When a business acquires intangible assets — goodwill, customer lists, trade names, covenants not to compete, or licenses — the tax treatment depends almost entirely on whether the asset is a Section 197 intangible under IRC §197.

Section 197 intangibles are amortized over 15 years on a straight-line basis, regardless of the actual useful life of the asset. This rule applies to intangibles acquired after August 10, 1993, in connection with the acquisition of a trade or business.

IRC §197(d) defines Section 197 intangibles to include:

1. Goodwill — the value of a business attributable to customer relationships, reputation, and the expectation of continued patronage;
2. Going concern value — the additional value of a business as a going concern (i.e., the value of having an assembled, operational business);
3. Workforce in place — the value of an existing assembled workforce, including its experience, education, and training;
4. Business books and records, operating systems, and other information bases — including customer lists, subscriber lists, insurance expirations, and patient or client files;
5. Patents, copyrights, formulas, processes, designs, patterns, know-how, formats, or similar items — when acquired in connection with a business acquisition;
6. Customer-based intangibles — the value of relationships with customers, including market share and customer deposits;
7. Supplier-based intangibles — the value of relationships with suppliers;
8. Licenses, permits, or other rights granted by a governmental unit — including liquor licenses, taxi medallions, and broadcast licenses;
9. Covenants not to compete — agreements by the seller not to compete with the buyer; and
10. Franchises, trademarks, and trade names — including the value of a franchise agreement or the right to use a trade name.

A Section 197 intangible is amortized over 180 months (15 years) beginning with the month in which the intangible is acquired. The amortization is straight-line — equal monthly amounts over the 15-year period.

The 15-year period applies regardless of the actual useful life of the intangible. A customer list that will be obsolete in three years is still amortized over 15 years. A covenant not to compete that expires in five years is still amortized over 15 years.

This rule is unfavorable for buyers who acquire intangibles with short useful lives. Before Section 197 was enacted, taxpayers could amortize intangibles over their actual useful life — which could be much shorter than 15 years. Section 197 eliminated this flexibility for most acquired intangibles.

Not all intangibles are Section 197 intangibles. IRC §197(e) excludes the following:

Separately acquired financial interests:

• Interests in a corporation, partnership, trust, or estate;
• Interests under existing futures contracts, foreign currency contracts, notional principal contracts, interest rate swaps, or similar financial contracts.

Interests in land:

• Interests in land (other than a Section 197 intangible described above).

Computer software:

• Readily available computer software (off-the-shelf software) is excluded from Section 197 and is instead depreciated over 3 years under IRC §167. Custom software developed for internal use may be treated differently.

Separately acquired rights with a fixed useful life:

• Certain rights to receive tangible property or services under a contract or from a governmental unit, if the right has a fixed duration of less than 15 years or is reasonably expected to be replaced.

Interests under leases of tangible property:

• The value of an existing lease of tangible property is not a Section 197 intangible.

Self-created intangibles:

• Section 197 applies only to acquired intangibles. Intangibles created by the taxpayer (rather than acquired in a business acquisition) are generally not Section 197 intangibles and are subject to different rules.

A covenant not to compete entered into in connection with the acquisition of a trade or business is a Section 197 intangible, amortized over 15 years — regardless of the actual term of the covenant.

This rule has significant implications for purchase price allocation. Before Section 197, buyers preferred to allocate purchase price to covenants not to compete because they could be amortized over the covenant's actual term (often 3–5 years). Under Section 197, covenants are amortized over 15 years — the same as goodwill — which reduces the buyer's incentive to allocate value to covenants rather than goodwill.

For the seller, a covenant not to compete is ordinary income — not capital gain. This creates a conflict between the buyer (who may prefer a covenant allocation for faster amortization under pre-Section 197 rules, but now has less incentive) and the seller (who prefers goodwill allocation for capital gain treatment).

IRC §197(f)(9) contains anti-churning rules designed to prevent taxpayers from converting non-amortizable goodwill (held before August 11, 1993) into amortizable Section 197 intangibles through related-party transactions.

The anti-churning rules apply when:

1. The intangible was held or used by the taxpayer or a related person at any time on or after July 25, 1991, and before August 11, 1993; and
2. The intangible is acquired from a person who held the intangible during that period, or the intangible is acquired in a transaction in which the user of the intangible does not change.

When the anti-churning rules apply, the intangible is not treated as a Section 197 intangible and cannot be amortized.

The anti-churning rules are most relevant in transactions involving related parties or in situations where the same business is being restructured or transferred among related entities.

When a Section 197 intangible is sold or otherwise disposed of, the gain is generally:

• Ordinary income to the extent of previously allowed amortization deductions (depreciation recapture under IRC §1245); and
• Capital gain for any remaining gain above the recaptured amount.

The no-loss rule: Under IRC §197(f)(1), if a taxpayer disposes of a Section 197 intangible and retains other Section 197 intangibles from the same acquisition, no loss is recognized on the disposition. The unrecognized loss is added to the basis of the retained intangibles. This rule prevents taxpayers from recognizing losses on individual intangibles while retaining the remaining intangibles from the same acquisition.

Maximize allocation to assets with faster cost recovery. Equipment and other tangible personal property can be depreciated over 5–7 years (or immediately expensed under bonus depreciation or Section 179). Real property is depreciated over 27.5–39 years. Section 197 intangibles are amortized over 15 years. Allocating more purchase price to equipment and less to goodwill produces faster cost recovery.

Identify excluded intangibles. If the acquisition includes intangibles that are excluded from Section 197 — such as off-the-shelf software or rights with a fixed useful life of less than 15 years — those assets may be amortized over their actual useful life, which could be much shorter than 15 years.

Document the allocation carefully. The purchase price allocation must be reported on Form 8594 and must be consistent between the buyer and seller. A well-documented allocation supported by independent valuations is more defensible in an IRS examination.

Section 197 intangibles are a fundamental concept in business acquisition taxation. The 15-year amortization rule, the exclusions, the anti-churning rules, and the no-loss rule all affect the after-tax economics of acquiring a business.

If you are acquiring or selling a business and want to understand the tax implications of the purchase price allocation, contact us for a consultation.

Governing authority: IRC §§197, 1245; Treas. Reg. §1.197-2; IRS Publication 535.

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