Amortizing Intangible Assets Under IRS Section 197

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Intangible assets are a type of business property that has no physical form, including copyrights, patents, and trademarks. They have value to your business, not only because you can use them for profit, but because you can deduct the cost over several years as a way to cut your tax bill. This article explains the asset deduction method for intangibles called amortization.

Key Takeaways

  • Intangible assets, like copyrights, trademarks, and trade secrets, have value to a business even though they don't have a physical form.
  • Businesses can deduct the cost of these assets as expenses over several years using a process called amortization.
  • Many intangibles are amortized under Section 197 of the Internal Revenue Code, which requires a 15-year amortization period.
  • Businesses must report the total amount of amortization for each year on their tax returns, using IRS Form 4562.

What Are Intangible Assets?

Businesses can deduct the cost of business expenses, and one of these expenses is the cost of buying business assets. Assets are things of value owned by someone. They come in two types:

  • Tangible assets: Things you can touch, like cars, buildings, and furniture)
  • Intangible assets: Things you can't touch, like trade secrets, product licenses, and goodwill

Intangible assets are types of business assets that have no tangible form but have value because a business can

  • Sell them for profit
  • Sell a license to others to sell them
  • Use them in a franchise
  • Include in the sale of a business to increase its value.

One common type of intangible asset owned by businesses is intellectual property (IP), products of the human intellect that are protected from unauthorized use by others. IP includes patents, copyrights, trademarks, and trade secrets.

Amortization vs. Depreciation

Physical (tangible) business assets and intangible assets have value to a business because the cost can be deducted as a business expense, cutting the business tax liability. However, the process of deducting these expenses (called capital expenses) is different from the deduction of other expenses (operating expenses).

Because the life of an asset is longer than a year, these assets must be deducted over what the Internal Revenue Service (IRS) calls their "useful life."

Useful life is the estimated lifespan of a physical asset when it is of use to the business. An asset's useful life is based on a standard value based on the type of asset.

  • Physical assets are deducted using a process called depreciation.
  • Intangible assets are deducted using a process called amortization.

The processes of depreciating and amortizing are basically the same. The value of the asset is determined, and the life of the asset is calculated by comparing it to other similar assets. One of several different methods is then used to spread out the cost, depending on the type of asset.

The basic calculation for depreciation or amortization in a year is:

Amortization equation

One difference between amortization and depreciation is that intangible assets don't have a useful life in the sense that they become unusable or become obsolete. The IRS designates 15 years as the useful life of most intangible assets.

Amortization is similar to the straight-line method of depreciation, with equal amounts of annual deductions over the life of the asset.

Amortization of Intangible Assets

The IRS designates certain assets as intangible assets under Section 197 of the Internal Revenue Code. Section 197 amortization rules apply to some business assets, but not to others. You must amortize these costs if you own Section 197 intangibles in connection with your trade or business or in an activity engaged in for the production of income.

If you amortize a specific intangible asset, you can't also take a Section 179 expense deduction for depreciation for that asset.

Section 197 Intangible Assets

You can amortize any of these 197 intangibles:

  • A license, permit, or other right granted by a government unit or agency
  • A non-compete agreement that is part of the purchase of an interest in a business
  • A franchise, trademark, or trade name.

These intangibles can only be amortized under Section 197 if you created them as a substantial part of buying the assets of a business:

  • Goodwill (the difference between the purchase price of a business and the business total asset value)
  • Going concern value
  • The workforce in place (that is, current employees, including their experience, education, and training)
  • Business books and records, operating systems, or any other information base, including lists or other information concerning current or prospective customers
  • A patent, copyright, formula, process, design, pattern, know-how, format, or similar item
  • A customer-based intangible, including customer base and relationships with customers
  • A supplier-based intangible (the value of future purchases due to relationships with vendors)

IRS Publication 535 Business Expenses has more definitions of the types of intangible assets listed above and details on which intangible assets you can and can't amortize.

How To Claim Amortization on Your Tax Return

To deduct amortization expenses for the year on your business tax return, use Form 4562 Depreciation and Amortization, Part VI. There are two sections to Part VI:

  • Amortization of costs that began (were acquired) during the current tax year
  • Amortization of costs that began before the current tax year

For each type of cost, include:

  • Columna (a): A description of the costs
  • Column (b): Date amortization begins
  • Column (c): Amortizable amount (the total amount being amortized)
  • Column (d): Code Section (Internal Revenue Code Section 197)
  • Column (e): Amortization period or percentage
  • Column (f); Total amortization for the year.

If you have more than one item of intangible property for either of the two sections, you'll need to itemize them on a separate sheet and include the total on the form. You may also need to attach statements and documents for this section.

The instructions for Form 4562 have more details on each of the items needed for the costs. These IRS regulations for amortizing business property are complex, and each business situation is different. You will need to get help from a tax professional to make sure you take this expense correctly.

Frequently Asked Questions (FAQs)

How is amortization of intangibles calculated?

Consider an intangible valued at $10,000 and amortized over 15 years (180 months). The intangible was bought on March 1, 2021.

  • Column (b): Date amortization begins: March 1, 2021 (amortized for 10 months in 2021)
  • Column (c): Amortizable amount (the total amount being amortized) = $10,000
  • Column (e): Amortization period or percentage = 180 months

To calculate the amortization for the year, first divide the amount in Column (c) by the number of months over which the costs are to be amortized (column (e) to get a monthly amortization.

  • Divide $10,000 by 180 months = $55.56 the monthly amortization.

Then multiply this by the number of months the intangible was amortized in the tax year.

  • Multiply $55.56 by 10 (the number of months of amortization in 2021)= $555.56 (column (f).

This is the amount you can claim for amortization for this intangible for the 2021 tax year.

How are intangible assets valued?

Valuing an intangible isn't easy. How do you set a value on a going concern or even on a patent? It's difficult to find a comparable transaction because most intangibles are unique (like a patent, for example). It's also difficult to find a comparable transaction and economic cycles have an effect on these transactions.

For accounting purposes, the book value of an intangible asset on a business's balance sheet is less each year.

Several common valuation methods for intangibles are:

  • Market-based (how much a willing buyer and willing seller would agree on for the asset)
  • Cost-based (how much it costs to create or replace the intangible)
  • Estimate of future economic benefit (for example, how much revenue a patent could bring in over the term of the patent)

Each intangible will need to be valued on a case-by-case basis.

How are other non-section 197 intangibles amortized?

Other non-Section 197 intangibles are valued and amortized in different ways. For example, most business startup and organization costs must be amortized for 15 years, but not under Section 197.

In another example, let's say you get an existing lease for property or equipment for your business. You must generally amortize the amount you pay for the lease over the remaining term. This amortization calculation works like straight-line depreciation.

Non-Section 197 intangibles are amortized in other parts of Form 4562.