Separately Identifiable Intangible Assets: Tax Opportunities and Traps

In Letter Ruling 201016053,1 the IRS ruled that where a taxpayer could separately identify and distinguish acquired customer-based intangibles from self-created customer-based intangibles, the taxpayer could separately calculate gains on the sale of each, thereby avoiding Sec. 1245 ordinary income recapture on the sale of the self-created customer-based intangibles. The ruling is consistent with a recent Chief Counsel Advice (CCA)2 holding that customer-based intangibles (among others) “can be separately described and valued apart from goodwill” and thus qualify as like-kind property under Sec. 1031. The underlying technical analysis of the ruling, albeit not groundbreaking, is significant to taxpayers in a variety of transactions outside of Sec. 1245 recapture, such as the application of the Sec. 197 antichurning provisions and the Sec. 1374 built-in gain (BIG) tax.

Simplified Ruling and Fact Pattern

The ruling appears to involve the sale of certain partnership interests held by an S corporation following the implementation of an Up-C3 initial public offering (IPO) transaction. Simplifying the facts in the ruling, shareholder SH owns S, a subchapter S corporation, which in turn owns an interest in the operating LLC (taxed as a partnership for federal tax purposes). The remainder of the LLC interest is owned by P, which prior to the IPO was controlled by SH. Following the IPO, P acquired LLC interests from S. The acquisition by P was presumably eligible for an election under Sec. 754 and asset basis adjustments under Sec. 743. The exhibit shows a simplified structure that differs from the actual structure in the ruling.

The LLC owned both self-created and acquired customer-based intangibles. The acquired intangibles were customer relationships with terminable-at-will written service contracts. The LLC acquired the intangibles while it was primarily engaged in the provision of Service A. The LLC took a cost basis in the assets and began amortizing them over 15 years. Following the acquisition, the LLC expended significant capital to expand its service offerings to include Service B and develop the capability to service customers it previously was unable to serve. The LLC operates in a competitive industry that requires continued capital investment, which the taxpayer (P) claimed was necessary to keep customers from choosing competitors. As a result, the LLC held x number of acquired customer relationships that were different from y number of self-created customer relationships.

Gain on the sale of the customer-based intangibles, presumably as a result of the application of Sec. 751, would generate ordinary income recapture under Sec. 1245 up to the amount of amortization deductions claimed on the intangibles. However, if the LLC could establish that rather than being a single intangible asset, the self-created customer-based intangibles were separate from the acquired customer-based intangibles, ordinary income recapture on the sale would be limited to gain on the acquired intangibles.4

Example: LLC pays $45 million for customer-based intangibles and also creates customer-based intangibles in the ordinary course of business. LLC disposes of the business assets in a taxable transaction. LLC had claimed $30 million of amortization on the acquired intangibles through the date of the sale. The total purchase price allocated to customer-based intangibles is $60 million. If the intangibles are looked at as a single asset, $30 million of the $45 million gain will represent Sec. 1245 gain. However, assuming that LLC is able to distinguish between the two and determines that the value of the acquired intangibles is $15 million and the self-created intangibles have a value of $45 million, none of the gain will be recaptured as ordinary (i.e., the tax basis of the acquired intangibles equals the value ($45 million – $30 million depreciation = $15 million), so there is no gain on the sale of these assets).

While the concept seems quite simple (i.e., segregate intangible assets as if they were pieces of equipment and allocate purchase price accordingly), it is often difficult to determine and substantiate that customer-based intangibles (e.g., customer lists) are both distinguishable from goodwill and separable from each other. In fact, the taxpayer in Letter Ruling 201016053 was required to make significant representations to the IRS, all of which were subject to challenge under exam, in order to get the ruling. In short, the representations were as follows:

1. The taxpayer represented that it had sufficient records and information to identify which of its current customers represent the acquired customer relationships (ACR) and which represent the self-created customer relationships (SCR).
2. It also represented that each of the identified types of customer relationship that are ACRs and SCRs has a reasonably ascertainable value and a reasonably determinable life.
3. Further, it represented that it has expended significant amounts of capital to solicit and service new customers.

Thus, by analogy, these representations—that the taxpayer can separately identify, value, and determine the life of the ACRs and the SCRs—support treating the SCRs as being a separate and distinct asset from the ACRs.

Given these facts and representations, the IRS ruled that the self-created customer relationships were separate and distinct from the acquired customer relationships, and as such the sale of the self-created customer-based intangibles was not subject to Sec. 1245 recapture. The IRS based its determination primarily on case law holding that, under pre–Sec. 197 rules, intangible assets with an ascertainable value and reasonably determinable limited useful life were amortizable.5 The ruling also addressed the fact that the mass-asset rule does not affect a taxpayer’s ability to achieve this favorable tax treatment as long as the taxpayer is able to satisfy the dual burden of establishing an ascertainable value separate from goodwill and a limited useful life.6

Separately Identifiable Intangibles

To meet the dual burden required to establish the existence of a separately identifiable asset, a valuation is likely required. As a result of changes in financial reporting with the issuance by the Financial Accounting Standards Board (FASB) of Statement of Financial Accounting Standards (FAS) 141R, Business Combinations, applicable to business acquisitions occurring in fiscal years beginning on or after December 15, 2008,7 additional attention is being paid to the identification of specific intangibles separate from goodwill for financial statement purposes. Taxpayers, however, should proceed with caution when relying on FAS 141R appraisals. Unless the taxpayer specifically directs the appraiser to do so, the appraiser does not perform a FAS 141R appraisal with the tax provisions in mind. As a result, such an appraisal may not provide the required analysis pertaining to distinct value apart from goodwill and a useful life.

While not a result of the implementation of FAS 141R, the Third Circuit decision in Technicolor USA Holdings8 provides a good reminder that not all valuations are created equal. In that case, the Third Circuit upheld the Tax Court’s decision finding that the intangible assets acquired by a taxpayer, which were supported by a valuation from a large national accounting firm, did not have a readily ascertainable useful life. Therefore the assets were not separate assets and their basis was attributed to goodwill and going concern value.

Even in giving the taxpayer the favorable ruling in Letter Ruling 201016053, the IRS made it clear that meeting this two-part test is no simple task. In its analysis of the law, the IRS cited Newark Morning Ledger,9 where the Court stated that the burden of proof is often too difficult for taxpayers to satisfy the two-part test. In the following paragraph, the IRS cited the Citizens and Southern Corp. decision, where the Tax Court stated that satisfying the two-part test is a “perhaps extremely difficult burden.”10

As a result, it is very important that taxpayers and their advisers closely review any appraisal to verify that any separately identifiable intangible has both a reasonably ascertainable value and a reasonably determinable life.

Additional Applications of the Underpinnings of Letter Ruling 201016053

While the ruling addressed only Sec. 1245 recapture, the identification of intangible assets separate from goodwill could play an important role in a number of areas. In particular, separate identification could be useful in the area of the Sec. 197 antichurning rules and the Sec. 1374 BIG tax.

Antichurning Rules

Prior to the enactment of Sec. 197, taxpayers could not amortize goodwill and similar intangible assets. Sec. 197 granted a 15-year amortizable life to intangible assets acquired after the enactment of the statute. Included in the enactment of Sec. 197 were the antichurning provisions, which disallow the amortization of intangibles subject to the rules.11 Assets subject to the antichurning provisions include goodwill and similar intangible assets held by the seller that were not amortizable prior to the enactment of Sec. 197 and that were acquired from a related person (as defined in Secs. 267(b) and 707(b), except substituting “more than 50 percent” for “more than 20 percent”) who continues to use the intangible.12 The relationship is tested immediately before and after the sale of the intangible13 and applies whether the continuing shareholders took part in a fully taxable transaction or received a tax-deferred rollover.14

The antichurning provisions apply only to goodwill and similar intangible assets held by the seller that were not amortizable prior to the enactment of Sec. 197. If the taxpayer can identify assets that would have been amortizable pre–Sec. 197, such assets are not subject to the antichurning rules.

To establish that an intangible asset would have been amortizable pre–Sec. 197, the taxpayer must show that the asset has both a readily ascertainable value separate and distinct from goodwill and a useful life.15 This is the same analysis performed and represented to by the taxpayer in Letter Ruling 201016053. A similar analysis was performed in CCA 200911006, addressing the segregation of intangibles for purposes of the Sec. 1031 like-kind exchange rules, where the IRS adopted the Newark Morning Ledger analysis, stating, “[i]n our opinion, except in rare and unusual situations, intangibles such as trademarks, trade names, mastheads, and customer-based intangibles can be separately described and valued apart from goodwill.” While neither the letter ruling nor the CCA directly applies to the antichurning provisions, they nonetheless are an indication of the IRS’s acceptance of separate identification of intangibles apart from goodwill. However, the language of the CCA in no way lessens the taxpayer’s burden of establishing that the intangible asset in question has both a readily ascertainable value separate and distinct from goodwill and a useful life.

Sec. 1374 BIG Tax

In general, when a subchapter C corporation elects subchapter S status, net recognized BIGs during the applicable recognition period (five, seven, or ten years following the subchapter S election depending on the years of election and gain) are subject to tax at the highest corporate tax rate (the Sec. 1374 BIG tax).16 The same rules generally apply to any asset transferred to an S corporation by a C corporation in a tax-deferred transaction.17

Recognized BIGs include any gain recognized during the recognition period, with two exceptions. The gain will not be taxed if the corporation establishes that it did not hold the asset as of the beginning of the first S corporation tax year (or it did not receive the asset from a C corporation in a tax-deferred transaction). In addition, the tax does not apply to the extent of the gain that exceeds the difference between the fair market value and the tax basis of the asset as of the beginning of the first S corporation tax year.18

As a result, BIGs attributable to goodwill and similar intangibles are subject to the Sec. 1374 BIG tax. However, if the S corporation can establish that an intangible is both separate from goodwill and was acquired or created after the subchapter S corporation election, any gain recognized on the disposition of the asset would avoid the Sec. 1374 BIG tax.

While Letter Ruling 201016053 addresses Sec. 1245, not Sec. 1374, the correlation between the two is clear. Just as with the customer-based intangibles in the ruling, if an S corporation can establish that a customer-based intangible (or any intangible for that matter) has a readily ascertainable value separate and distinct from goodwill and a useful life, the determination of whether a gain is subject to the Sec. 1374 BIG tax is made on an asset-by-asset basis. If the asset was acquired or created after the S corporation election, any gain on the sale of the intangible would avoid tax under Sec. 1374. As discussed above, this should be the case even where the intangible may be part of a mass asset such as a customer list.

Conclusion

When acquiring or disposing of intangible assets, such as customer-based intangibles, understanding the impact of an intangible’s distinction from goodwill and other similar intangibles may be critical. As addressed above, such a determination could provide tax advantages when dealing with the recapture provisions of Sec. 1245, avoidance of Sec. 197 antichurning limitations, and application of the Sec. 1374 BIG tax.

However, it is important to remember that the taxpayer carries the significant burden of establishing, and defending under exam, that the intangibles in question have a readily ascertainable value separate and distinct from goodwill and a useful life. Reliance on valuations prepared for financial statements or other nontax purposes should be carefully reviewed to determine if they truly meet both requirements to establish separateness. The more advisable route would be to engage an appraiser to specifically identify and value intangible assets that are both separate from goodwill and have a reasonable ascertainable useful life.

Footnotes

¹ IRS Letter Ruling 201016053 (4/23/10).

² CCA 200911006 (3/13/09).

³ An Up-C or umbrella partnership C corporation structure allows the business to acquire assets by issuing operating partnership units.

⁴ See, e.g., IRS Letter Ruling 200243002 (10/25/02), which ruled that self-created intangibles generally constitute capital assets.

⁵ Newark Morning Ledger Co., 507 U.S. 546 (1993); and Citizens and Southern Corp., 91 T.C. 463 (1988), aff’d, 919 F.2d 1492 (11th Cir. 1990).

⁶ Houston Chronicle Pub. Co., 481 F.2d 1240 (5th Cir. 1973), cert. denied, 414 U.S. 1129 (1974).

⁷ Codified at FASB Accounting Standards Codification (ASC) Topic 805, Business Combinations.

⁸ Technicolor USA Holdings Inc., 288 Fed. Appx. 15 (3d Cir. 2008), aff’g Claymont Investments, Inc., T.C. Memo. 2005-254.

⁹ Newark Morning Ledger Co., 507 U.S. at 566.

¹⁰ Citizens and Southern Corp., 91 T.C. at 482.

¹¹ Sec. 197(f)(9).

¹² Sec. 197(f)(9)(C).

¹³ Sec. 197(f)(9)(C)(ii).

¹⁴ See Regs. Sec. 1.197-2(h).

¹⁵ Id.

¹⁶ See Secs. 1374(a), (b), and (d)(7).

¹⁷ Sec. 1374(d)(8).

¹⁸ Sec. 1374(d)(3).

EditorNotes

Nick Gruidl is a partner and managing director in the M&A tax practice of RSM McGladrey in Minneapolis, MN. He is the chair of the AICPA’ s Corporations and Shareholders Technical Resource Panel. For more information about this article, contact Mr. Gruidl at nick.gruidl@mcgladrey.com.