Intangibles

1. Intangible assets are those assets that do not have a physical substance. For the most part, these assets are created from the operation of legal or contractual rights. Examples include trademarks, patents, non-compete agreements, and employment contracts. Some intangibles such as goodwill/going concern clearly exist but are not defined by any specified "rights."
2. Intangible assets may be self-created or they may be purchased. Expenditures relating to the creation of an intangible asset should be capitalized unless Congress has allowed a specific deduction, such as software or Research and Development. Any costs incurred to defend these intangible assets from infringement should be capitalized as well. If the intangible asset has a definite useful life, such as a patent or a contract with a fixed term, then amortization of the cost over that life is allowable under IRC 167. If there is no definite useful life, such as with trademarks or copyrights, then no amortization is allowed. A deduction would be allowable at such time the "rights" are abandoned.
3. If an intangible is separately acquired its cost and nature are probably well defined. However, intangibles acquired as part of the overall acquisition of a business are more likely to provide an audit issue. The problem is one of distinguishing the intangible(s) from the other assets acquired and determining its fair market value. The problem is exacerbated by the fact that the taxpayer will usually want to place as little value as possible into goodwill/going concern which by definition has an indefinite life and cannot be amortized. This is done by inflating the value of the other assets acquired and/or by valuing "creative intangibles." Thus the examiner will probably see intangibles that have little or no substance or are really goodwill/going concern in disguise. Purchased intangibles will appear on the balance sheet and the amortization schedule. If acquired as part of a trade or business, they also should appear on Form 8594-Asset Acquisition Statement, attached to the return for the year of acquisition.
4. If intangibles are acquired after August 10, 1993, the retailer must amortize the intangible asset ratably over 15 years under IRC 197. IRC 197 requires 15 year straight-line amortization for IRC 197 intangibles, which specifically include goodwill and going concern value. A taxpayer may elect to apply the provisions of IRC 197 retroactively to property acquired after July 25, 1991.

Valuation Techniques

1. When examining an intangible the examiner will need to consider the following:
   1. Does the asset really exist?
   2. If an asset exists, is it separate and distinct from goodwill/going concern?
   3. If it is separable, does it have a definite useful life?
   4. Is the life determined by the taxpayer appropriate?
   5. Is the value determined by the taxpayer accurate?
2. The key to reviewing the valuation of an intangible asset is to thoroughly analyze the methods used by the appraiser in valuing the asset and in determining a useful life. By doing this the examiner may be able to show that an intangible asset is inseparable from goodwill/going concern or that the value and life of the asset, when separated from the goodwill/going concern, differs from the appraisal.
3. Most intangible assets are valued using an income approach. This is usually done because the income approach lends itself to manipulation due to the comparatively large number of assumptions and calculations which are required. Many appraisals exclude the cost and market approaches on the basis that they are not applicable. This is often incorrect. By relying on only one valuation approach, there is no reconciliation between approaches and no check and balance for the determined value.
4. The life of an intangible asset is usually determined either by using a survivor curve approach or through "management discussion." The survivor curve approaches (Iowa survivor curves, Weibull curves) require substantial data and appraiser knowledge of the method in order to be accurate. Too often the appraisers circumvent this need for data by making unrealistic or unsubstantiated assumptions. "Management discussions" are suspect in establishing the life of an asset because they tend to be self-serving.
5. Some of the intangibles that may be encountered in a retail examination are:
   1. Leasehold Valuation: See IRC 422, Leases.
   2. Key Money Payments: In the context of an acquisition key money payments usually are not separately valued. Often, these are payments made by a landlord or community development group to entice a retailer to operate at a particular location. The payments may have restrictions attached such as a requirement that the payment must be used only for leasehold improvements or for the purchase of inventory. Key money payments should be recognized as ordinary income and the assets created by spending this income should be capitalized.
   3. Non-Compete Agreements: These are agreements reached between a buyer and a seller preventing the seller from reestablishing a business that will compete with the buyer. These can be between individuals as well as corporations. They usually specify a legal life and value. When tax rates for ordinary income and capital gains are nearly the same, the buyer and seller do not have opposing interest and an arms-length transaction is in doubt. The non-compete agreement merely becomes a convenient way for the buyer to quickly amortize purchase price. Therefore, the buyer must provide documentation to support the value of the covenant. The value must account for both the probability of the seller competing as well as the effectiveness of the competition. The projection period for valuing the covenant should not extend beyond the legal life of the covenant.
   4. Zone Protection: These are similar to non-compete agreements but tend to involve smaller geographic areas. After an acquisition, they buyer will use a zone protection agreement to ensure that the seller does not quickly reestablish in a given market area and compete with the buyer.
   5. Computer Software: The cost approach is usually applicable in valuing computer software. Many appraisals ignore the cost approach and use only an income approach because it tends to inflate the value. The Data Processing Issue Specialist has staff to assist in valuing computer software.
   6. Assembled Workforce: This is a "creative" intangible meant to represent the cost savings realized by the purchaser of an existing business in which the employees will continue to work despite the change of ownership. Because the purchaser will not have to spend time, effort and money to go out on the open market to find, hire and then train new employees, a value is assigned to the assembled workforce. It is usually determined by taking some percentage of total salaries to represent the cost of training saved by acquiring an assembled workforce. This value is then either amortized over the average length of employment or allocated to each employee and written off when that employee leaves the taxpayer's service. Although an assembled workforce may have value, it is really an inseparable element of going concern value defined as the value of the ability to generate income without interruption. The leading case on this subject is Ithaca Industries, Inc., 97 T.C. 253 (1991), aff'd, 17 F.3d 684 (4th Cir. 1994), where the judge ruled that the assembled workforce was not separate and distinct from going concern value. Assembled workforce is not the same as employment contracts. A workforce usually involves all of the employees of a firm and no contractual agreements for the employees' services exist. Where a company has obtained the exclusive rights to an individual's work product, there may be some intangible value to the employment contract that is separate and distinct from goodwill/going concern.
   7. Customer Lists/Credit Files: Any information about customers or potential customers of a business may be considered by the taxpayer to be an intangible asset. It may be something as simple as a mailing list containing names and addresses or it may be as complex as a computer file of all credit histories of customers for the past ten years. The common factor is that the value of the asset is based on the probability that the individuals on the list will become or remain customers of the business. This is also known as a "Customer Based Intangible." The treatment of this intangible differs depending on how it was acquired. When a customer list is acquired separately in an arms-length transaction, the case law has been that the asset is amortizable (e.g., Houston Chronicle Publishing Co., 73-2 USTC 9537). This position assumes that a definite useful life can be determined for the asset. When a customer list is acquired as part of a going concern, the general rule is that it is an element of goodwill value and cannot be amortized. But see IRC 197 discussed in text 4.4. Rev. Rul. 74-456 provides that the determination of whether a customer list is distinguishable from goodwill is a factual determination. The burden is on the taxpayer to establish that the asset has an ascertainable value separate and distinct from goodwill and a limited useful life, the duration of which can be ascertained with reasonable accuracy. One important factor in the determination of separability is how the value of the intangible is derived. In an arms-length transaction, a willing buyer will not pay more for a customer list than the cost of creating such a list. This cost approach is rarely used by taxpayers because it produces a much lower value than the income approach. The income approach usually bases the value of the intangible on the present value of the income expected to be generated from the continued patronage of the individuals on the list. This continued patronage is not based on any legal or contractual obligation, but is one of the definitions of goodwill (see Newark Morning Ledger, Co., 68 AFTR 2d 91-5552).

WARNINGS ABOUT THIS SITE'S CONTENT BOB PARRISH CPA. P.C.