FEDTAX * IRS * HOME * PUB_535

Publication 535
Business Expenses

For use in preparing 2002 Returns

Section 197 Intangibles

You must generally amortize over 15 years the capitalized costs of section 197 intangibles you acquired after August 10, 1993. You must amortize these costs if you hold the section 197 intangibles in connection with your trade or business or in an activity engaged in for the production of income.

CAUTION: You may not be able to amortize section 197 intangibles acquired in a transaction that did not result in a significant change in ownership or use. See Anti-Churning Rules, later.

Your amortization deduction each year is the applicable part of the intangible's adjusted basis (for purposes of determining gain), figured by amortizing it ratably over 15 years (180 months). The 15-year period begins with the later of:

  • The month the intangible is acquired, or
  • The month the trade or business or activity engaged in for the production of income begins.

You cannot deduct amortization for the month you dispose of the intangible.

If you pay or incur an amount that increases the basis of an amortizable section 197 intangible after the 15-year period begins, amortize it over the remainder of the 15-year period beginning with the month the basis increase occurs.

You are not allowed any other depreciation or amortization deduction for an amortizable section 197 intangible.

Cost attributable to other property.   The rules for section 197 intangibles do not apply to any amount that is included in determining the cost of property that is not a section 197 intangible. For example, if the cost of computer software is not separately stated from the cost of hardware or other tangible property and you consistently treat it as part of the cost of the hardware or other tangible property, these rules do not apply. Similarly, none of the cost of acquiring real property held for the production of rental income is considered the cost of goodwill, going concern value, or any other section 197 intangible.

Section 197
Intangibles Defined

The following assets are section 197 intangibles.

  1. Goodwill.
  2. Going concern value.
  3. Workforce in place.
  4. Business books and records, operating systems, or any other information base, including lists or other information concerning current or prospective customers.
  5. A patent, copyright, formula, process, design, pattern, know-how, format, or similar item.
  6. A customer-based intangible.
  7. A supplier-based intangible.
  8. Any item similar to items (3) through (7).
  9. A license, permit, or other right granted by a governmental unit or agency (including issuances and renewals).
  10. A covenant not to compete entered into in connection with the acquisition of an interest in a trade or business.
  11. A franchise, trademark, or trade name (including renewals).
  12. A contract for the use of, or a term interest in, any item in this list.

CAUTION: You cannot amortize any of the intangibles listed in items (1) through (8) that you created (rather than acquired) unless you created them in connection with the acquisition of assets constituting a trade or business or a substantial part of a trade or business.

Goodwill.   This is the value of a trade or business based on expected continued customer patronage due to its name, reputation, or any other factor.

Going concern value.   This is the additional value of a trade or business that attaches to property because the property is an integral part of an ongoing business activity. It includes value based on the ability of a business to continue to function and generate income even though there is a change in ownership (but does not include any other section 197 intangible). It also includes value based on the immediate use or availability of an acquired trade or business, such as the use of earnings during any period in which the business would not otherwise be available or operational.

Workforce in place, etc.   This includes the composition of a workforce (for example, its experience, education, or training). It also includes the terms and conditions of employment, whether contractual or otherwise, and any other value placed on employees or any of their attributes.

For example, you must amortize the part of the purchase price of a business that is for the existence of a highly skilled workforce. Also, you must amortize the cost of acquiring an existing employment contract or relationship with employees or consultants.

Business books and records, etc.   This includes the intangible value of technical manuals, training manuals or programs, data files, and accounting or inventory control systems. It also includes the cost of customer lists, subscription lists, insurance expirations, patient or client files, and lists of newspaper, magazine, radio, and television advertisers.

Patents, copyrights, etc.   This includes package design, computer software, and any interest in a film, sound recording, videotape, book, or other similar property, except as discussed later under Assets That Are Not Section 197 Intangibles.

Customer-based intangible.   This is the composition of market, market share, and any other value resulting from the future provision of goods or services because of relationships with customers in the ordinary course of business. For example, you must amortize the part of the purchase price of a business that is for the existence of the following intangibles.

  • A customer base.
  • A circulation base.
  • An undeveloped market or market growth.
  • Insurance in force.
  • A mortgage servicing contract.
  • An investment management contract.
  • Any other relationship with customers involving the future provision of goods or services.

Accounts receivable or other similar rights to income for goods or services provided to customers before the acquisition of a trade or business are not section 197 intangibles.

Supplier-based intangible.   This is the value resulting from the future acquisition of goods or services used or sold by the business because of business relationships with suppliers.

For example, you must amortize the part of the purchase price of a business that is for the existence of the following intangibles.

  • A favorable relationship with distributors (such as favorable shelf or display space at a retail outlet).
  • A favorable credit rating.
  • A favorable supply contract.

Government-granted license, permit, etc.   This is any right granted by a governmental unit or an agency or instrumentality of a governmental unit. For example, you must amortize the capitalized costs of acquiring (including issuing or renewing) a liquor license, a taxicab medallion or license, or a television or radio broadcasting license.

Covenant not to compete.   Section 197 intangibles include a covenant not to compete (or similar arrangement) entered into in connection with the acquisition of an interest in a trade or business, or a substantial portion of a trade or business. An interest in a trade or business includes an interest in a partnership or a corporation engaged in a trade or business.

An arrangement that requires the former owner to perform services (or to provide property or the use of property) is not similar to a covenant not to compete to the extent the amount paid under the arrangement represents reasonable compensation for those services or for that property or its use.

Franchise, trademark, or trade name.   A franchise, trademark, or trade name is a section 197 intangible. You must amortize its purchase or renewal costs, other than certain contingent payments that you can deduct currently. For information on currently deductible contingent payments, see Franchise, trademark, trade name under Miscellaneous Expenses in
chapter 13.

Contract for the use of, or a term interest in, a section 197 intangible.   Section 197 intangibles include any right under a license, contract, or other arrangement providing for the use of any section 197 intangible. It also includes any term interest in any section 197 intangible, whether the interest is outright or in trust.

Assets That Are Not
Section 197 Intangibles

The following assets are not section 197 intangibles.

  1. Any interest in a corporation, partnership, trust, or estate.
  2. Any interest under an existing futures contract, foreign currency contract, notional principal contract, interest rate swap, or similar financial contract.
  3. Any interest in land.
  4. Most computer software. (See Computer software, later.)
  5. Any of the following assets not acquired in connection with the acquisition of a trade or business or a substantial part of a trade or business.
    1. An interest in a film, sound recording, video tape, book, or similar property.
    2. A right to receive tangible property or services under a contract or from a governmental agency.
    3. An interest in a patent or copyright.
    4. Certain rights that have a fixed duration or amount. (See Rights of fixed duration or amount, later.)
  6. An interest under either of the following.
    1. An existing lease or sublease of tangible property.
    2. A debt that was in existence when the interest was acquired.
  7. A professional sports franchise or any item acquired in connection with the franchise.
  8. A right to service residential mortgages unless the right is acquired in connection with the acquisition of a trade or business or a substantial part of a trade or business.
  9. Certain transaction costs incurred by parties to a corporate organization or reorganization in which any part of a gain or loss is not recognized.

Intangible property that is not amortizable under the rules for section 197 intangibles can be depreciated if it meets certain requirements. You generally must use the straight line method over its useful life. For certain intangibles, the depreciation period is specified in the law and regulations. For example, the depreciation period for computer software that is not a section 197 intangible is 36 months.

For more information on depreciating intangible property, see Intangible Property under Can You Use MACRS To Depreciate Your Property? in chapter 1 of Publication 946.

Computer software.   Section 197 intangibles do not include the following types of computer software.

  1. Software that meets all the following requirements.
    1. It is (or has been) readily available for purchase by the general public.
    2. It is subject to a nonexclusive license.
    3. It has not been substantially modified. This requirement is considered met if the cost of all modifications is not more than the greater of 25% of the price of the publicly available unmodified software or $2,000.
  2. Software that is not acquired in connection with the acquisition of a trade or business or a substantial part of a trade or business.

Computer software defined.   Computer software includes all programs designed to cause a computer to perform a desired function. It also includes any database or similar item that is in the public domain and is incidental to the operation of qualifying software.

Rights of fixed duration or amount.   Section 197 intangibles do not include any right under a contract or from a governmental agency if the right is acquired in the ordinary course of a trade or business (or in an activity engaged in for the production of income) but not as part of a purchase of a trade or business and either:

  1. Has a fixed life of less than 15 years, or
  2. Is of a fixed amount that, except for the rules for section 197 intangibles, would be recovered under a method similar to the unit-of-production method of cost recovery.

However, this does not apply to the following intangibles.

  • Goodwill.
  • Going concern value.
  • A covenant not to compete.
  • A franchise, trademark, or trade name.
  • A customer-related information base, customer-based intangible, or similar item.

Anti-Churning Rules

Anti-churning rules prevent you from amortizing most section 197 intangibles if the transaction in which you acquired them did not result in a significant change in ownership or use. These rules apply to goodwill and going concern value, and to any other section 197 intangible that is not otherwise depreciable or amortizable.

Under the anti-churning rules, you cannot use 15-year amortization for the intangible if any of the following conditions apply.

  1. You or a related person (defined later) held or used the intangible at any time from July 25, 1991, through August 10, 1993.
  2. You acquired the intangible from a person who held it at any time during the period in (1) and, as part of the transaction, the user did not change.
  3. You granted the right to use the intangible to a person (or a person related to that person) who held or used it at any time during the period in (1). This applies only if the transaction in which you granted the right and the transaction in which you acquired the intangible are part of a series of related transactions. See Related person, later, for information about the kinds of persons that are related.

Exceptions.   The anti-churning rules do not apply in the following situations.

  • You acquired the intangible from a decedent and its basis was stepped up to its fair market value.
  • The intangible was amortizable as a section 197 intangible by the seller or transferor you acquired it from. This exception does not apply if the transaction in which you acquired the intangible and the transaction in which the seller or transferor acquired it are part of a series of related transactions.
  • The gain-recognition exception, discussed later, applies.

Related person.   For purposes of the anti-churning rules, the following are related persons.

  • An individual and his or her brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
  • A corporation and an individual who owns, directly or indirectly, more than 20% of the value of the corporation's outstanding stock.
  • Two corporations that are members of the same controlled group as defined in section 1563(a) of the Internal Revenue Code, except that more than 20% is substituted for at least 80% in that definition and the determination is made without regard to subsections (a)(4) and (e)(3)(C) of section 1563. (For an exception, see section 1.197-2(h)(6)(iv) of the regulations.)
  • A trust fiduciary and a corporation if more than 20% of the value of the corporation's outstanding stock is owned, directly or indirectly, by or for the trust or grantor of the trust.
  • The grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
  • The fiduciaries of two different trusts, and the fiduciaries and beneficiaries of two different trusts, if the same person is the grantor of both trusts.
  • The executor and beneficiary of an estate.
  • A tax-exempt educational or charitable organization and a person who directly or indirectly controls the organization (or whose family members control it).
  • A corporation and a partnership if the same persons own more than 20% of the value of the outstanding stock of the corporation and more than 20% of the capital or profits interest in the partnership.
  • Two S corporations, and an S corporation and a regular corporation, if the same persons own more than 20% of the value of the outstanding stock of each corporation.
  • Two partnerships if the same persons own, directly or indirectly, more than 20% of the capital or profits interests in both partnerships.
  • A partnership and a person who owns, directly or indirectly, more than 20% of the capital or profits interests in the partnership.
  • Two persons who are engaged in trades or businesses under common control (as described in section 41(f)(1) of the Internal Revenue Code).

When to determine relationship.   Persons are treated as related if the relationship existed at the following time.

  • In the case of a single transaction, immediately before or immediately after the transaction in which the intangible was acquired.
  • In the case of a series of related transactions (or a series of transactions that comprise a qualified stock purchase under section 338(d)(3) of the Internal Revenue Code), immediately before the earliest transaction or immediately after the last transaction.

Ownership of stock.   In determining whether an individual directly or indirectly owns any of the outstanding stock of a corporation, the following rules apply.

Rule 1.   Stock directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries.

Rule 2.   An individual is considered to own the stock directly or indirectly owned by or for his or her family. Family includes only brothers and sisters, half-brothers and half-sisters, spouse, ancestors, and lineal descendants.

Rule 3.   An individual owning (other than by applying rule 2) any stock in a corporation is considered to own the stock directly or indirectly owned by or for his or her partner.

Rule 4.   For purposes of applying rule 1, 2, or 3, treat stock constructively owned by a person under rule 1 as actually owned by that person. Do not treat stock constructively owned by an individual under rule 2 or 3 as owned by the individual for reapplying rule 2 or 3 to make another person the constructive owner of the stock.

Gain-recognition exception.   This exception to the anti-churning rules applies if the person you acquired the intangible from (the transferor) meets both the following requirements.

  • That person would not be related to you (as described under Related person, earlier) if the 20% test for ownership of stock and partnership interests were replaced by a 50% test.
  • That person chose to recognize gain on the disposition of the intangible and pay income tax on the gain at the highest tax rate. See chapter 2 in Publication 544 for information on making this choice.

If this exception applies, the anti-churning rules apply only to the amount of your adjusted basis in the intangible that is more than the gain recognized by the transferor.

Notification.   If the person you acquired the intangible from chooses to recognize gain under the rules for this exception, that person must notify you in writing by the due date of the return on which the choice is made.

Anti-abuse rule.   You cannot amortize any section 197 intangible acquired in a transaction for which the principal purpose was either of the following.

  • To avoid the requirement that the intangible be acquired after August 10, 1993.
  • To avoid any of the anti-churning rules.

More information.   For more information about the anti-churning rules, including additional rules for partnerships, see section 1.197-2(h) of the regulations.

Incorrect Amount of
Amortization Deducted

If you did not deduct the correct amortization for a section 197 intangible in any year, you may be able to make a correction for that year by filing an amended return. See Amended Return, later. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amortization. See Changing Your Accounting Method, later.

Basis adjustment.   If you could have deducted amortization but you did not take the deduction, you must reduce the basis of the section 197 intangible by the amortization you were entitled to deduct. If you deducted more amortization than you should have, you must reduce your basis by the correct amortization plus any of the excess for which you received a tax benefit.

Amended Return

If you did not deduct the correct amortization, you can file an amended return to make any of the following corrections.

  • Correction of a mathematical error made in any year.
  • Correction of a posting error made in any year.
  • Correction of the amortization deduction for a section 197 intangible for which you have not adopted a method of accounting.

You have adopted a method of accounting for a section 197 intangible if you did not deduct the correct amortization for the intangible on two or more consecutively filed tax returns for reasons other than a mathematical or posting error. You cannot file amended returns to correct the amount of amortization.

When to file.   If an amended return is allowed, you must file it by the later of the following dates.

  • 3 years from the date you filed your original return for the year in which you did not deduct the correct amount. (A return filed early is considered filed on the due date.)
  • 2 years from the time you paid your tax for that year.

Changing Your
Accounting Method

If you cannot correct your amortization deductions for a section 197 intangible by filing amended returns, you can claim the correct amount only by changing your method of accounting for the intangible. You will then be able to take into account any unclaimed or excess amortization from years before the year of change.

Approval required.   You must get IRS approval to change your method of accounting. File Form 3115, Application for Change in Accounting Method, to request a change to a permissible method of accounting for amortization. Revenue Procedure 97-27, which is in Cumulative Bulletin 1997-1, gives general instructions for getting approval. You do not need IRS approval to correct any mathematical or posting error. See Amended Return, earlier.

Automatic approval.   You may be able to get automatic approval from the IRS to change your method of accounting for a section 197 intangible if you meet both the following conditions.

  • You did not deduct amortization or you deducted the incorrect amount of amortization for the intangible in at least the 2 years immediately preceding the year of change.
  • You owned the intangible at the beginning of the year of change.

File Form 3115 to request a change to a permissible method of accounting for amortization. Revenue Procedure 2002-9 and section 2.01 of its Appendix, which is in Internal Revenue Bulletin No. 2002-3, have instructions for getting automatic approval and list exceptions to the automatic approval procedures.

Exceptions.   You generally cannot use the automatic approval procedure in any of the following situations.

  • You (your federal income tax return) are under examination.
  • You are before a federal court or an appeals office for any income tax issue and the method of accounting to be changed is an issue under consideration by the federal court or appeals office.
  • You changed the same method of accounting (with or without obtaining IRS approval) during the last 5 years (including the year of change).
  • You filed a Form 3115 to change the same method of accounting during the last 5 years (including the year of change), but did not make the change because the Form 3115 was withdrawn, not perfected, denied, or not granted.

Also, see the other exceptions listed in section 4.02 and section 2.01(2)(c) of the Appendix of Revenue Procedure 2002-9.

- Continue -