September 19, 2023
Intangible assets have become increasingly vital to the value of many companies. While their benefits may be obvious to business owners, their tax treatment often isn’t. Taxpayers may be surprised by the expansive IRS definition of “intangible asset” and the impact it can have on their tax bills.
For tax purposes, the term “intangible asset” extends beyond goodwill and intellectual property rights, such as patents, trademarks and copyrights. Under federal tax regulations, the term also can include:
- Ownership and financial interests,
- Debt instruments,
- Endowment, annuity and insurance contracts,
- Nonfunctional currency,
- Customer lists, and
- Computer software.
Intangible assets can be either created or acquired. This factor may affect an asset’s tax treatment.
Business expenses are generally treated one of three ways under the tax laws and regulations. They’re:
- Immediately deductible in the year incurred,
- Capitalized and deducted over time, or
- Capitalized without any deduction allowed.
Typically, businesses are required to capitalize amounts paid to:
- Acquire or create an intangible asset,
- Create or enhance an intangible asset that’s “separate and distinct” from a business,
- Create or enhance certain future benefits (meaning benefits beyond the year the cost is incurred) that the IRS has identified as requiring capitalization, and
- Facilitate the acquisition or creation of an intangible (such as legal and accounting fees paid to investigate or pursue a transaction).
The IRS casts a wide net as far as costs that fall within these categories. For example, the list of costs related to created intangibles that must be capitalized includes:
- Prepaid expenses, such as rent or insurance,
- Memberships and privileges, such as certifications,
- Costs of trademarks, copyrights, permits, and business and professional licenses, and
- Amounts paid to other parties to create, originate, enter into, renew or renegotiate certain financial interests.
Capitalized costs become part of a created intangible asset’s tax basis.
There are some important exceptions to the capitalization requirement. For example, certain expenses don’t need be capitalized if you spend $5,000 or less in total. The so-called “12-month rule” is another exception. Under that rule, capitalization generally isn’t required for amounts paid to create, or facilitate the creation of, any right or benefit that doesn’t extend beyond the earlier of:
- 12 months after the first date on which the taxpayer realizes the right or benefit, or
- The end of the tax year after the tax year in which the payment is made.
Important: The 12-month rule doesn’t apply to amounts paid to create financial interests or amortizable Section 197 assets.
Sec. 197 Assets
Internal Revenue Code Section 197 allows for cost recovery of expenses related to certain intangible assets. It’s generally limited to intangibles that are acquired, usually as a part of the acquisition of a business in an asset purchase transaction. Such assets include:
- Going concern value,
- Workforces in place,
- Information bases, such as business records, operating systems and customer lists, and
- Patents, copyrights, formulas, designs and other “know-how.”
Sec. 197 also applies to self-created intangible assets that aren’t part of a business acquisition. This could include:
- Licenses, permits or other government-granted rights,
- Noncompete agreements related to the acquisition of a business interest, and
- Franchises, trademarks and trade names.
If you license or contract for the use of a Sec. 197 intangible, it’s considered to be a Sec. 197 intangible, too.
Sec. 197 applies only if you hold the asset as part of your business or in another for-profit activity. Generally, the provision requires you to ratably amortize the capitalized costs of covered intangibles over 15 years, regardless of the asset’s useful life. The amortization period typically begins with the later of:
- The month the intangible asset is acquired, or
- The month the business or income-producing activity begins.
If you pay an amount that increases the asset’s basis during the 15-year period, you must amortize that amount over the remainder of the period. This treatment begins with the month the basis increases. In addition, you can’t claim any other depreciation or amortization deduction for an amortizable Sec. 197 intangible.
Other Recovery Options
An intangible asset that isn’t an amortizable Sec. 197 intangible might qualify for depreciation under other tax code provisions that typically require a straight-line depreciation over the asset’s useful life. In certain circumstances, a safe harbor will allow a taxpayer to treat an intangible asset as having a useful life of 15 years.
For some intangibles, tax law will specify the depreciation period. For example, the depreciation period for computer software generally is 36 months.
GRF Can Help
The tax rules for intangible assets are complicated and riddled with potential pitfalls for the unwary. Your tax advisors can help you avoid mistakes that can put you in the crosshairs of the IRS. Contact the GRF Tax Team for assistance.