What Are Section 197 Intangibles?

Section 197 intangibles are certain intangible assets acquired after August 10, 1993 (or after July 25, 1991, if chosen) in connection with the acquisition of a business which must be amortized over 15 years from the date of acquisition regardless of the assets useful life.

You start amortization the month the intangible is acquired. Use Form 4563 to report annual amortization. The annual amortization amount is generally determined by dividing the cost by 15.

An amortizeable section 197 intangible is treated as depreciable property; it is not a capital asset. If held for more than one year, it will generally qualify as a section 1231 asset and be subject to the rules of section 1231.

Intangible assets have no physical form; they cannot be touched. For example, goodwill, franchises, and trade names are intangible assets

Recapture Rules that Apply to Dispositions of Section 197 Intangibles after August 8, 2005

If you dispose of more than one amortizeable section 197 intangible in a single transaction (or a series of related transactions), all of these intangibles are treated as one section 1245 property, which means, the depreciation recapture rules of Section 1245 apply. Section 1245 property is property that is depreciable or amortizeable.

If the adjusted basis of any amortizeable section 197 intangible exceeds its fair market value, the above rule does not apply to that intangible.

The rule for reporting recaptured depreciation as ordinary gain is as follows:

  • Report as ordinary gain the SMALLER of:
    • Depreciation allowed (or allowable), or
    • The amount of the gain.

Amortization claimed on section 1231 property (depreciable business property held more than one year) is subject to the recapture rules under section 1245. Section 1245 contains the depreciation recapture rules that apply to the "Gain From Dispostions Of Certain Depreciable Property".

Section 1245 Property:
To be classified as Section 1245 property, the property must be depreciable or amortizeable. A common misunderstanding about Section 1245 property is that it only consists of personal property. This is not true. It can be tangible, personal property, certain types of real property, or intangible property.

The legal definition of personal property is:

Things movable, as distinguished from real property or things attached to realty. However, things attached to the realty may be considered personalty if by their nature they are severable without injury to the realty. The term "personalty" embraces both tangible property other than realty and intangible property.

- Law Dictionary, second edition, page 343, by Steve H. Gifis

The significance of being classified as Section 1245 property is that part or all of the gain on the property’s disposal will be treated as ordinary income under the depreciation recapture rules.

The rule for reporting recaptured depreciation as ordinary gain is as follows:

  • Report as ordinary gain the SMALLER of:
    • Depreciation allowed (or allowable), or
    • The amount of the gain.

Allowed vs Allowable Depreciation:
Depreciation allowed is what you actually claimed on your return and was not disallowed by the IRS. Depreciation allowable is the amount of depreciation that could have been claimed under an approved depreciation method, but, for whatever reason, the taxpayer did bother to claim any depreciation on his return for a depreciable asset.

Keep in mind, IRS rules assume you have claimed depreciation even if you actually did not claim any depreciation. This is where the allowable amount comes into play. If you failed to claim depreciation on a depreciable asset, the IRS will assume that you claimed the allowable amount of depreciation under an approved depreciation method.

Related Party Transactions:

Gain on the sale of section 197 property to certain related persons is subject to ordinary income treatment under Section 1239.

The following are section 197 intangible assets:

  • Agreements not to compete
  • Computer software
  • Copyrights
  • Customer-based intangibles:
    • Insurance in force
    • investment management contracts
    • Any other intangible attributable to a customer base.
  • Designs and patterns
  • Formulas, processes, designs, patterns or formats
  • Franchises (excluding sports franchises)
    • Renewal costs are amortized over 15 years.
  • Goodwill.
    • Goodwill represents the expected continued customer/client patronage due to the name, reputation, or other factors of the business.
    • Goodwill is a recognized, amortizeable, intangible business asset.
    • It is a Balance Sheet item.
    • Goodwill may only be purchased.
      • When you purchase a business you must allocate the purchase price to the assets included in the purchase according to their market value. Any portion of the purchase price remaining after doing the allocation (the unallocated portion) is classified as goodwill in the purchaser's books of account and amortized over 15 years.
  • Going concern value
    • reflects the additional value attributable to assets because of their ability to generate a return on investment in spite of a change in ownership.
    • Going concern value incorporates goodwill.
    • Going concern value for a profitable enterprise is generally higher than its liquidation value.
    • Going concern value for an unprofitable business may be less than its liquidation value.
  • Information base.
    • Include the cost of acquiring:
      • Subscription lists
      • Customer lists
      • Insurance expirations
      • Patient or client files
      • Lists of newspaper, magazines radio or television advertisers
      • Training manuals or programs, Data files
      • Accounting or inventory control systems
  • Location contracts
  • The following items are also section 197 intangibles only if acquired as part of the acquisition of a business:

Self-Created Intangibles

You cannot amortize the cost of self-created intangibles, such as a customer list that you developed over the years for your own business. However, if you sell your business, and the customer list is part of the sale, part of the total sales price of the business will be allocated to your customer list as a section 197 intangible on Form 8594, Asset Acquisition Statement.

Section 197 intangibles (except goodwill and going concern value) are Class VII assets on Form 8594.

The amount of the total sales price allocated to a section 197 asset becomes the buyer's basis in the asset. The buyer is allowed to amortize a section 197 intangible over 15 years.

Gain or loss on the sale or exchange of amortizeable or depreciable intangible property held over one year (excluding any amount recaptured as ordinary income) is a section 1231 gain or loss.

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