IRS Regulations Regarding Intangible Assets
The IRS has issued comprehensive regulations explaining how Internal Revenue Code Sec. 263(a) rule barring deductions for capital expenses applies to amounts paid to acquire, create, or enhance intangible assets.
The regulations generally would require taxpayers to capitalize an amount paid to acquire, create, or enhance an intangible asset, a term that includes the following assets: (Reg § 1.263(a)-4(c))
Acquired Intangibles
Amounts paid to another party to acquire an intangible asset from that party in a purchase or similar transaction. Generally, they include:
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An ownership interest in a corporation, partnership, trust, estate, limited liability company, or other similar entity;
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A debt instrument, deposit, stripped bond, stripped coupon (including a servicing right treated for federal income tax purposes as a stripped coupon), regular interest in a REMIC or FASIT, or any other intangible treated as debt for federal income tax purposes;
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A financial instrument, such as a notional principal contract; a foreign currency contract; a futures contract; a forward contract (including an agreement under which the taxpayer has the right and obligation to provide or to acquire property (or to be compensated for such property, regardless of whether the taxpayer provides or acquires the property)); an option (including an agreement under which the taxpayer has a right to provide or to acquire property (or to be compensated for such property), regardless of whether the taxpayer provides or acquires the property)); any other financial derivative.
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An endowment contract, annuity contract, or insurance contract.
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Non-functional currency.
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A lease.
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A patent or copyright.
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A franchise, trademark or trade name (as defined in §1.197-2(b)(10)).
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An assembled workforce (as defined in §1.197-2(b)(3)).
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Goodwill (as defined in §1.197-2(b)(1)) or going concern value (as defined in §1.197-2(b)(2)).
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A customer lists.
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A servicing right (for example, a mortgage servicing right that is not treated for Federal income tax purposes as a stripped coupon).
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A customer-based intangible (as defined in §1.197-2(b)(6)) or supplier-based intangible (as defined in §1.197-2(b)(7)).
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Computer software.
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An agreement providing either party the right to use, possess or sell an intangible described in paragraphs (c)(1)(i) through (v) of this section.
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Readily available software.
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Intangibles acquired from an employee. However, if the amount paid to acquire the intangible is includible in the employee’s income for performing services under § 61 or 83, the amount paid is not required to be capitalized.
Created Intangibles
This broad class of intangibles would include:
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Amounts paid to another party to create or originate with that party any of a number of enumerated financial interests; (Reg § 1.263(a)-4(d)(2))
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Prepaid expenses (for example, prepaying a 3-year insurance policy premium or prepaying the rent on a 2-year lease); Reg § 1.263(a)-4(d)(3))
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Amounts paid to an organization to obtain or renew a membership or privilege; (Reg § 1.263(a)4(d)(4))
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Amounts paid to a governmental agency to obtain or renew a trademark, trade name, copyright, license, permit, franchise, or other similar right; (Reg § 1.263(a)-4(d)(5))
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Amounts paid to another party to induce that party to enter into, renew, or renegotiate an agreement giving the taxpayer the right to (a) use tangible or intangible property or be compensated for the use of such property; (b) provide or acquire services (or be compensated for such services), but not if the amount is allocable to services that the taxpayer must provide or acquire before the end of the tax year in which the payment is made; (c) a covenant not to compete; (d) an agreement not to acquire additional ownership interest in the taxpayer; or (e) an agreement providing the taxpayer with an annuity, endowment or insurance coverage; (Reg § 1.263(a)-4(d)(6))
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Certain contract terminations; (Reg § 1.263(a)-4(d)(7))
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Amounts paid for realty relinquished to another, or amounts paid to produce or improve realty owned by another, if the realty can reasonably be expected to produce significant economic benefits for the taxpayer; and (Reg § 1.263(a)-4(d)(8))
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Amounts paid to another party to defend or perfect title to intangible property where the other party challenges the taxpayer's title to the intangible property. (Reg § 1.263(a)-4(d)(9)
Goodwill
Goodwill can be purchased or created. If purchased, it can be amortized over 15 years as a Sec 197 intangible. If created, it has no basis.
Gain from Sale
While no deduction for depreciation is allowable with respect to goodwill, the sale of goodwill is a section 1231 transaction because goodwill, under Section 197(f)(7), is treated as if it was a depreciable asset for all purposes under “chapter 1”. Thus, a sale of goodwill is reported on Form 4797, and if held for longer than one year, becomes a long-term capital gain.
Loss from Sale or Abandonment
Loss on the sale or abandonment of goodwill is not allowed unless goodwill is the only intangible the business owns. (Reg Sec 1.197-2(g)(1)(ii)). If the business owns other intangibles the loss is added to their bases using a pro rata allocation. (Reg Sec 1.197-2(g)(1)(i)(A)(2)). If a loss is allowed, it is a Sec 1231 ordinary loss reported on Form 4797.
Form 8594
An often forgotten, but very important IRS form is the 8594. Both the seller and purchaser of a group of assets that makes up a trade or business must use Form 8594 to report such a sale if goodwill or going concern value attaches, or could attach, to such assets and if the purchaser's basis in the assets is determined only by the amount paid for the assets.
Form 8594 must also be filed if the purchaser or seller is amending an original or a previously filed supplemental Form 8594 because of an increase or decrease in the purchaser's cost of the assets or the amount realized by the seller.
Both the purchaser and seller must file Form 8594 and attach it to their income tax returns (Forms 1040, 1041, 1065, 1120, 1120-S, etc.) in the year of sale when there is a transfer of a group of assets that makes up a trade or business (defined below) and the purchaser's basis in such assets is determined wholly by the amount paid for the assets. This applies whether the group of assets constitutes a trade or business in the hands of the seller, the purchaser, or both.
If the Form 8594 is not filed with a tax return by the due date of the return and reasonable cause cannot be shown, a penalty under Sec 6721, may be imposed. The 2022 Sec 6721 penalty is $290, reduced to $50 if corrected within 30 days and $100 if corrected by August 1st.
The form allocates the businesses sales price among several categories based upon the sales agreement or if no sales agreement then by the “residual method”.
The residual method requires that all assets of an acquired business be divided into seven classes:
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Class I: Cash and cash equivalents.
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Class II: Certificates of deposit, U.S. government securities, readily marketable securities, foreign currency.,
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Class III: Assets the taxpayer marks to market at least annually for tax purposes, including accounts receivable.,
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Class IV: Stock in trade or other property that would be included in inventory if on hand at the close of the tax year, property held primarily for sale to customers.
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Class V: All assets other than Class I, II, III, IV, VI and VII assets (generally including furniture and fixtures, buildings, land, vehicles, and equipment, which constitute all or part of a trade or business).
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Class VI: Code Sec. 197 intangibles, except goodwill and going concern value.
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Class VII: Assets in the nature of goodwill and going concern value.
The purchase price (reduced by Class I amounts) is allocated successively to the assets in Classes II through VI based on their fair market value. The excess (residual) of the purchase price over the values of Class I through VI assets is goodwill and going concern value.
Capitalization of Transaction Costs
Under Regulation § 1.263(a)-4(b)(1), taxpayers are required to capitalize an amount paid to “facilitate” (a) the acquisition, creation, or enhancement of an intangible asset, (b) a restructuring or reorganization of a business entity, or (c) a transaction involving the acquisition of capital, including a stock issuance, borrowing, or recapitalization.
12-Month Rule
The regulations don’t require a taxpayer to capitalize under Code Sec. 263(a) amounts paid to create or enhance an intangible asset (see discussion above), or the related transaction costs, if the amounts do not create or enhance any right or benefit for the taxpayer that extends beyond the earlier of:
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12 months after the first date on which the taxpayer realizes the right or benefit, or,
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The end of the tax year following the tax year in which the payment is made. (Regulation § 1.263(a)-4(f)),
The 12-month rule does not apply to amounts paid to create or enhance financial interests or amortizable Code Sec. 197 intangibles.
California Differences - Regulations
California conforms to Federal treatment of intangibles except with regard to intangibles transferred in Sec 1031 exchanges, where only exchanges of real property qualify for 1031 treatment for federal for years after 2017 while California adopted the TCJA provision that limits Sec 1031 treatment only to exchanges of real property only for exchanges completed after January 10, 2019, and only for taxpayers with AGI of $500,000 or more ($250,000 for those filing single or married separate). (AB 91 (6/27/19))