by
James P. Swanick, CPA, and Michael J. Tighe, CPA | May 30, 2019
In a
column published in last summer’s
Pennsylvania CPA Journal, we discussed why we anticipated seeing more asset deals among mergers and acquisitions as a result of certain changes brought on by the Tax Cuts and Jobs Act of 2017. This includes
deemed asset purchases via an Internal Revenue Code (IRC) Section 338(h)(10) election. Taxpayers would receive the benefit of getting a stepped-up basis in the assets acquired and resulting depreciation (including immediate expensing via bonus depreciation)
and amortization deductions to follow. IRC Section 1060 provides guidance for allocating the purchase price among the various assets acquired in a business combination. The buyer follows what is commonly referred to as the residual method, and assigns
values to the newly acquired hard assets (accounts receivable, inventory, fixed assets, etc.) and intangible assets (customer lists, noncompetes, etc.), with any excess purchase price ultimately assigned to goodwill. Typically, if these intangible assets
were acquired from an unrelated third party, they are considered Section 197 intangibles. Pursuant to Section 197(a), taxpayers must amortize the intangibles on a straight-line basis, beginning in the month of acquisition over a period of 15 years, even
if there is corroborating evidence substantiating a clear definite or legal life that is shorter than 15 years.
Disposing of Section 197 Intangibles
There is a unique rule within Section 197 that can catch taxpayers off guard and yield unfavorable results in a situation where their intangibles are either sold at a loss, abandoned, or deemed worthless. Under ordinary circumstances, when you dispose
of a depreciable (or amortizable) asset you are entitled to claim a loss to the extent the adjusted basis of the asset at the time of the disposition exceeds the amount realized. The adjusted basis of the asset is generally determined to be the initial
purchase price of the asset less any accumulated amortization taken throughout its useful life up to the date of disposition. However, when you acquire Section 197 intangibles in a transaction (or series of related transactions), those intangibles
become permanently tethered and cannot be bifurcated. Therefore, when the time comes to dispose of these intangibles, it is essentially an “all or nothing” approach in order to claim any potential loss in the current year. The disallowed
loss is not lost forever, but rather treated as an increase to the basis of the remaining Section 197 intangibles, on a pro rata basis, and will continue to be amortized over the remaining life of the Section 197 intangible assets being retained.
It is important to note that this only applies if the adjusted basis is in excess of the sale price (i.e., sold at a loss), as any gain resulting from the disposition of a Section 197 intangible is recognized immediately under general tax law principles.
Furthermore, the recapture rules for Sections 1231 and 1245 property would apply, essentially treating any gain as ordinary – first to the extent of previous amortization deductions taken, with any excess gain receiving the more taxpayer-friendly
capital gain treatment. To prevent taxpayers from manipulating the values assigned to intangibles either upon acquisition or disposition, Congress enacted Section 1245(b)(8), which says that if a taxpayer disposes of more than one Section 197 intangible
in a transaction or series of transactions, all such Section 197 intangibles shall be treated as one Section 1245 property. This rule eliminates the possibility of assigning the sales price to the intangibles with the lowest adjusted basis in order
to maximize capital gain treatment and avoid the fair share of taxes owed.
Related-Party Transactions
Even if you plan to use related parties to acquire the assets of another business, there is no escaping the long reach of the general loss disallowance rules of Section 197(f). The code effectively adopted the related-party definition contained within
Section 41(f)(1). This treats a group of related parties as a single taxpayer, and serves as a way of preventing taxpayers from circumventing the intended purpose of the loss disallowance rules. The timing of determining related-party status is governed
by Section 197(f)(9)(C)(ii), which provides that a person shall be treated as related to another person if such relationship exists immediately before or immediately after the acquisition of the intangible involved.
For example, Company A and Company B are brother-sister corporations (who are in different consolidated groups, but under common control) and each acquires various assets of a target business in the same transaction(s). After allocating the purchase price
among the assets acquired, various Section 197 intangibles are created that now become permanently linked. If Company A later sells its intangibles while Company B retains its own, then the loss becomes disallowed to Company A. However, instead of
treating the disallowed loss as an increase to the basis of the retained intangibles of Company B, the intangibles simply continue to be amortized for tax purposes over the remaining 15-year period for the selling corporation. If in a future period
Company B sells its existing Section 197 intangibles, then it is entitled to claim a full deduction for any loss incurred, and Company A is entitled to write off the remaining adjusted basis in its Section 197 intangibles that had been previously
disallowed.
Acquisition and Disposition
As with all material business transactions, it is imperative to have proper documentation and support for your tax position. Things can get complicated if you are selling both Section 197 intangibles with self-created intangibles (which are not considered
Section 197 intangibles). Otherwise, it can be an uphill battle trying to prove that you entirely disposed of assets like customer lists and goodwill, while not retaining any of them whatsoever, even when a piece of that business line is still in
existence.
Having thorough and contemporaneous documentation – not only during the time of acquisition of those intangibles but also upon their disposition in later years – is critical. There are endless court cases reflecting the competing objectives
between the taxpayer and the IRS on this matter alone. The burden of proof is always on the taxpayer, but half the battle is knowing the rules highlighted above as well as knowing the specific areas that the IRS will target when dealing with the sale
of Section 197 intangibles.
James P. Swanick, CPA, is managing director with Global Tax Management Inc. in its Wayne office, and is a member of the Pennsylvania CPA Journal
Editorial Board. He can be reached at jswanick@gtmtax.com.
Michael J. Tighe, CPA, is a senior tax manager with Global Tax Management in Wayne, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at mtighe@gtmtax.com.