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New Tangible Tax Benefits for Intangibles

The U.S. Treasury Department is turning one of the most complex areas of our tax law on its head.

By Mark E. Battersby

. Soon, the government will no longer require that all expenditures made to acquire, create or enhance intangible assets to be automatically capitalized rather than deducted as a legitimate cost of doing business.

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  • Intangible assets are an important but frequently overlooked asset in every sign business. Our tax laws, for the most part, deny write-offs for most intangible assets because the duration of time in which they benefit the business and contribute in the production of income can't be readily determined.

    The other factor ruling out tax write-offs for intangible assets involves the question of what is the dollar-value of an intangible assets such as the goodwill built up in your business over the years? It was only in 1993, when the Internal Revenue Service created regulations that permitted intangible assets that had been "acquired" to be amortized or written-off over a 15-year period as Section 197 assets.

    The only exceptions under Section 197 applying to self-created assets apply to government-granted licenses, permits and rights, covenants-not-to-compete entered into in connection with the purchase of a trade or business and franchises, trademarks and trade names. All other self-created intangibles -- as well as any expenditures made to acquire, create or enhance those intangible assets remain a capital expense and are usually denied a tax write-off.

    Despite the creation of Section 197, the infamous and misunderstood Section 263A, remained part of the tax laws. Section 263, the uniform capitalization rules, require sign businesses to capitalize direct costs as well as an allocable portion of most indirect costs of both producing or acquiring property.

    Thus, both legal fees as well as a portion of all employee salaries for anyone involved in applying for a local business license become capital expenditures under Section 263. And, since they apply to an intangible asset, the business license, they are not amortizable.

    Recently, the U.S. Treasury Department proposed regulations that do not change that Section 263A requirement to capitalize expenses. While the newly proposed rules still require the capitalization of amounts paid to acquire, create or enhance intangible assets, examples of specific transactions has been provided. This should result in a better understanding of this complex area.

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    Under the proposed rules, specific intangible assets for which capitalization is required are identified. Once identified, the intangible assets may then be grouped into categories -- or pools -- based on whether the intangible assets is acquired from another taxpayer or created by the sign operation. These pools of capitalized expenses, each treated as one asset, should simplify the accounting process.

    Those new rules also create so-called "safe harbors" and simplified guidelines that will permit the current deduction, rather than capitalization of many of those Section 263 costs that relate to intangible assets. A safe harbor is provided, for example, that applies to some created intangible assets that do not have readily ascertainable useful lives and for which an amortization period is not prescribed or prohibited.

    There will also be a "12-month" rule covering costs of intangible assets with relatively short lives. Accordingly, under the proposed rules, amounts (including transaction costs) paid to create or enhance intangible rights or benefits that do not exist beyond a 12-month period, are treated as having a useful life that does not extend substantially beyond the close of the sign operation's taxable year. Thus, those amounts do not have to be capitalized.

    Also proposed is an employee compensation rule, covering salaries, bonuses and commissions paid to employees but related to acquiring, creating or enhancing intangible assets, an overhead rule, covering both fixed and variable overhead costs and, best of all, a "de minimis" rule that will permit costs of less than $5,000 to be immediately expensed or written off.

    The new rules also propose a 15-year safe harbor amortization period for certain created intangible assets that do not have a readily ascertainable useful life. If, for example, amounts paid to obtain certain memberships or privileges have an indefinite duration, they would be eligible for the safe harbor amortization provision.

    It should be noted, however, that a sign business is not required to capitalize an amount paid to obtain certification of its products, services or business process. The hospital privileges of a physician, product ratings or business process certification sought by a business or the initiation fees paid by a sign business to obtain membership in a trade organization are not usually capitalized.

    Intangible assets are usually defined as a right or nonphysical resource. Under the tax rules, an intangible asset is defined as (1) an intangible that is acquired from another period in a purchase or similar transaction; (2) certain rights, privileges or benefits that are created or originated by the taxpayer; (3) a separate and distinct intangible asset; or (4) a future benefit that the IRS and Treasury classify as an intangible asset for which capitalization is required.

    Even more important is the required capitalization of transaction costs that facilitate the acquisition, creation or enhancement of an intangible asset or that facilitate a restructuring or reorganization of a business entity or a transaction involving the acquisition of capital, such as stock issuance, borrowing or recapitalization.

    More to the point, the intangible assets of a business include such things as goodwill, corporate programs, licenses, franchises, organizational expenses, copyrights, trademarks, capitalized advertising costs, exploration permits, import and export permits, etc., etc. Those intangible assets include all of the sign business's rights and nonphysical assets in other words.

    As mentioned, many of these intangible assets do not show up on the sign operation's books. After all, how can anyone put a value on the goodwill or going concern value that a sign operation gradually builds up each year that it is in business? That goodwill is recognized only when the business is eventually sold.

    The amount of the business's eventual selling price, less the amounts earmarked by the buyer and seller for the operation's other, more tangible assets, is usually viewed as "goodwill." To the seller, that figure is the gain or profit from the sale. The buyer, however, has acquired an asset, goodwill, to which a value can be assigned.

    Unfortunately, while the new owner has a readily recognizable intangible asset with a value, a specific time-frame over which that goodwill can be expected to benefit the business or have an effect on its income cannot be readily determined. Thus, the 1993, tax law changes that established an automatic 15-year life or amortization period for acquired intangible assets such as that goodwill.

    The proposed rules require sign businesses to capitalize amounts paid to others to create or originate certain financial interests such as interests in entities (e.g., corporations, partnerships, trusts) and financial instruments (e.g., debt instruments, notional privilege contracts, options). Thus, all amounts paid to acquire an interest in a partnership, such as legal and accounting advice, must be capitalized.

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    Amounts associated with the sign operation's debt, be it an option to acquire another business or property or the fees paid to a broker to obtain financing for the business, are all costs that must be capitalized.

    Capitalization of prepaid expenses is mandated on the ground that the prepayment creates an intangible asset in the form of a right; specifically, the right to receive goods, services or other benefits in the future. While the existing tax rules require capitalization of prepaid expenses in general, the proposed regulations go even further, requiring the capitalization of all amounts prepaid for all benefits to be received in the future.

    Termination payments that enable sign businesses to reacquire some valuable right that it did not posses immediately prior to the transaction must normally be capitalized. Thus, payments by a lessor to terminate a lease agreement with a lessee, payments by a taxpayer to terminate an agreement that provides another party the exclusive right to acquire and use the taxpayer's property or services or to conduct the taxpayer's business as well as payment to terminate an agreement that prohibits the taxpayer from competing with another or from acquiring property or services from a competitor of another.

    Fortunately, this rule does not require capitalization for a payment made to terminate a supply contract with a supplier and does not require a lessee to capitalize a payment to terminate a lease agreement with a lessor.

    "Uncertainty regarding the proper tax treatment of amounts spent that result in intangible assets has caused significant controversy between taxpayers and the Internal Revenue Service in recent years," Treasury Assistant Secretary of Tax Policy Pam Olson recently stated. "The proposed regulations are an important step to clear the administratable rules that will allow taxpayers to compute their tax liability properly and the IRS to administer the law efficiently and fairly."

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