With the recent reduction in tax rates and changes to net-operating-loss (NOL) rules in P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA), taxpayers have been focusing on maximizing deductions in the 2017 tax year, including attempts to write off Sec. 197 intangible assets from prior asset acquisitions.
In the case of an asset purchase (or deemed asset purchase), these intangible assets are amortizable for tax purposes under Sec. 197(a) ratably over 15 years, beginning in the month of acquisition, regardless of the useful or legal life of the underlying assets. When it comes to claiming losses, all intangibles acquired in a transaction or series of related transactions are part of a group of Sec. 197 intangibles. These assets are tethered to each other for life, including any additional tax basis booked because of contingent consideration paid in later years related to the original transaction (which is amortized on a prorated basis over the remaining life of the related Sec. 197 intangibles).
What happens when the underlying business fundamentally changes or economically fails to be a going concern? Taxpayers are required by FASB to evaluate and write off or impair overvalued intangible assets on their books under GAAP. However, the Internal Revenue Code is rigid on the position that for income tax purposes under Sec. 197, a taxpayer must amortize acquired intangible assets on a straight-line basis over a 15-year period, regardless of any changes in the value or useful life asserted by the taxpayer or disclosed in its financial statements, unless there is a complete disposal of the group of intangibles.
Abandonment, sale, or worthlessness of tax intangibles
Regs. Sec. 1.167(a)-8(a)(4) provides that when a depreciable asset (which would include Sec. 197 intangibles) is abandoned, a loss is recognized and measured by the amount of the adjusted basis of the abandoned asset at the time of the abandonment. In the case of Sec. 197 intangibles, the loss would be the value allocated at the time of the purchase less the accumulated amortization taken up to the date of sale, abandonment, or worthlessness.
The challenge taxpayers frequently face is determining the date of sale, abandonment, or worthlessness. This is where it gets more complicated for Sec. 197 intangibles, as the general loss disallowance rules under Sec. 197(f)(1)(A) frequently limit a taxpayer's ability to take a loss on a specific Sec. 197 intangible from a business acquisition until all Sec. 197 intangibles from that acquisition are written off or disposed of.
General loss disallowance rules of Sec. 197(f)(1)(A)
The general loss disallowance rule in Sec. 197(f)(1)(A) applies to any loss that would be realized on the disposition of a Sec. 197 intangible asset that was acquired in a transaction with other Sec. 197 intangible assets if, at the time of the disposition, the taxpayer retains one or more of the other Sec. 197 intangible assets from the same acquisition.
Example 1: A taxpayer purchased a business in an asset acquisition in 2010, and one of the acquired intangibles was a customer list for a specific product, Product A. The customers for the product were unique and did not purchase any other products from the business. Following the acquisition, rapid technological changes made Product A obsolete. In 2017, the company ceased manufacturing Product A, disposed of all production assets, and laid off the related production workers. At the end of the year, the taxpayer appropriately determined that the Sec. 197 intangible for the Product A customer list was worthless. However, at the end of 2017, none of the other acquired Sec. 197 intangibles are worthless.
In this situation, no loss would be allowed for the worthlessness of the customer list. Instead, the remaining tax basis from the worthless customer list will increase the basis of the other associated amortizable Sec. 197 intangibles. As a result, the loss for worthlessness would, in effect, be recognized over the remaining portion of the applicable 15-year recovery period of the retained intangibles or upon a disposition of the remaining intangibles from the acquisition.
Timing of the tax loss deduction
As discussed, the disposition loss is permitted to be taken only in the year the taxpayer abandons or disposes of all Sec. 197 intangibles from the acquisition. To support a loss deduction, any sale, discontinuance, or abandonment must be evidenced by a completed or closed transaction.
The Code provides some instruction and guidance relative to classifying a transaction involving intellectual property as either a sale or a license. Specifically, in Sec. 1253(b)(2), the term "significant power, right, or continuing interest" is used to define transactions that would be considered a licensing of an intangible and not a sale or transfer. Maintaining significant power, right, or continuing interest over an intangible would result in the intangible's being treated as though it is still retained by the taxpayer. Therefore, any loss would become subject to the general loss disallowance rules of Sec. 197(f)(1)(A), and the disposition loss would not be permitted for tax purposes. Conditions that would rise to the level of significant power, right, or continuing interest include the right to terminate the agreement at will, the right to disapprove the assignment of the intangible to other parties, the right to control how the intangible is used in marketing/advertising, or the ability to control the business practices of the holder as a stipulation for the use of the intangible.
Example 2: A taxpayer purchased a business in an asset acquisition in 2014 that solely manufactured one product under the brand name Product B. One of the intangibles acquired was the trade name for Product B. In 2017, the taxpayer sold the business that manufactures Product B to an unrelated third party. The sale included all of the acquired intangible assets except the right to control the use of the trade name.
Regardless of the taxpayer's motive for retaining control of the trade name, the fact that it maintained the right would result in the disallowance of the loss on the sale of the intangibles associated with the Product B business. Under Sec. 197(f)(1)(A), the loss would not be currently deductible for tax, and the unamortized tax basis would continue to be recovered through increased amortization deductions connected to the retained trade name asset.
Any taxpayer taking the position that it may recover the unamortized basis upon the disposition of intangibles should have supporting documentation as evidence that the assets were sold in a completed or closed transaction. The taxpayer should document any identified intangibles sold to an unrelated buyer, preferably subject to an executed asset purchase agreement. For these purposes, Sec. 197(f)(1)(C) adopts the related-party definition of Sec. 41(f)(1). It should also be documented in that agreement that the taxpayer has relinquished control of the intangibles and does not maintain significant power, right, or continuing interest going forward.
If goodwill was associated with the transaction that created the identified intangibles, then evidence of abandonment, sale, or discontinuance of the related purchased business must be documented. This can include the sale of substantially all of the taxpayer's assets, the complete abandonment of the acquired business or division associated with the Sec. 197 intangibles, or the complete cessation of operations except for those general and administrative activities required to wind down and liquidate a business.
The disposition loss is fully recognized in the year that the final sale or abandonment of a related intangible can be documented to have occurred. If the timing of the loss deduction will affect the taxpayer's ability to use NOLs, credits, or other offsets of taxable income, it is vital that these events occur in the tax year the deduction is taken and that all documentation and evidence is in place and consistent with the position taken.
Impact of the TCJA
The TCJA added another challenge for taxpayers whose intangibles have become worthless as a result of a bankruptcy or another triggering event that will lead to the eventual liquidation of the business. Prior to the enactment of the TCJA, Sec. 172(b)(1)(A) allowed a taxpayer to carry NOLs back two years and forward 20 years. This meant that if a tax loss created by the disposition of the Sec. 197 intangibles was not taken until the final year, it could be carried back to offset taxable income in prior years. While this was not an ideal situation for most taxpayers, it was in most cases an issue of the timing of the deduction and the additional compliance burden of needing to file carryback claims or amended returns.
The TCJA amended Sec. 172(b)(1)(A) to read that there shall not be an NOL carryback to any tax year. In the case where the loss disallowance rules of Sec. 197(f)(1)(A) have limited the taxpayer's ability to deduct the remaining unamortized basis until the final year, the result could have a permanent unfavorable impact on the taxpayer. This could result in NOLs' going to their graves unused and taxable income in the years leading up to the final year that cannot be offset (often as a result of cancellation-of-debt income or as the proceeds of a sale of business assets associated with the bankruptcy or wind-down of a business).
The changes to the NOL rules place increased importance on the timing of all deductions. A taxpayer can no longer rely on the NOL carryback provisions to adjust for differences in timing deductions. It is important for taxpayers, with the assistance of their tax advisers, to understand the timing of these loss deductions for tax and the impact it may have on their cash flow.
Howard Wagner is a partner with Crowe LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe LLP.