Understanding Section 197 Intangibles
What Is a Section 197 Intangible?
Intangible assets have no physical representation, but that doesn’t mean they’re worthless. Like tangible property, intangibles can be bought, sold, traded, licensed, or used as bargaining tools.
Suppose your business purchases an intangible asset or acquires an entity that has intangible assets. In that case, you’ll need to report those intangibles on your tax return following Section 197 of the internal revenue code. This tax law requires you to amortize your intangibles over 15 years rather than depreciating them as capital assets.
What Are the Three Types of Section 197 Intangibles?
Section 197 of the tax code addresses only a subset of intangible assets. Specifically, Section 197 covers any intangible asset that (1) has been acquired and (2) is used in a trade or business. It does not apply to intangibles you created (like goodwill you’ve accumulated based on name recognition).
The three most common types of Section 197 intangibles are:
Information – Information-based Section 179 intangibles could be the target company’s customer base, formulas and processes, internal training manuals, and other proprietary information.
Rights – Rights-based intangibles are assets that grant a business the right to use something, do something, or enforce something, like licenses, permits, trademarks, trade names, franchises, and non-compete covenants.
Goodwill – You can think of goodwill as a catch-all category for intangible property. Goodwill exists if no discrete intangible asset — like a patent — exists, but the business’s purchase price still exceeds the net fair market value of all its business assets and liabilities. Goodwill could be attributed to relationships with customers and vendors, name recognition, going concern value, employee loyalty and experience, business synergy, and nearly any other nontangible benefit that is difficult to pinpoint or classify.
How Are Intangible Assets Taxed?
Intangibles that you purchase outright or intangibles that you obtain as part of a business acquisition are amortizable assets that are going to affect your federal income tax return. Fortunately, the tax return calculation is simple:
First, you value your intangibles. Then, you amortize them over 15 years.
As a taxpayer, valuing your intangibles will be the most challenging part of the calculation. It will require you to make assumptions and judgments about your business, the target company, and sometimes even the industry, the market, or the economy.
Here are a few common methods used to value intangibles for tax purposes:
Market Value – Some intangible assets, like patents, can be bought and sold in private or public marketplaces. You can use the market value of a similar item to estimate the value of the intangibles you’re purchasing.
Future Benefit – You may be able to estimate the value of your intangible based on the future benefit it will provide your business. For example, suppose you anticipate that having access to a new customer database will help you make X number of recent sales. In that case, you can easily intuit the value of that database.
Difference Between Book Value and Market Value – If you purchase a business with intangibles, there will likely be a difference between the net book value of the company and what you actually paid for it. Naturally, we attribute the difference between those two numbers to intangible assets.
Calculated Intangible Value – The calculated intangible value (CIV) is the present value of business earnings exceeding the expected earnings from similar companies in the same industry. The CIV method is commonly used in business valuations. However, it can be a flawed method if industry data is obscured or if most companies in that industry have intangible assets of their own.
You should select the valuation method that most accurately represents the economic value of your purchased assets. Use your best judgment and be prepared to defend your assumptions.
Once you’ve determined value, the next step is to amortize those intangibles on your tax return.
What Is the Recovery Period for Section 197 Intangibles?
Under Section 197, you should amortize all acquired intangible assets over 180 months, or 15 years, regardless of the asset’s useful life. Amortization of Section 197 assets is done on a straight-line basis. This means that each year for 15 years, you will deduct 1/15th of the acquisition cost of that amortized asset.
If you acquire an asset mid-year, you must calculate the amortization you accumulate each month. For example, if you obtain an asset on March 1st, you will have 10 months of amortization to report. To get your first-year deduction, you would divide the purchase price by 180 months and multiply that result by 10 months.
Today, there are resources to aid teams in ensuring accuracy and timeliness during the amortization process. Learn more about automated amortizations.
How Do You Claim Amortization on Your Tax Return?
Amortization is a business deduction. An amortization deduction will reduce your business’s taxable income just like any other business expense would.
You report your amortization on Form 4562 alongside depreciation. The amortization section of the tax form requires you to list the calculation for each cost separately. However, when purchasing intangibles under Section 197, all intangibles must be grouped together. Those assets are inextricably linked, and even if one or more of those intangibles lose value over the next 15 years, the IRS requires you to continue amortizing them according to the 15-year amortization schedule rather than allocating the deductions to individual assets.
Examples of Section 197 intangibles
To better understand how Section 197 intangibles are reported on the tax return, let’s look at a few examples.
You acquire a business via asset acquisition on January 1, 2022. As part of that asset acquisition, you now hold a patent. Using the CIV method, you estimate the value of that patent to be $45,000.
In 2022, you will deduct $3,000 of amortization for your patent.
($45,000 ÷ 180 months x 12 months = $3,000)
On June 18, 2022, you purchase a customer list from another company in your industry for $6,000.
In 2022, you will deduct $233 of amortization for that customer list.
($6,000 ÷ 180 months x 7 months = $233)
June will count as a full month of amortization.*
On February 4, 2022, your startup acquired a similar business that included $9,000 of goodwill. You didn’t officially begin business until September 3, 2022.
In 2022, you will deduct $200 for amortization of goodwill.
($9,000 ÷ 180 months x 4 months = $200)
You can only begin amortizing intangibles once you’ve become actively engaged in your trade or business.
*According to Page 15 of Form 4562 instructions
Can You Sell Intangible Assets?
Yes, you can sell Section 197 intangibles, but partial sales can get tricky because all Section 197 intangibles are treated as one asset. The IRS does not allow you to report a tax loss from the sale of a Section 197 intangible unless one of two things occurs: (1) The 15-year period is up, or (2) the sale is finalized in such a way where you have no significant power, right, or continuing interest in the assets. Let’s look at an example:
In a business purchase, you acquired two intangibles: a trade name and a patent. Before the 15-year amortization period is up, you sell the patent but continue to hold onto the trade name. The IRS cannot prevent you from selling the patent, but they can prevent you from recording a loss from the sale of that patent.
The adjusted basis of your patent would remain with the original group of Section 197 intangibles. In this instance, the tax basis from the patent would simply transfer to the trade name, and you would only be able to recognize the tax loss from the sale of the patent at the end of the 15-year amortization period.
Selling Section 197 intangibles or marking one or more of them as worthless before the 15-year amortization period can be complicated, so it’s best to talk to a tax advisor if you’re in this situation.
Documentation Is Important
The IRS treats Section 197 intangibles differently than you would treat those intangibles for financial reporting purposes, so it’s important to document each asset carefully. Using amortization schedules (and sticking to those schedules) will make your tax reporting process that much easier.