance policy can be estimated with reasonable accuracy (two years), the prepaid insurance would be amortized over that period.
Example 9—purchase of ownership interest: R, an individual, paid $30,000 for stock in P Co.
Pursuant to the INDOPCO regulations, R must capitalize the $30,000, because the ownership interest is a category 1 intangible asset. Because the useful life of this intangible asset is not limited, there is no amortization deduction. R recovers the $30,000 when she disposes of the stock. For instance, if R sells the stock for $35,000, she would report a $5,000 gain ($35,000 – $30,000).
Contract Termination Payments
Contract termination payment issues arise in a number of situations, including a landlord’s payment to induce a tenant to prematurely terminate a lease and vacate the premises. Under the INDOPCO regulations, the landlord must capitalize the contract termination payment, because it is a category 2 intangible asset.
Example 10—lease-cancellation fee: A landlord, L, pays a $48,000 lease-cancellation fee, because it needs the additional space for itself.
Because the payment is made for the property’s use for the remainder of the lease term, L would amortize the $48,000 capitalized cancellation fee over the remaining term (four years) of the cancelled lease. 12 This is true even if the property is subsequently leased to another tenant in an independently conceived transaction. 13
Example 11—lease-cancellation fee: L, from the previous example, pays the lease-cancellation fee because it wants to construct improvements on the premises.
The capitalized cancellation fee of $48,000 is considered an additional cost of the improvements 14 and would be recovered through depreciation of the improvements, even if the premises are being constructed for a new tenant. 15
Example 12—lease-cancellation fee: L, from the previous example, pays the lease-cancellation fee because it wants to rent the premises to a new tenant who is willing to pay more rent than the current one. L enters into a six-year lease with the new tenant.
The capitalized cancellation fee of $48,000 would be amortized over the six-year term of the new lease. This result is reasonable, because the cancellation fee resembles a lease acquisition cost that, under Sec. 178, would be amortized over the term of the new lease. 16
15-Year Amortization Safe Harbor
When the INDOPCO regulations were issued, the Sec. 167 regulations were amended to clarify the amortization rules for self-created intangible assets (category 2 intangible assets) that are not amortizable Sec. 197 intangibles. New Regs. Sec. 1.167(a)-(3)(b) provides for a 15-year amortization safe harbor. In essence, it applies (1) to created intangible assets (category 2 intangible assets), (2) with unascertainable useful lives, (3) for which another amortization period is not prescribed by the Code, regulations or published guidance and (4) for which amortization is not prohibited.
Example 13—membership fee: In year 1, F Co. paid an initiation fee (membership fee) of $60,000 to become a member of a trade association.
Pursuant to the INDOPCO regulations, F must capitalize the $60,000, because the membership fee is a category 2 intangible asset. It is not an amortizable Sec. 197 intangible. If F can establish from experience or other factors that the membership has a useful life shorter than 15 years, it could amortize the $60,000 over the shorter period. If the membership is for an indefinite period, so that F cannot establish its useful life, the 15-year amortization safe harbor would apply.
Planning tip: The newly created 15-year amortization safe harbor under Sec. 167 is not mandatory. If taxpayers can support a shorter amortization period, through their experience with similar assets or economic life studies, they can accelerate their amortization deductions.
Part II of this article, in the May 2007 issue, will discuss other aspects of capitalizing and amortizing intangible assets, such as the income-forecast method, lease acquisitions, options, computer software, and transaction and business acquisition costs.
For more information about this article, contact Prof. Witner at email@example.comEditor's note: This article was awarded The Tax Adviser's Best Article Award for 2007.
1 TD 9107 (1/5/04).
2 See, e.g., Melone, “Final Intangible Asset Regulations Modify and Clarify, but Conform in Most Respects, to the Proposed Rules,” 31 J Corp. Tax’n 15 (May/June 2004); Jagdman, “Final Regs. on Capitalization of Intangibles,” 35 The Tax Adviser (April 2004); Yale, “The Final INDOPCO Regulations,” 2004 TNT 207-29 (10/26/04); Conjura, et al., “To Capitalize or Not? The INDOPCO Era Ends with Final Regulations Under Section 263(a),” 100 J Tax’n 215 (April 2004); and Burnett and Pulliam, “IRS Provides Much-Needed Guidance on Capitalization of Intangibles,” 73 Practical Tax Strategies 68 (August 2004).
3 INDOPCO, Inc., 503 US 79 (1992).
4 For instance, there is a 12-month rule (Regs. Sec. 1.263(a)-4(f)), a $5,000 de minimis rule (Regs. Secs. 1.263(a)-4(e)(4)(iii) and -5(d)(2) and (3)) and a date rule (Regs. Sec. 1.263(a)-5(e)).
5 For an in-depth discussion of the INDOPCO regulations, see the articles listed in note 2, supra.
6 The term “category” is used in this article, not in the regulations.
7 See the preamble to TD 9107, note 1 supra, at II. A. and B.
8 Intangible property is not accelerated cost recovery system or modified accelerated cost recovery system property (Sec. 168 property), so it is amortized, if at all, under Sec. 167.
9 “Useful life” as used in Sec. 167 should not be confused with “recovery period” as used in Sec. 168.
10 It is not clear which payments constitute a separate and distinct intangible asset (category 3 intangible asset). Until guidance is issued, this category is an open question.
11 See Regs. Sec. 1.263(a)-1(d)(6)(iv) and (vii), Example 8.
12 See The Trustee Corp., 42 TC 482 (1964), acq., 1966-2 CB 7.
13 Rev. Rul. 71-283, 1971-2 CB 168.
14 See Third National Bank in Nashville, MD TN, 2/16/71, aff’d per cur., 454 F2d 689 (6th Cir. 1972).
15 John W. Keiler, II, 285 FSupp 520 (WD KY 1966), aff’d per cur., 395 F2d 991 (6th Cir. 1968).
16 See the discussion in Part II of this article, in the May 2007 issue, under “Sec. 178 Lease Acquisition Costs.”