Enactment of the Revenue Reconciliation Act of 1993 (the RRA),1 which added section 197.
Section 197 was enacted to reduce controversy between taxpayers and the IRS in connection with the amortization of certain intangible assets, including goodwill and going concern value. Although section 197 has largely served its purpose, the antichurning rules contained in section 197(f)(9) remain a source of much consternation for tax practitioners.
The intangible assets of a business, such as goodwill, going concern value, patents, and customer lists, often constitute a significant portion, if not most, of the value of an enterprise, as compared with its tangible assets such as property, plant, and equipment. When a purchaser acquires the assets of a business, the purchaser’s ability to offset future taxable income generated by the business with depreciation or amortization deductions for U.S. federal income tax purposes can significantly affect the economics of the transaction; in other words, it can affect the price the purchaser is willing to pay for the business.
Before the enactment of the Revenue Reconciliation Act of 1993 (the RRA) (part of the Omnibus Budget Reconciliation Act of 1993) which added section 197, goodwill and going concern value were generally treated as nonamortizable intangible assets (Reg. section 1.167(a)-3, before amendment by T.D. 8865, 65 Fed. Reg. 3820 (Jan. 25, 2000), Doc 2000-2456, 2000 TNT 14-4). As a result, the portion of the purchase price of a business allocated to those assets could be used only to offset gain recognized on a future sale of the assets of the business.
Because of the less-than-optimal tax treatment of those intangibles, purchasers of businesses were often tempted to assign a proportionately greater amount of the purchase price of a business to depreciable tangible and amortizable intangible assets than to goodwill or going concern value. This often gave rise to conflicts between taxpayers, who attempted to allocate significant value to short-lived intangible assets similar to goodwill for which a useful life had been assigned and, accordingly, could be amortized, and the IRS, which claimed that a greater portion of the value should have been allocated to nonamortizable intangibles, such as going concern value. It also resulted in protracted negotiations between purchasers of businesses, who wanted to allocate as large a portion of the purchase price of a business as reasonably possible to a seller covenant not to compete, which portion could be amortized over the term of the covenant, and sellers, who wanted to
allocate as small a portion of the purchase price of a business to the covenant, because the portion of the purchase price allocable to a covenant not to compete was treated as ordinary income rather than capital gain.
The frequent litigation between taxpayers and the IRS, as amplified by the subjective nature of the valuation process generally and the significant amount of money at stake, was called one of the oldest controversies between taxpayers and the IRS by the General Accounting Office in its 1991 report to Congress on the taxation of intangibles. Also, because depreciation deductions were allowed for the cost or other basis of intangible property used in a trade or business or held for the production of income only if the intangible property had a limited useful life that could be determined with reasonable accuracy, questions about what constituted a limited useful life and reasonable accuracy abounded.
In 1992 the Supreme Court granted certiorari in Newark Morning Ledger Co. v. United States, a case involving some of the relevant issues, and it issued its decision on April 20, 1993. A divided Supreme Court held 5 to 4 that if a taxpayer is able to prove with reasonable accuracy that an intangible asset that the taxpayer uses in a trade or business or holds for the production of income has a value that wastes over an ascertainable period of time, the taxpayer may depreciate the value of the asset over the asset’s useful life regardless of how much the asset appears to reflect the expectancy of continued patronage. The Supreme Court cautioned that the taxpayer’s burden of proof was substantial and would often prove too great to bear.
In response, Congress enacted section 197, in part because the ‘‘severe backlog of cases in audit and litigation’’ was ‘‘a matter of great concern." Tax practitioners generally greeted the new section 197 with enthusiasm.What practitioners may not have realized was that many years after enactment, they would still be spending significant time and energy grappling with the antiabuse provisions in section 197(f)(9) (the "antichurning rules"), which were intended to prevent taxpayers from converting a nonamortizable intangible into an amortizable section 197 intangible.
Section 197 and Regulations
Although section 197 was enacted in 1993, proposed regulations were not issued until early 1997 and were not finalized until January 2000. The final regulations issued in January 2000 included proposed regulations that elaborated on specific issues related to partnerships, and those proposed regulations were finalized in November 2000.
Section 197 permits taxpayers to amortize the adjusted basis of those intangible assets that constitute amortizable section 197 intangibles ratably over 15 years, beginning with the month in which they are acquired.
Section 197 Intangibles
Section 197 intangibles comprise the following: (1) goodwill; (2) going concern value; (3) workforce in place, including its composition and terms and conditions of its employment; (4) business books and records, operating systems, or any other information base (including lists or other information regarding current or prospective customers); (5) any patent, copyright, formula, process, design, pattern, know-how, format, or other similar item; (6) any customer-based intangible, meaning composition of market, market share, and any other value resulting from the future provision of goods or services pursuant to relationships (contractual or otherwise) in the ordinary course of business with customers, and, in the case of a financial institution, deposit base and similar items; (7) any supplier-based intangible, meaning any value resulting from future acquisitions of goods or services pursuant to relationships (contractual or otherwise) in the ordinary course of business with suppliers of goods or services to be used or sold by the taxpayer; (8) any item similar to those listed in (3) through (7) above; (9) any license, permit, or other right granted by a governmental unit or an agency or instrumentality thereof; (10) any covenant not to compete (or other arrangement to the extent it has substantially the same effect) entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof; and (11) any franchise, trademark, or trade name.
Excluded Intangibles
Intangibles specifically excluded from the definition of section 197 intangibles are: (1) any interest in a corporation, partnership, trust, or estate, or under an existing futures contract, foreign currency contract, notional principal contract, or other similar financial contract; (2) any interest in land; (3) any computer software that is readily available for purchase by the public, is subject to a nonexclusive license, and has not been substantially modified, and other computer software that is not acquired in a transaction (or series of related transactions) involving the acquisition of assets constituting a trade or business or substantial portion thereof; (4) any of the following items if not acquired in a transaction or series of related transactions involving the acquisition of assets constituting a trade or business or a substantial portion thereof: (a) any interest in a film, sound recording, videotape, book, or similar property; (b) any right to receive tangible property or services under a contract or granted by a governmental unit or agency or instrumentality thereof; (c) any interest in a patent or copyright; and (d) to the extent provided in reg. section 1.197-2(c)(13), any right under a contract (or granted by a governmental unit or an agency or instrumentality thereof) if the right has a fixed duration of less than 15 years or is fixed as to amount and would otherwise be recoverable under a method similar to the unit-of-production method; (5) any interest under an existing lease or tangible property or any existing indebtedness (except as provided regarding financial institutions); (6) any right to service indebtedness that is secured by residential real property unless the right is acquired in a transaction (or series of related transactions) involving the acquisition of assets (other than those rights) constituting a trade or business or substantial portion thereof; and (7) any fees for profes
sional services and any other transaction costs incurred by parties to a transaction regarding which any portion of the gain or loss is not recognized under sections 351 through 368.
"Acquired" "After" "August 10, 1993"
To constitute an amortizable section 197 intangible, a section 197 intangible must have been acquired after August 10, 1993, the date of enactment of section 197, and must be held in connection with the conduct of a trade or business or an activity engaged in for the production of income. Intangibles, other than (1) franchises, trademarks, or trade names; (2) covenants not to compete entered into in connection with an acquisition of an interest in a trade or business or a substantial portion thereof; and (3) licenses, permits, or other rights granted by a governmental unit or an agency or instrumentality thereof that are self-created rather than acquired will not constitute amortizable section 197 intangibles unless they are created in connection with a transaction (or series of related transactions) involving the acquisition of assets constituting a trade or business or a substantial portion thereof.
No Other Depreciation or Amortization Deduction Allowed
If an asset constitutes an amortizable section 197 intangible, no other depreciation or amortization deduction is allowed with respect to it.26 Thus, if a covenant not to compete constitutes an amortizable section 197 intangible, a taxpayer must amortize any portion of the purchase price of a business allocated to the covenant over 15 years, even if, under prior law, that amount would have been amortizable over the term of the covenant.
Section 197(f) contains special rules that affect the applicability and operation of section 197. Among them is a rule that provides that if a section 197 intangible is acquired in a nonrecognition transaction under section 332 (complete liquidations of subsidiaries), section 351 (transfers to controlled corporations), section 361 (non- recognition of gain or loss to corporations), section 721 (contributions to partnerships), section 731 (distributions from partnerships), section 1031 (like-kind exchanges), section 1033 (involuntary conversions), or in a transaction between members of an affiliated group that files a consolidated income tax return, the transferee steps into the shoes of the transferor for purposes of applying section 197 regarding the amount of the transferee’s adjusted basis that does not exceed the transferor’s adjusted basis in the section 197 intangible.
The Antichurning Rules of Section 197(f)(9)
Section 197(f)(9) contains antichurning rules that exclude from the definition of amortizable section
197 intangible certain intangibles acquired in certain transactions. The conference report on section 197 states that those rules were enacted to ‘‘prevent taxpayers from converting existing goodwill, going concern value, or any other section 197 intangible for which a depreciation or amortization deduction would not have been allowable under [prior] law into amortizable property.’’
The antichurning rules apply to except from the definition of amortizable section 197 intangible any otherwise amortizable section 197 intangible for which depreciation and amortization deductions would not have been allowed under prior law, including specifically goodwill and going concern value if (1) the intangible was held or used at any time on or after July 25, 1991, and on or before August 10, 1993 (the transition period), by the taxpayer or a related person; (2) the taxpayer acquired the intangible from a person who held it during the transition period, and the user of the intangible does not change as part of the transaction; or (3) the taxpayer grants the right to use the intangible to a person (or a person related to that person) who held or used the intangible at any time during the transition period, but only if the transaction in which the taxpayer grants the right and the transaction in which the taxpayer acquired the intangible are part of a series of related transactions.
The antichurning rules define ‘‘related persons’’ as any persons that are related under sections 267(b) or 707(b)(1), in each case applied by substituting 20 percent for 50 percent, and any persons that are engaged in trades or businesses under common control, within the meaning of section 41(f)(1)(A) and (B).
a. Section 267(b). Section 267(b) defines ‘‘related persons’’ to include the following:
• members of a family, including only brothers and sisters (by whole or half blood), spouse, ancestors, and lineal descendants;
• an individual and a corporation, more than 20 percent of the value of the outstanding stock of
which is owned directly or indirectly by or for that individual;
• two corporations that are members of the same controlled group under section 1563(a), with modifications;
• a grantor and a fiduciary of any trust;
• fiduciaries of different trusts, if the same person is the grantor of both trusts;
• a fiduciary of a trust and a beneficiary of such trust;
• a fiduciary of a trust and a beneficiary of another trust, if the same person is the grantor of both trusts;
• a fiduciary of a trust and a corporation, more than 20 percent of the value of the outstanding stock of
which is owned directly or indirectly by or for that trust or the grantor of that trust;
• a person and an organization to which section 501 applies, and that is controlled, directly or indirectly,by that person or, if the person is an individual, by members of the person’s family;
• a corporation and a partnership if the same persons own more than 20 percent of the value of the outstanding stock of the corporation and more than 20 percent of the capital or profits interests in the partnership;
• an S corporation and another S corporation, or an S corporation and a C corporation, if the same persons own more than 20 percent of the value of the outstanding stock of each corporation; and
• with some exceptions, an executor of an estate and a beneficiary of the estate.
Also, the following constructive ownership rules apply: (1) stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries; (2) an individual is considered as owning the stock owned, directly or indirectly, by or for the individual’s family (which includes, for this purpose, only brothers and sisters, spouse, ancestors, and lineal descendants); and (3) an individual owning (otherwise than by the application of (2)) any stock of a corporation is considered as owning the stock owned, directly or indirectly, by or for the individual’s partner (the partner stock attribution rule). Stock constructively owned by reason of clause (1) of the preceding sentence is treated as actually owned by that person for purposes of applying the constructive ownership rules to treat another as the owner of the stock.
b. Section 707(b)(1). Section 707(b)(1) defines ‘‘related persons’’ to include the following:
• a partnership and a person owning, directly or indirectly, more than 20 percent of the capital or profits interest in the partnership; or
• two partnerships in which the same persons own, directly or indirectly, more than 20 percent of the capital or profits interests.
The constructive ownership rules that apply for purposes of section 267(b), other than the partner stock attribution rule, also apply for purposes of section 707(b)(1).
Timing of determination. The determination of whether persons are related is made both immediately before and immediately after the acquisition of the section 197 intangible. In the case of a series of related transactions, or a series of transactions that together comprise a qualified stock purchase under section 338(d)(3), the determination is made immediately before the earliest transaction in the series of transactions and immediately after the last transaction in the series of transactions.
Partnership rules. If there is an increase in the basis of partnership property under section 732, 734, or 743, for purposes of applying the ‘‘related person’’ rules, each partner is treated as having owned and used its proportionate share of the partnership’s assets. In those cases, the partnership is treated as an aggregate, rather than as an entity, for purposes of applying the antichurning rules. In all other partnership situations, the antichurning rules are generally applied at the partnership level, rather than at the partner level.
a.
Section 743(b).
If a partnership interest is sold or transferred on death
and the partnership has in effect an election under section 754 (a section 754 election) or one is made for the tax year in which the transfer occurs or the partnership has a substantial built-in loss immediately after the transfer, the basis of partnership property is adjusted with respect to the transferee.
The antichurning rules apply to those basis adjustments only if the transferee is related to the transferor, and
they do not apply based on the transferee’s relationship to the partnership or other partners.
Example: Drop Down LLC Structure
It should be noted that the above referenced LLC structures may not avoid the anti-churning rules of Section 197 if the business of the S corporation was in existence prior to August 1993 and the existing shareholders roll over more than 20 percent. The application of this rule would, in general, result in any portion of the step-up allocated to goodwill being non-amortizable for tax purposes. These rules can be avoided by limiting the historical shareholders’ rollover into the acquiring entity to 20 percent.
In the case where anti-churning is an issue and there is expected to be greater than 20 percent rollover, the transaction should be structured as an “over-the-top” sale of partnership interests, so the step-up comes from a Section 754 election. Under these facts, the new LLC will need to have at least two partners and be formed some period prior to the closing of the transaction.
Example: Over-the-Top Sale of LLC Interest
In this transaction, the acquisition is a purchase of a partnership interest from the target. As mentioned, to ensure the step-up, a valid Section 754 election must be in place. The over-the-top purchase will result in the acquirer’s proportionate share of the inside basis of the partnership’s assets being stepped-up to reflect the purchase price paid and entitle the purchaser to tax deductions and amortization of goodwill reflective of such stepped-up inside basis.
Also, in accordance with the exception to the anti- churning rules for transfers on death in which basis is determined under section 1014 (discussed further below), the antichurning rules do not apply when a section 743(b) basis adjustment is made by reason of the death of a partner, with the new partner’s basis determined under section 1014(a). In that situation, the new partner is treated for purposes of the antichurning rules as acquiring the interest from an unrelated person.
"Subject
to the provisions of Purchase Price Allocation (filing tax return provisions), if requested by the Acquirer in
writing and subject to the provisions of Purchase Price Allocation (filing tax return provisions), New LLC shall make
a timely, effective and irrevocable election under Section 754 (the “Section
754 Election”) of the Code with regard to the sale and the purchase of the
Acquired Units as contemplated herein and shall file such election in
accordance with applicable federal regulations.
Subject to the provisions of Purchase Price Allocation (filing tax return provisions), the Acquirer and
Target shall complete, execute and deliver to the federal and applicable state
Tax authorities such forms or documents as may be required to make the Section
754 Election binding and effective. Such
parties agree to act in accordance with all applicable laws and regulations
relating to the Section 754 Election in the preparation and filing of any
federal or state Tax Return."
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