Tax Treatment for the Sale of Intangible Assets

The sale of an intangible asset, such as a patent or customer list, is a business transaction with significant tax implications. These non-physical assets derive their value from intellectual or contractual rights. The tax treatment depends on the specific type of intangible, how it was originally obtained, and its use within a business.

The rules dictate how to classify the asset, calculate the resulting gain or loss, and determine whether that financial outcome is taxed at capital gains rates or as ordinary income. Different regulations apply to assets purchased as part of a business acquisition versus those created internally by a company. Navigating these distinctions is key to managing the transaction’s financial consequences.

Identifying and Classifying Intangible Assets for Tax Purposes

For tax purposes, the Internal Revenue Code (IRC) provides classifications that determine how intangible assets are treated when sold. The main distinction is whether an asset is a “Section 197 intangible.” This classification impacts its amortization and the character of any gain or loss upon its sale.

Section 197 Intangibles

Section 197 of the Internal Revenue Code provides rules for certain acquired intangible assets, typically those obtained when purchasing a business. A key feature is their amortization schedule; the cost must be amortized over a 15-year period, beginning in the month the asset is acquired. Common examples include:

• Goodwill and going concern value
• Workforce in place and business records
• Patents, copyrights, formulas, and computer software acquired in a business purchase
• Customer lists acquired in a business purchase
• Covenants not to compete, franchises, trademarks, and trade names acquired with a business

Non-Section 197 Intangibles

Intangible assets that are not Section 197 intangibles are subject to different rules, a category that includes many self-created assets. A patent developed by an inventor or a copyright on a book written by an author are not Section 197 assets for the creator. The tax treatment for these assets varies.

Some may be amortized if they have a determinable useful life. For example, the amortization rules for computer software depend on its origin; off-the-shelf software is amortized over 36 months, whereas costs to develop software must be amortized over five years. In other cases, costs to create an asset might have been deducted as business expenses, resulting in a zero basis.

Calculating the Gain or Loss from the Sale

To determine the tax impact of selling an intangible asset, you must first calculate the financial gain or loss. The basic formula is the amount realized from the sale minus the asset’s adjusted basis. The amount realized includes cash, the fair market value of any property or services received, and any of the seller’s liabilities the buyer assumes.

The adjusted basis is the asset’s cost after accounting for tax-related adjustments. For a purchased intangible, the initial basis is its cost, which is then reduced by any amortization deductions claimed. For example, if a business acquired a customer list for $150,000 and held it for five years, it would have claimed $50,000 in amortization deductions. The adjusted basis would be $100,000 ($150,000 cost – $50,000 amortization). If this list were sold for $120,000, the gain would be $20,000.

The basis for a self-created intangible consists of the capitalized costs to create it, such as legal and registration fees. If these costs were deducted as business expenses instead of capitalized, the asset’s basis may be zero, making the entire sale amount a gain.

Determining the Character of the Gain or Loss

After calculating the gain or loss, the next step is to determine its character as either capital or ordinary. An intangible asset used in a trade or business and held for more than one year is considered a capital asset. Its sale typically results in a long-term capital gain or loss, with gains often taxed at lower rates than ordinary income.

A significant exception is the depreciation recapture rule under Section 1245. This rule applies to amortizable intangibles, including all Section 197 assets. Under this rule, any gain on the sale is treated as ordinary income to the extent of the amortization deductions previously claimed.

Using the earlier example of the customer list, the entire $20,000 gain is recaptured and taxed as ordinary income because it is less than the $50,000 in amortization claimed. If the asset sold for $160,000, the total gain would be $60,000. Of that gain, $50,000 would be recaptured as ordinary income, and the remaining $10,000 would be a capital gain under Section 1231. Another exception applies to certain self-created intangibles, like a copyright or literary work, where the creator’s gain is treated as ordinary income.

Special Tax Rules for Specific Intangible Assets

Beyond the general framework, the tax code provides unique rules for certain types of intangible assets that can override standard treatment.

Patents

While a self-created patent’s sale would normally generate ordinary income, Section 1235 provides an exception. This rule allows an individual creator or their financial backer to treat income from a patent sale as a long-term capital gain. This treatment applies regardless of how long the patent was held and even if payments are contingent on the patent’s future use.

Franchises, Trademarks, and Trade Names

The tax treatment for selling franchises, trademarks, and trade names is governed by Section 1253. If the seller retains any significant power, right, or continuing interest in the asset, any gain is treated as ordinary income. Significant retained rights include the power to disapprove assignments or prescribe quality standards. If no such rights are retained, the sale may qualify for capital gain treatment.

Goodwill and Covenants Not to Compete

Goodwill and covenants not to compete are almost always sold as part of a larger business sale, classifying them as Section 197 intangibles. The cost allocated to these assets must be amortized over 15 years by the buyer. For the seller, any gain is calculated as the sale price less the basis, with its character determined by applying the standard recapture rules.

How to Report the Sale on Tax Forms

Once the gain or loss has been calculated and its character determined, the final step is to report the transaction correctly to the IRS. The primary form for reporting the sale of business property, including most intangible assets, is Form 4797, Sales of Business Property. This form is used to report gains and losses from business assets and to calculate depreciation recapture.

The ordinary income portion of the gain is calculated and reported in Part III of Form 4797. Any portion of the gain that qualifies for capital treatment flows from Form 4797 to Schedule D, Capital Gains and Losses, which is used to report all capital transactions.

When intangible assets are sold as part of a group of assets that constitute a business, both the buyer and the seller must file Form 8594, Asset Acquisition Statement. This form requires both parties to report the allocation of the purchase price among the various asset classes. The IRS uses this form to ensure that the buyer and seller are treating the transaction consistently.