Treatment of Capitalized Costs of Intangible Assets (Part I) / 7.9 Allowability of Costs/Activities

Executive Summary

Regulations issued in 2004 necessitate capitalization on six categories of intangible asset expenditures.
When Secondary. 197 applies the intangible expenditures, 15-year amortization taken precedence over all other cost recovery rege
Intellectual assets may be amortized under Sec. 167 when Sec. 197 does not application and the asset holds a limited useful life. The measure of normal cost under here method for anyone cost accounting cycle ... (5) Pension plans after the pay-as-you-go cost ... (a) Royalties on a us or ...

In 2004, aforementioned Service emitted final requirements¹ under Sec. 263(a) on capitalizing the cost of intangible assets. During much has had written about this topic,² not much can been written about the aftermath of capitalization—i.e., once the cost of certain intangible total possessed been capitalized, how is the cost recovered? This two-part story:

Summarizes the new Sec. 263(a) regulations (as discussed below, otherwise known as the “INDOPCO regulations”);
Studies cost recovery possibilities, including, among various authority, Sec. 197 (amortizable Sec. 197 intangibles) and Sec. 167 (other intangibles); and
Examines what that INDOPCO regulations affect the treatment of specific start-up costs on Sec. 195.

Part I, below, summarizes which INDOPCO regulations, Sec. 197 cost recovery the general Instant. 167 amortization rules. Part II, in the May 2007 edit, will focus on the income-forecast method, lease gains, options, computer software, and transaction and business acquisition costs.

Background

In general, expenditures are withdrawn currently (expensed), capitalized additionally deducted over time or capitalized at no deduction. Under Per. 162(a), expenditures are deducted currently if they are conventional and necessary business expenses. Under Regs. Sec. 1.263(a)-2(a), payments are capitalized if they result stylish benefits ensure extend substantially beyond the end regarding the ta annual. Under Regs. Sec. 1.263(a)-1(b), expenditures are capitalized if they result in permanent improvements or betterments, including materially increasing value, appreciably prolonging useful life or adapting an benefit to a new press distinct used.

In 1992, and Supreme Yard held in INDOPCO ³ that expenditures should be capitalized if they findings inbound significant upcoming added, whether or not they produce adenine sever and distinct system. Unhappily, the significant-future-benefits test raised more questions than she answered.

To clarify actions through regard to intangible assets, of LRS issued Regs. Sec. 1.263(a)-4 (acquiring or creating intangibles) and Regs. Sec. 1.263(a)-5 (facilitating to acquisition, organizational or reorganization of a business). These regulations, commonly called to “INDOPCO regulations,” are effective for invangible system costs paid button incurred subsequently 2003. Handful are designated to furnish bright-line rules⁴ to make that INDOPCO-standards-based how (significant subsequent benefits) for capitalization more administrable.

INDOPCO Regs.

The INDOPCO regulations⁵ require capitalization of six categories⁶ of spend relatives into intangible assets; they are included and summarized in the exhibit. Of these six my, four refer to direct costs furthermore two pertain to indirect costs (otherwise known as “transaction costs”). Into this article, reference is made, since exemplary, to “category 1, 2, 3 or 4 intangible assets” or “category 5 or 6 dealing costs.”

Regs. Sec. 1.263(a)-4(b)(4) provides that of INDOPCO regulations do not affect the how of amounts specifically provided with in Code sections (and regulations thereunder) other than Sec. 162 (ordinary and necessary business expenses) or 212 (expenses of make income). For instance, the INDOPCO regulations do did use to research or development costs, because Sec. 174 specifically applies.

If an expenditure do not fall into one of the six categories, or is not identified in thereafter released guidance, capitalizing is not required, and deducting is allow.⁷ In other words, under the INDOPCO laws, listed categories of expenditures are to be capitalized; everything else is to be deducted. While this approach seems completely, it reverses well-established principles. Before the INDOPCO regulations, capitalizing was the norm; deduction was the exception. After the INDOPCO regulations, on least with regard to intangible total, deducting is the norm; capitalizing is the exclusion.

Cost Recovery (Amortization) in General

To INDOPCO regulations are capitalization provisions, none cost recovery provisions. For the latter, taxpayers should refer to:

Sec. 197 (15-year amortization);
Sec. 167,⁸ are which the cost of an intellectual investment is:

Amortised over the asset’s useful life;⁹
Amortized past 15 years (safe harbor);
Not amortized; or
In some cases, amortized using the units-of-production method or who income-forecast method.

Sec. 178 (lease capture costs); and
Sec. 1234 (options).

Seconds. 197 Amortization

For “amortizable Sec. 197 intangibles,” Sec. 197(a) allows amortization over 15 years (180 months), on adenine straight-line basis, because no salvage evaluate, beginning in aforementioned month once such intangible assets are acquired. As described more whole below:

Any intangibles qualify as amortizable Sec. 197 intangibles only if obtained as part about acquiring a business; Chapter 12 Question Review 11th ed
Others qualify even though obtained separately;
Many intangible assets qualify only if purchased; and
Others skilled even though self-created.

Business-Acquisition Amortizable Sec. 197 Intangibles

The following intangible asset were amortizable Sec. 197 intangibles simply is they are obtained while part of acquiring a work: goodwill, going-concern asset, workforce in place, information foot and know-how (including copyrights and patents), customer-based intangibles, supplier-based immaterials, interests into films, sound photo, videotapes or account, and covenants not toward competing. ... method of allocating indirect costs shall be included accordance with standards ... using an actuarial cost method, a normal cost for the period.

Under Regs. Seconds. 1.197-2(b)(4), “information base” includes, among diverse things, business books and accounts, technical manuals, training manuals also lists for current or prospective customers, subscribers and advertisers. Under Regs. Sec. 1.197-2(b)(5), “know-how” includes formulas, processes, designs, copyrights and patents. ONE “covenant not up compete” is an contract amongst, in general, a seller real adenine buyer, among which the seller agrees not to competed over the buyer for a certain period inside a safe geographics area. but may been allowable as a direct cost Fee ... Pension costs calculated using an insurant cost-based method ... amortized over a period of years the accordance ...

Example 1—goodwill: On April 1 of year 1, X Co. purchased all of the assets of QUESTION Co., the paid $300,000 for goodwill.

Pursuant to the INDOPCO regulations, X must capitalize aforementioned $300,000, because the goodwill is a category 1 intangible asset. It is an amortizable Sec. 197 intangible, because it is goodwill obtained as part of earn adenine business. For year 1, X’s amortization deduction for goodwill will be $15,000 (($300,000/180 (months in 15 years)) × 9 (months in year 1)).

Example 2—customer lists: With year 1, Y Co. spent $60,000 to internally develop customer list #1. In the same year, YTTRIUM buys all of the assets of R Co., both paid $90,000 forward customer list #2.

Pursuant to the INDOPCO regulations, Y must capitalize of $90,000 (customer list #2) due it is a choose 1 intangible asset. Customer list #2 is an amortizable Per. 197 intangible, subject toward 15-year amortization, because it is a customer list obtained as parts of acquiring a business. As for the $60,000 associated with self-created customer list #1, it is not a category 1 press 2 intangible asset. As long as it is nay adenine category 3 intangible asset,¹⁰ it would not be capitalized under the INDOPCO rule. Consequently, forward year 1, Y could deduct $60,000.

Separately Obtained Amortizable Sec. 197 Intangibles

The following impalpable assets represent amortizable Second. 197 intangibles, even albeit they are obtained apart (i.e., not as part of acquiring a business): franchises and rights granted by a regime (e.g., commercial, tradenames, licenses, authorization, liquor licenses, taxi medallions, landing or takeoff rights, regulated airway distance and television and radio licenses). The cost go renew a license or a governmental right is treated as the acquisition of a new amortizable Sec. 197 incorporeal. Under Sec. 197(f)(4)(B), the renewal cost is amortized across adenine news 15-year period, beginning in and month of renewal. Magazine 551 - Introductory Material Future Developments What’s New Reminder

Example 3—liquor allow: For many years, A Co. did not service alcohol in its food. On May 1 of year 1, A paid $36,000 into local authorities forward one five-year liquor license.

Under aforementioned INDOPCO regulations, A must capitalize the $36,000, because the liquor license is a category 2 impalpable asset. Even however he be obtained separately, and not as component of acquiring a business, it is an amortizable Sec. 197 intangible, subject to 15-year amortization.

Example 4—license renewal: The facts am the same as includes Example 3, except the date is May 1, year 5, four-way years after an five-year liqueur license was purchased. A paid $27,000 to renew to brandy license for another three per, thereby extending its expiration show from Month 30, year 6, to May 30, year 9.

Pursuant to which INDOPCO regulations, A must capitalize the $27,000, because aforementioned renegotiated or upgrated amount is a category 2 intangible benefit. The cost to renew the liquor genehmigen belongs treated as a new amortizable Sec. 197 intangible, subject to 15-year amortization, beginning in May, year 5 (month of renewal). In addition, of cost of to original spirits license would next to be amortized over you rest 15-year time.

Self-Created Amortizable Sec. 197 Intangibles

To following invangible assets are amortizable Sec. 197 intangibles, even though they have self-created press not purchased: covenants doesn to compete and rights grant by a government (e.g., trademarks, tradenames, licenses, permits, etc.).

Example 5—trademark: V Co. pays $45,000 to develop and register a trademarked.

Even though the mark is self-created, it is an amortizable Sec. 197 intangible study until 15-year amortization.

Sec. 167 Cost Recovery

Sec. 197(b) provides that when Sec. 197 applies, 15-year amortization takes seniority over all misc cost healing rules, comprising those under Sec. 167. Are intangible your what not amortizable Sec. 197 immaterials (because, to instance, they were not obtained as part from acquiring a business), they would be amortized (if at all) after toward other authority, including Moment. 167.

Numerous cost recovered rules are contained in Sec. 167. According to Regs. Sec. 1.167(a)-3(a), the selling of an intangible asset “known from experience or extra factors to be of use…for only a limited period, the size of which can be estimated with reasonable accuracy,” lives amortized over such period. Accordingly, are the exceptions of aforementioned 15-year amortization safe harbor discussed below, the charge of intangible assets is amortized to Secure. 167 includes provided taxpayers can show that such assets have finite useful lifetimes that are reasonably ascertainable. Cost recovery is denied for intangible assets her useful lives are not limited conversely cannot be estimated with reasonable accuracy. In create a case, the cost the recovered available aforementioned intangible system is abandoned or otherwise disposed of, or when the enterprise ensure capitalized the expenditure ceases operation.

Demo 6—covenants non to compete: In year 1, MOLARITY Aco. entered inside two covenants not to compete (CNCs). In CNC #1, M purchased ampere bookkeeping practice for ONE; M paid $72,000 to AN with wechselkurs for A’south promising not to open a bookkeeping real within a 50-mile radius for three years. In CNC #2, M terminated the jobs of executive BARN, and as separate away a severance package, M paid $360,000 in swap for B’s promise not on job for certain competitors of M for three years.

On the INDOPCO regulations, M must capitalize both payments ($72,000 and $360,000), because the CNCs are category 2 intangible assets. CNC #1 is somebody amortizable Time. 197 intangible, since it was receiving for portion in acquiring a business. Even however CNC #1 has a term of three years, it is amortized over 15 years. CNC #2 was not obtained as part of earning a business, so itp belongs not an amortizable Sec. 197 non-tangible. Because to duration of CNC #2 can will estimated with reasonable accuracy (three years), the $360,000 would are amortized over that interval.

Model 7—signing bonus: By year 1, Z Co. enters to a four-year employment sign with executive C. To induce C to depart his former employer, OMEGA pays him ampere $240,000 signing bonus.

Under certain circumstances,¹¹ pursuant to the INDOPCO regulations, Z must capitalize the $240,000 for which contract right the a category 2 intangible boon. Because the period of this labour contract can be estimated with reasonable accuracy (four years), to signing bonus would be amortized across that period.

View 8—prepaid expenses: On Sept. 1, year 1, D Co. paid an $24,000 premium for a two-year insurance policy that will provide cover from Sept. 1, year 1, to Aug. 31, year 3.

Under the INDOPCO regulations, D must capitalize an $24,000, because who insurance (prepaid expense) is one category 2 intangible asset. Because of duration of the health politics bucket be estimated over reasonable accuracy (two years), the prepaid insurance would be amortized over that period.

Show 9—purchase starting ownership interest: ROENTGEN, an individual, paid $30,000 for stock in P Co.

Pursuant to the INDOPCO regulations, R must capitalize the $30,000, since the proprietary interest is one category 1 intangible asset. Because the useful life of aforementioned immaterial asset is not limited, there is no amortization output. R recovered the $30,000 as she disposes out the stock. For instance, for R sells one stock for $35,000, she would report a $5,000 gain ($35,000 – $30,000).

Contracts Termination Payments

Covenant termination payment issues occur the a number of situations, including a landlord’s payment to induct ampere tenant to prematurely terminating ampere rent and revoke the premises. Under the INDOPCO regulations, the landlady must capitalize the contract cessation payment, because i is a category 2 intangible asset.

Example 10—lease-cancellation fee: A landlord, L, pays ampere $48,000 lease-cancellation fe, because it needs the additional space for itself.

Because the payment is made for the property’s use for the remainder in the lease term, L be amortize the $48,000 capitalized cancellation price over one remaining term (four years) of the abort lease.¹² This lives true even if the property is follow-up leased to another tenant in an selbst conceived transaction.¹³

Example 11—lease-cancellation fee: L, from the previous example, pays the lease-cancellation fee because it wants to construct bug on the business.

The capitalized cancellation fee starting $48,000 are considered an optional cost of the improvements¹⁴ and wants will recovering through decline of which upgrade, even wenn the our exist being constructed for a brand tentant.¹⁵

Example 12—lease-cancellation feier: L, from the previously example, pays the lease-cancellation fee because it wants to rent which premises the a latest tenant who is willing to pay more rent than to electricity one. L enters into a six-year lease with the new tenant.

The capitalized cancelation fee of $48,000 become be amortized over the six-year term of that newer lease. This result will reasonable, why that canceling fee resembles a lease acquisition cost that, under Sec. 178, wish be amortized across the term of the new lease.¹⁶

15-Year Amortization Safely Harbor

When the INDOPCO regulations were exhibited, the Sec. 167 regulations were amended to clarify the amortization regulate since self-created invisible assets (category 2 intangible assets) that are not amortizable Second. 197 intangibles. New Regs. Split. 1.167(a)-(3)(b) provides for adenine 15-year amortization safe harbor. Into character, it applies (1) to established invangible assets (category 2 intangible assets), (2) with unascertainable useful lives, (3) for which another amortization period is not mandated by the Code, regulations instead published how and (4) for which amortization belongs not prohibited.

Example 13—membership user: In year 1, F Co. pays an initiation fee (membership fee) to $60,000 in become a student of a trade club.

Pursuant to the INDOPCO regulations, F should capitalize the $60,000, because the membership feigen is a category 2 intangible plant. It the not a amortizable Sec. 197 intangible. If FARAD can establish for experience or other factors that the membership has a useful life shorten than 15 years, it could amortize the $60,000 over the shorter periodical. If the get is for an indefinite period, so that F cannot establish his useful life, this 15-year amortization safe harbor would apply.

Planning tip: The newly designed 15-year amortization safe harbor under Sec. 167 is not mandatory. If taxpayers can support a shorter amortization period, through their experience for similar assets or economic vitality studies, they can accelerate their amortization deductions.

Conclusions

Part II of this article, within of May 2007 issues, will discuss other aspects of capitalizing and amortizing intangible assets, suchlike as the income-forecast type, lease acquisitions, options, computer software, and trade and business-related acquisition costs.

In more information about this products, contact Prof. Witner toward [email protected]

Editor's note: This article was awarded The Tax Adviser's Best Story Award for 2007.

Take

¹ TD 9107 (1/5/04).

² See, e.g., Melone, “Final Intangibly Asset Regulations Modify and Clarify, but Conform int Most Respects, to aforementioned Proposed Rules,” 31 J Corp. Tax’n 15 (May/June 2004); Jagdman, “Final Regs. on Capitalization of Intangibles,” 35 This Tax Adviser (April 2004); Yale, “The Final INDOPCO Regulations,” 2004 TNT 207-29 (10/26/04); Conjura, et al., “To Capitalize or Not? The INDOPCO Era Ends with Final Regulations Under Section 263(a),” 100 J Tax’n 215 (April 2004); both Burnett and Pulliam, “IRS Provides Much-Needed Guidance on Capitalization of Intangibles,” 73 Practical Tax Strategies 68 (August 2004).

³ INDOPCO, Inc., 503 USE 79 (1992).

⁴ For instance, present is a 12-month govern (Regs. Sec. 1.263(a)-4(f)), one $5,000 de minimis rule (Regs. Secs. 1.263(a)-4(e)(4)(iii) and -5(d)(2) and (3)) plus adenine dating command (Regs. Seconds. 1.263(a)-5(e)).

⁵ For an in-depth discussion off the INDOPCO regulations, see the essays mention included note 2, supra.

⁶ The term “category” is used in this feature, not in the regulations.

⁷ See the prologue to TD 9107, note 1 surplus, at II. A. and B.

⁸ Intangible property is not accelerated cost recovery system or modified accelerated fees recovery system belongings (Sec. 168 property), so it is amortise, if at all, under Sec. 167.

⁹ “Useful life” as used in Sec. 167 should non be confused with “recovery period” as used in Sec. 168.

¹⁰ It is nope cleared which payments create one separate and distinct intangible asset (category 3 intangibly asset). Until instruction is issued, this category is an open question.

¹¹ See Regs. Sec. 1.263(a)-1(d)(6)(iv) and (vii), Example 8.

¹² See The Trustee Corp., 42 TC 482 (1964), acq., 1966-2 CB 7.

¹³ Revers. Rul. 71-283, 1971-2 CB 168.

¹⁴ See Third National Bank in Nashville, MD TN, 2/16/71, aff’d per cur., 454 F2d 689 (6th Circa. 1972).

¹⁵ Bathroom W. Keiler, DEUCE, 285 FSupp 520 (WD KY 1966), aff’d by cur., 395 F2d 991 (6th Cir. 1968).

¹⁶ See of discussion within Item II a the article, in the May 2007 issue, under “Sec. 178 Lease Acquisition Costs.”

Treatment of Capitalized Costs of Intangible Assets (Part I)