Amortizable §197 Intangibles and Partnerships
By James M. Kehl, CPA
Mister, Burton & Palmisano, PC, Hunt Valley, Md
Section §197 and its anti-churning rules may still come into
play upon the formation of certain partnerships. Section 197 permits
taxpayers amortization deductions for property that is an amortizable
“§197 intangible” if the following conditions are
satisfied: (1) the amortizable §197 intangible was acquired after
August 10, 1993 (or after July 25, 1991 in certain cases); (2) the
amortizable §197 intangible is used in connection with a trade or
business or an activity engaged in for the production of income; (3)
the amortizable §197 intangible is not self-created property; and
(4) the amortizable §197 intangible is not subject to §197's
anti-churning rules.1 A
§197 intangible includes goodwill, going concern value,
franchises, trademarks, trade names and other assets specified by
§197(c). Amortizable §197 intangibles may arise in
connection with a contribution of property in exchange for a
partnership interest, upon the purchase of assets and a contribution
to a partnership or upon the acquisition of a partnership interest.
Section 197 amortization may be allocated among the partners using the
rules of §704(c) in order to account for any variation between a
contributed asset's tax basis and its agreed-upon fair market
value.
Assume
the facts in the following
example:
Example: Burton
owns and operates a distributorship of fishing rods and tackle as a
single member LLC. This LLC owns a §197 intangible that was
acquired in 1988. Burton is willing to transfer an ownership interest
in this LLC to his wife Lucia if that would be advantageous for tax
purposes. Burton also desires to expand this business and is willing
to admit Bundy, an unrelated person, as an equal partner if Bundy will
contribute additional capital to the business.
Burton may sell Bundy a portion of his membership interest in the
LLC. If this is done, Burton will be deemed to have sold an undivided
interest in each of the LLC's assets to Bundy. Bundy and Burton will
then be deemed to have formed a partnership and to have contributed
their undivided interests in each of the LLC's assets to that
partnership.2 Because the
§197 intangible was acquired before §197's effective date,
it is not amortizable. The partnership takes a carryover basis in this
intangible from Burton and
Bundy.3 The partnership also
steps into Burton's shoes with respect to Burton's basis in the
non-amortizable intangible
asset.4 The §197
anti-churning rules apply to Bundy's transfer of his interest in the
non-amortizable intangible asset to the partnership because Burton,
who is considered related to the partnership due to his more than 20%
ownership interest in the partnership immediately after these
transactions, held Bundy's interest in this intangible asset before
August 10, 1993.5 If Burton
elects to recognize the gain on the sale of the intangible as ordinary
income and pay tax at the highest marginal rate, then this intangible
may be amortizable.6
In order for the partnership's allocations of income and deductions
to have substantial economic effect, the capital account maintenance
rules of §704(b) require a partnership to increase or decrease
partners' capital accounts to reflect a revaluation of the
partnership's property if property is contributed to a partnership in
exchange for an interest in the
partnership.7 If there is a
variation between the basis of property to the partnership and the
property's agreed-upon fair market value at the time of contribution,
the partnership's income or loss with respect to the contributed
property must be allocated among the partners using a reasonable
method to account for this
variation.8 Three reasonable
methods for making these required allocations are the traditional
method, the traditional method with curative allocations and the
remedial method.9 In the
example, there is no variation between the tax basis and the fair
market value of the undivided interest in the intangible asset
contributed by Bundy because Bundy's basis and the value of that
undivided interest equal the amount he paid for it. There will be a
§704(c) variation for Burton's undivided interest in the
intangible asset because the partnership has a carryover basis of that
asset that is different from the asset's agreed-upon fair market
value.10 The only method that
the partnership may use to account for this variation is the remedial
method.11 If the intangible
asset was an amortizable §197 intangible, then the anti-churning
rules would not apply and the partnership could make the allocations
that take into account any built-in gain or loss with respect to this
asset using any of the three methods provided for in the §704(c)
regulations.12
Let's change the facts of the example so that Burton formed a
partnership with his wife Lucia prior to any transactions with Bundy.
Also assume that this partnership makes an election under §754.
After these transactions occur, assume that Bundy purchases a 50%
interest in the partnership's capital and profits from Burton. In this
case, Bundy is treated, with respect to the partnership's intangible
asset, as if the partnership had two assets. Bundy's proportionate
share of the partnership's adjusted basis in the non-amortizable
intangible asset is based on a substitution of Burton's adjusted basis
in that asset and is not amortizable. However, Bundy's proportionate
share of the partnership's remaining basis, created as a result of the
§743(b) basis adjustment, is amortized over a new 15 year
period.13 Bundy is the only
partner that is allocated these amortization deductions.
Assume that Bundy contributes cash to Burton's single member LLC in
exchange for an equal interest in that LLC. This results in the
formation of a partnership. The partnership books its assets under the
capital account maintenance rules at their agreed upon fair market
values. The partnership must adopt the remedial method to account for
any variation between Burton's tax basis for the intangible asset and
its agreed-upon fair market value because its intangible asset is not
amortizable.14 The partnership
will have a non-amortizable intangible asset to the extent of Burton's
basis in the intangible
asset.15 Any value of the
intangible asset in excess of that amount will be amortized over a 15
year term if the remedial method is used. Bundy should receive
allocations of amortization deductions for his share of the
excess.
Another possibility would be if Burton transferred a portion of the
LLC interest to Lucia prior to any transactions with Bundy in a manner
that would cause a partnership between Burton and Lucia to come into
existence. Bundy would then contribute money to that partnership in
exchange for an interest in the capital and profits of that
partnership. Upon Bundy's contribution of property, the partnership
would revalue its assets under the §704(b) income tax
regulations.16 Because the
intangible asset is not amortizable in the hands of the partnership,
the anti-churning rules of §197
apply.17 For this reason, the
partnership may make deductible remedial, but not traditional or
curative, allocations of the amortization deduction in order to take
into account any built-in gain or loss from the revaluation of the
intangible asset.18 If Burton,
Lucia and Bundy were unrelated individuals and the intangible asset
were an amortizable intangible asset in the hands of this partnership,
the anti-churning rules would not apply and the partnership could make
traditional, curative or remedial allocations of the amortization
deduction in order to account for the built-in gain or loss from the
revaluation of the intangible asset.
Even though §197 has been in effect for over 14 years, the
anti-churning rules may still be relevant for any businesses that were
in existence prior to the effective date of §197.
For more information, in the Tax Management Portfolios, see
Conzelmann, 533 T.M., Amortization of Intangibles, and in Tax
Practice Series, see ¶2380, Amortization of Intangibles.
1
§197(c).
2
Rev. Rul. 99-5, 1999-1 C.B. 434.
3
§723.
4
Regs. §1.197-2(k), Ex. 18.
5
Id.. See also Regs. §1.197-2(h)(12)(vi).
6
Regs. §1.197-2(k), Ex. 18 and Regs. §1.197-2(h)(9)(i).
7
Regs. §1.704-1(b)(2)(iv)(f).
8
Regs. §1.704-3(a)(1).
9
Regs. §1.704-3.
10
See §723 and Regs. §1.197-2(k), Ex. 18.
11
Rev. Rul. 2004-49, 2004-21 I.R.B. 939.
12
Id.
13
Regs. §1.197-2(k), Ex. 19.
14
See Rev. Rul. 2004-49, 2004-21 I.R.B. 939.
15
Regs. §1.197-2(g)(2)(ii)(A) and (C).
16
Regs. §1.704-1(b)(2)(iv)(f).
17
Rev. Rul. 2004-49, 2004-21 I.R.B. 939.
18
Id.
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