Treas. Reg. 1.197-2: Rules for Section 197 Intangibles

Internal Revenue Code Section 197 simplifies the tax treatment of acquired intangible assets by establishing a uniform 15-year amortization period. The detailed rules are in Treasury Regulation 1.197-2, which defines which assets qualify, which are excluded, and how special circumstances are handled. This guidance is for any business involved in acquiring another trade or business or its assets.

Defining Section 197 Intangibles

Goodwill and Going Concern Value

Goodwill is the value of a business attributable to the expectation of continued customer patronage from its name or reputation. Going concern value is the additional value that attaches to assets because they are part of an operational business. When a company buys another for a price exceeding the value of its individual assets, the excess amount is allocated to goodwill and going concern value.

Workforce in Place

Workforce in place refers to the value from the collective knowledge and experience of a company’s employees, including the cost to recruit and train a new workforce. This intangible is a Section 197 asset whether the employees are under contract or are at-will.

Information Base

An information base includes the value of business books and records, operating systems, customer lists, subscription lists, and technical manuals. For instance, a marketing company acquiring a competitor would treat the competitor’s database of client contacts and purchasing histories as an information base intangible.

Know-How

Know-how encompasses intellectual property, including patents, copyrights, formulas, processes, designs, and patterns. When a pharmaceutical company acquires a smaller biotech firm, the purchase price allocated to the biotech’s patented drug formulas is classified as know-how.

Customer-Based Intangibles

Customer-based intangibles represent the value derived from established relationships with customers, including market share and customer relationships. An example is the value of depositor relationships acquired by a bank, which expects to benefit from their continued business.

Supplier-Based Intangibles

Similar to customer-based intangibles, supplier-based intangibles derive their value from relationships with suppliers. This includes favorable supply contracts or established distribution networks. If a company acquires a business with a long-term, below-market-rate contract with a supplier, the value of that contract is a supplier-based intangible.

Licenses, Permits, and Other Rights Granted by Governmental Units

Rights granted by a governmental unit, such as liquor licenses, taxi medallions, or broadcast licenses, are Section 197 intangibles. This applies even if the rights are granted for an indefinite period or are expected to be renewed indefinitely.

Covenants Not to Compete

A covenant not to compete entered into in connection with acquiring an interest in a trade or business is a Section 197 intangible. The payment to a former owner or employee prevents them from competing with the acquired business. This ensures the value of the acquired business is not diminished by the seller’s immediate reentry into the market.

Franchises, Trademarks, and Trade Names

The value of franchises, trademarks, and trade names is subject to 15-year amortization. When an individual purchases an existing fast-food franchise, a portion of the purchase price is allocated to the franchise right itself, along with any associated trademarks.

Exclusions from Section 197

Interests in a Corporation, Partnership, Trust, or Estate

An interest in a corporation, partnership, trust, or estate is excluded from the definition of a Section 197 intangible. When a taxpayer acquires stock in a corporation or an interest in a partnership, the asset acquired is the equity interest itself, not the underlying intangible assets of the entity.

Interests in Land

Any interest in land is excluded from Section 197, including fees, life estates, remainders, and easements. While land can appreciate, it is not considered a depreciable or amortizable asset for tax purposes.

Certain Computer Software

Computer software is excluded from Section 197 unless it is acquired as part of a trade or business acquisition. Off-the-shelf software is instead depreciated over 36 months under Section 167. Software acquired in a business purchase, however, is bundled with other assets and amortized over 15 years.

Certain Interests in Films, Sound Recordings, Videotapes, Books, or Similar Property

Interests in creative properties like films, sound recordings, and books are not Section 197 intangibles if they are not acquired as part of a larger acquisition of a trade or business. The depreciation for these assets is often calculated using methods that match the income stream they generate, such as the income forecast method.

Interests under Existing Leases or Indebtedness

An interest as a lessee under an existing lease of tangible property is not a Section 197 intangible. The value of a favorable lease is accounted for separately. Similarly, an interest as a creditor or debtor under any existing indebtedness is excluded.

Professional Sports Franchises

The costs of acquiring a professional sports franchise and its player contracts are excluded from Section 197. These assets are subject to their own set of tax rules.

Mortgage Servicing Rights

Rights to service indebtedness secured by residential real property are not Section 197 intangibles unless acquired with a trade or business. When these rights are acquired separately, they are amortized over 108 months.

Certain Transaction Costs

Fees for professional services and transaction costs in a transaction where gain or loss is not recognized are not Section 197 intangibles. This applies in certain corporate reorganizations and other non-taxable exchanges. These costs are capitalized and added to the basis of the assets involved.

Special Rules for Specific Transactions

Nonrecognition Transactions

In certain nonrecognition transactions, such as transfers to a controlled corporation under Section 351 or contributions to a partnership under Section 721, the transferee is treated as the transferor. This “step-in-the-shoes” rule requires the transferee to continue amortizing the intangible’s basis over the remainder of the original 15-year period. For example, if an intangible with 10 years left on its amortization schedule is contributed to a new corporation for stock, the corporation amortizes the remaining basis over those 10 years.

Partnership Transactions

Section 197 rules apply to partnership transactions involving distributions and sales of partnership interests. When a partnership makes a basis adjustment under Section 743 after a sale of a partnership interest, any part of the adjustment allocated to a Section 197 intangible is treated as a new intangible asset amortized over a fresh 15-year period. Similar rules apply to basis adjustments made under Section 734 due to a partnership distribution.

Dispositions

A specific rule applies when a taxpayer disposes of a Section 197 intangible at a loss but retains other intangibles from the same transaction. The taxpayer is not permitted to recognize the loss on the disposition. Instead, the basis of the disposed intangible is reallocated among the bases of the retained intangibles, and the disallowed loss is recovered through their continued amortization.

The Anti-Churning Rules

Purpose

The anti-churning rules prevent taxpayers from converting non-amortizable intangible assets into amortizable Section 197 intangibles. These rules target goodwill, going concern value, and other intangibles that were not eligible for amortization before the enactment of Section 197 in 1993. The goal is to stop amortization deductions on pre-existing intangibles without a genuine change in economic ownership.

Applicability

These rules apply to intangibles that were held or used at any time between July 25, 1991, and August 10, 1993, by the taxpayer or a related party. If an intangible asset like goodwill was owned by the taxpayer or a related party during this period, it cannot be converted into an amortizable Section 197 intangible through a subsequent transfer to another related party.

Definition of a Related Party

A related party includes immediate family members, such as a spouse, ancestors, and lineal descendants. The definition also extends to entities with a specified level of common ownership. A person is related to a corporation or partnership if they own, directly or indirectly, more than 20% of the entity’s value or capital and profits interest.

Example of a Prohibited Transaction

An example of a transaction blocked by the anti-churning rules involves a sole proprietorship. If an individual operated a business with significant goodwill before 1993 and then sells the business assets to a new corporation in which they own 50% of the stock, the transaction is “churning.” Because the individual and the corporation are related parties, the goodwill acquired by the new corporation is not an amortizable Section 197 intangible and retains its pre-1993 character.