- In many cases, taxpayers may be eligible to accelerate amortization deductions using the income-forecast or units-of-production methods.
- ransaction costs are added to the basis of acquired intangible assets, acquired stock or, in the case of a tax-free reorganization, a separate intangible asset.
- When acquiring a business, investigatory costs are amortized over 15 years, but facilitative costs may not be amortized.
This two-part article provides an overview of cost recovery for intangible asset expenditures. Part II covers the income- forecast and units-of-production methods, computer software, transaction costs and Sec. 195 deductions.
This two-part article examines how capitalized costs of intangible assets are recovered. Part I, in the April 2007 issue, explained the INDOPCO regulations 1 7 and capitalization and amortization in the context of Secs. 197 and 167 (the useful-life method and 15-year amortization safe harbor). Part II, below, continues the discussion of capitalizing and amortizing intangible assets in the context of Sec. 167 (e.g., units-of-production method), computer software, transaction costs and certain Sec. 195 start-up costs.
The cost of certain intangible assets can be recovered using the units-of-production method described in Regs. Sec. 1.167(a)-14. Example 1 below illustrates this method with a forward contract that, according to Regs. Sec. 1.263(a)-4(d)(2)(vi), includes an agreement under which a taxpayer has the right and obligation to provide or acquire property.
Example 1—units-of-production method: 18 S paid $1 million to B in exchange for a promise to purchase 1,000 units of S’s product within the next three years (year 1–year 3). In year 1, B purchases 300 of the 1,000 units.
In essence, S gave B a sales discount in advance. Because S has the right and obligation to provide property, the arrangement is a forward contract (category 1 intangible asset). According to the INDOPCO regulations, S must capitalize the $1 million sales discount. As for recovering it, neither Sec. 197 15-year amortization nor the 15-year amortization safe harbor of Sec. 167(a)-(3)(b) is appropriate. According to the units-of-production method under Regs. Sec. 1.167(a)-14(c)(2)(i), S’s cost recovery deduction equals S’s basis in the right ($1 million) times a fraction, the numerator of which is the number of units purchased this year (300), and the denominator of which is the total number to be purchased (1,000). Thus, for year 1, S’s amortization deduction would be $300,000 ($1,000,000 × (300/1,000)).
Example 2—units-of-production method: The facts are the same as in Example 1, except no quantity is specified. Thus, B is given a sales discount on all purchases for the next three years, with no quantity specified.
According to Regs. Sec. 1.167(a)-14(c)(2)(ii), the capitalized amount ($1 million) would be recovered ratably over the three-year period. For all three years, S’s amortization deduction would be $333,333 ($1,000,000/3).
Under the Sec. 167(g) income-forecast method, taxpayers can depreciate certain property on the basis of anticipated income. Specifically, a property’s cost recovery deduction for a year is determined by multiplying its adjusted basis by a fraction, the numerator of which is current-year income, and the denominator of which is forecasted total income. Forecasted total income is that income expected to be generated prior to the close of the tenth year after the year the property is placed in service. Any costs not recovered by the end of the tenth year are deducted in that year.
The income-forecast method may be used to calculate cost recovery on copyrights, books, patents, motion picture films, theatrical productions, videotapes, sound recordings and similar property, under Sec. 167(g)(6). The following examples, dealing with patents, provide a good overview of the cost recovery possibilities for such assets.
Example 3—patents: A, an inventor, procured a patent and used it for eight years in his business. (In general, a patent has a legal life of 20 years.) 19 On Oct. 1, year 1, with 12 years (144 months) remaining on the patent’s legal life, R Co. paid $48,000 for A’s patent.
Under the INDOPCO regulations, R must capitalize the $48,000, because the patent is a category 1 intangible asset.
Example 4—patents: R from Example 3 obtained the patent as part of acquiring A’s business.
The patent would be an amortizable Sec. 197 intangible. In year 1, R’s amortization deduction would be $800 (($48,000/180 (months in 15 years)) × 3 (months in year 1)).
Example 5—patents: R from Example 3 obtains the patent separately, not as part of acquiring A’s business.
The patent would not be an amortizable Sec. 197 intangible. Because its useful life can be estimated with reasonable accuracy (20 years), it would be amortized over that period. R inherits the remaining legal life (12 years) from A (seller-inventor). For year 1, R’s amortization deduction for the patent would be $1,000 (($48,000/144 (months in 12 years)) × 3 (months in year 1)).
Example 6—patents: The facts are the same as in Example 5, except that R can estimate with reasonable accuracy that, even though the patent has a legal life of 12 years, it has an economic life (useful life) of only eight years.
In situations like this, taxpayers re-cover cost over the intangible asset’s legal or useful life, whichever is shorter. For year 1, R’s amortization deduction for the patent would be $1,500 (($48,000/96 (months in eight years)) × 3 (months in year 1)).
Example 7—patents: R from Example 6 uses the income-forecast method to calculate amortization. The patent generates year-1 income of $10,000 and forecasted total income of $250,000.
In year 1, R’s amortization deduction would be $1,920 ($48,000 × ($10,000/$250,000)).
Example 8—defense or perfection of title: Q files suit against R, from Example 6, claiming that Q is the true owner of the patent. The sole issue involves the validity of R’s patent. R settles the suit by paying $120,000 to Q in exchange for a release of all future claims to the patent.
Pursuant to the INDOPCO regulations, R must capitalize the $120,000, because the payment to defend or perfect title to intangible property is a category 2 intangible asset. As in Example 6, R should amortize the capitalized amount ($120,000) over the patent’s legal (12 years) or useful life (eight), whichever is shorter.
Planning tip: There are cost-recovery methods other than straight-line over, say, 15 years. For instance, taxpayers may be able to accelerate amortization deductions with either the units-of-production method or the income-forecast method.
Sec. 178 Lease Acquisition Costs
According to Sec. 178, lease acquisition costs are amortized over the term of the lease; in certain circumstances, this includes extensions.
Example 9—lease acquisition costs: R Co. incurred lease acquisition costs of $30,000 when it paid a real estate broker and lawyer to find property that R will lease for five years, beginning Nov. 1, year 1.
Pursuant to the INDOPCO regulations, R must capitalize the $30,000, because the lease-related cost is a category 1 intangible asset. Under Sec. 178, if extensions were not included, the amortization period would be five years.
Sec. 1234 Options to Buy or Sell Property
Under a call option, the potential buyer (option holder) will make a payment to a potential seller that entitles the former to purchase the property for a certain price within a certain period. There are three rules:
If the option is exercised, the holder adds the option’s cost to the basis of the acquired property.
If the option expires, the holder takes a loss equal to the option’s cost, under Sec. 1234(a)(2).
If the option is sold, the holder reports gain or loss of the difference between the option’s selling price and its cost.
Example 10—options: N Co. paid $35,000 to O for the right to buy O’s real property for $700,000 at any time within the next 12 months.
Under the INDOPCO regulations, N must capitalize the $35,000, because the option is a category 2 intangible asset.
If N exercises the option, its basis in the land would be $735,000 ($700,000 + $35,000). The option’s cost is recovered when N sells, or otherwise disposes of, the property.
If 12 months pass and the option expires, N would recognize a $35,000 loss.
If, within 12 months, N sells the option for, say, $40,000, it would have a $5,000 gain ($40,000 – $35,000). The cost of the option is recovered when N’s taxable gain is reduced by $35,000.
If software is purchased along with hardware, and the former’s cost is not separately stated, it is depreciated as part of the cost of the hardware. 22
The cost of acquiring “off-the-shelf” software 23 is deductible:
Currently under Sec. 179 (Sec. 179(d)(1)(A)(ii)) or
Ratably over 36 months (Sec. 167(f)(1)(A)).
If software development qualifies as “research and development,” the cost is either deducted currently or amortized over five years, under Sec. 174(a)(1) and (b)(1).
If the software cost is not accounted for under the first three rules, it is a Sec. 197 intangible, subject to 15-year amortization.
Two types (categories 5 and 6) of indirect (transaction) costs must be capitalized. 24 Category 5 transaction costs are amounts paid or incurred to facilitate the acquisition or creation of category 1–4 intangible assets. Category 6 transaction costs are amounts paid or incurred to facilitate the acquisition, restructuring or reorganization of a business.
Under Regs. Sec. 1.263(a)-4(e)(l)(i) and -5(b)(1), “facilitate” refers to the process of investigating or otherwise pursuing the acquisition, creation, restructuring or reorganization. The fact that an amount would not be paid or incurred but for the acquisition, creation, restructuring or reorganization is relevant, but not determinative, in establishing the existence of transaction costs.
These include professional fees (e.g., legal, accounting), broker fees, appraisal fees, meals, travel and any other cost determined by the facts and circumstances to be facilitative. Under Regs. Sec. 1.263(a)-4(g)(1), category 5 transaction costs are added to the basis of category 1–4 intangible assets acquired or created.
Example 11—category 5 transaction costs: Potential franchisee A and potential franchisor F are in the process of concluding a deal. They entered into a letter of intent and are engaged in ironing out the details. To close the deal, A paid legal fees of $18,000, consulting fees of $30,000, appraisal fees of $9,000, meal and travel costs of $3,000 and a franchise fee of $120,000.
Pursuant to the INDOPCO regulations, A must capitalize the $120,000, because the franchise is a category 2 intangible asset. A must also capitalize $60,000 ($18,000 + $30,000 + $9,000 + $3,000); this amount represents category 5 transaction costs. A’s initial basis in the franchise, then, is $180,000 ($120,000 + $60,000). As for cost recovery, the franchise is a self-created amortizable Sec. 197 intangible, so the capitalized amount of $180,000 would be subject to 15-year amortization.
Category 6 transaction costs include appraisal fees and other costs determined by the facts and circumstances to be facilitative. Which expenditures should be capitalized? In the context of taxable acquisitions, category 6 transaction costs are added to the basis of (1) assets if acquired, under Regs. Sec. 1.263(a)-5(g)(2)(i); or (2) stock if acquired, under Regs. Sec. 1.263(a)-5(g)(2)(ii).
In the context of nontaxable acquisitions (i.e., Sec. 368 reorganizations, which are not addressed in the INDOPCO regulations), category 6 transaction costs would be added to a separate intangible asset (e.g., “acquisition costs”) and not amortized. 25 Such costs would be recovered when the entity is dissolved. Specifically, gain on dissolution would be decreased or loss on dissolution would be increased. According to the preamble to the INDOPCO regulations: 26
[T]he IRS and Treasury Department intend to issue separate guidance to address the treatment of these amounts and will consider at that time whether such amounts should be eligible for the 15-year safe harbor amortization period.... 27
Planning tip: Changes are looming; the IRS is still studying the matter, but soon there may be a 15-year amortization safe harbor for category 6 transaction costs.
Business Acquisition Costs
Secs. 195 Investigatory Costs and 263 Facilitative Costs
With regard to business acquisition costs, there is a tension between Secs. 195 and 263. When acquiring a business (as opposed to creating one), Sec. 195(b)(1) provides that investigatory costs are capitalized and deducted/amortized over 15 years, 28 beginning in the month business begins. However, facilitative costs (within the meaning of Sec. 263) are category 6 transaction costs and would be capitalized, not amortized. As mentioned previously, such costs would not be recovered until dissolution.
Before the INDOPCO regulations, to differentiate between investigatory costs (Sec. 195) and facilitative costs (Sec. 263), the Service relied on the “whether-and-which” analysis of Rev. Rul. 99-23. 29 During the investigation phase, a potential acquirer would consider whether to go forward and, if so, with which target business. After the whether-and-which analysis, there would be a final decision. According to the ruling, all costs incurred before the final decision would be investigatory costs (Sec. 195), capitalized and deducted/amortized (over 15 years). All costs incurred after the final decision would be facilitative costs (Sec. 263), capitalized and not amortized.
In superseding Rev. Rul. 99-23, the INDOPCO regulations, at least with regard to business acquisition costs, provide an “inherently facilitative” rule and some bright-line dates. Under Regs. Sec. 1.263(a)-5(e)(1), business acquisition costs are facilitative (category 6 transaction costs) only if they:
Are inherently facilitative of the acquisition 30 or
Relate to activities performed on or after the earlier of the date on which:
A letter of intent or similar written communication is executed by representatives of the acquirer and the target;
The material terms of the transaction are authorized or approved by the taxpayer’s board of directors (if a corporation) or governing officials (if not a corporation); or
The acquirer and the target execute
a binding written contract if the transaction does not need the authorization or approval of the taxpayer’s board of directors or governing officials.
Planning tip: When acquiring a business, taxpayers may want to do as much work as possible before the bright-line date. By so doing, they will maximize investigatory costs (as opposed to facilitative costs), and can take advantage of the deduction/amortization (15 years) afforded by Sec. 195.
Example 12—category 6 transaction costs: In year 1, to explore the possibilities of expanding its operations, G Co. hired an investment banker for $600,000. On Jan. 1, year 2, based on the banker’s recommendation, G’s board of directors authorized its representatives to pursue acquiring H, one of G’s competitors. In year 2, while pursuing the acquisition, G incurred professional fees of $900,000: $500,000 in legal fees, $320,000 in investment banking fees and $80,000 of appraisal fees. In year 3, G acquired H.
According to the INDOPCO regulations, there cannot be any category 6 transaction costs before Jan. 1, year 2, when G’s board of directors authorized the deal. Thus, assuming that the $600,000 investment banking fee is not inherently facilitative, it is not a category 6 transaction cost. It would be a Sec. 195 start-up cost, capitalized and amortized over 15 years. The year 2 $900,000 professional fees are category 6 transaction costs, because they are facilitative costs incurred for services performed after year 1.
Example 13—category 6 transaction costs: The facts are the same as in Example 12, except that G acquired H in a taxable acquisition, purchasing all of H’s assets for $8 million.
G’s basis in the purchased assets would be determined under Sec. 1060 (applicable asset acquisition). Under that provision and its regulations, category 6 transaction costs of $900,000 would be capitalized into a new “class V” intangible asset (e.g., acquisition costs), not eligible for amortization.
Example 14—category 6 transaction costs: G from Example 12 acquires H in a taxable acquisition, purchasing all of H’s stock for $8 million.
The $900,000 category 6 transaction costs would be capitalized into the cost of the stock. The stock would have a basis of $8.9 million ($8,000,000 + $900,000); G would recover this cost when it sold the stock.
Example 15—category 6 transaction costs: G from Example 12 acquires H in a nontaxable acquisition. Specifically, G issued its stock either in exchange for all of the H stock in a B reorganization, or for all of the H assets in a C reorganization.
The $900,000 category 6 transaction costs would be capitalized into a separate intangible asset (e.g., acquisition costs). This cost would not be recovered until G dissolved. At dissolution, gain would be decreased or loss would be increased.
Example 16—issuing bonds: In year 1, L Co. paid $200,000 to an investment banker to explore the possibility of borrowing money through issuing bonds. On Jan. 1, year 2, L issued 10-year bonds (face value of $10 million) for $9 million.
Under the INDOPCO regulations, L must capitalize the $200,000 investment banking fee, because this bond-related cost is a category 6 transaction cost. L would have original issue discount (OID) of $1.2 million (($10,000,000 – $9,000,000) + $200,000), amortized over the life of the bonds under the OID rules.
As was discussed, some intangible assets can be amortized under the units-of-production method or income-forecast method. Some transaction costs (category 5) are added to the basis of category 1–4 intangible assets acquired or created, with the possibility of deducting or amortizing the transaction costs. Category 6 transaction costs are capitalized, not amortized. Until the IRS clarifies the treatment of computer software, taxpayers may rely on the four rules presented in this article.
Example 13 states that capitalized transaction costs in an asset acquisition are treated under Sec. 1060 as category 6 transaction costs, not eligible for amortization. However, Regs. Sec. 1.263(a)-5(g)(2)(i) states that such costs are added to the basis of the acquired (1) assets (in an asset transaction) or (2) stock (in a stock transaction). Assuming such costs are allocable to goodwill and the Sec. 197 anti-churning rules do not apply, they would be eligible for 15-year amortization.
For more information about this article, contact Prof. Witner at firstname.lastname@example.org
17 TD 9107 (1/5/04).
18 This example is modeled after Regs. Sec. 1.263(a)-4(d)(2)(vi), Example 5.
19 See 35 USC Section 154.
20 See the preamble to TD 9107, note 17 supra, at II. H.
21 Rev. Proc. 2000-50, 2000-2 CB 601; for a detailed discussion, see Witner and Krumwiede, “Purchasing, Leasing and Developing Software,” Part I, 34 The Tax Adviser (July 2003), and Part II, 34 The Tax Adviser (August 2003).
22 Rev. Proc. 69-21, 1969-2 CB 303.
25 See INDOPCO, Inc., 503 US 79 (1992), at 84.
26 Preamble to TD 9107, note 17 supra, at III. H.
27 Treasury issued Notice 2004-18, IRB 2004-11, 605, soliciting comments on the proper content of future guidance in this area.
28 In general, the first $5,000 of start-up costs is deducted; any excess is amortized over 15 years.
29 Rev. Rul. 99-23, 1999-1 CB 998.
30 For a list of inherently facilitative costs, see Regs. Sec. 1.263(a)-5(e)(2).