Amortizing Intangible Assets Under IRS Section 197
One major issue in accounting and taxes for businesses is how to figure the cost of buying business assets. Since the use of these assets is spread out over time, the tax benefit should also be spread out over time. There are two ways of spreading out these expenses – depreciation and amortization.
Depreciation and 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 calculated as:
- Cost basis of asset,
- Minus salvage value (for depreciation only),
- Divided by the number of years.
Assets are things of value owned by someone. They come in two types: tangible (like cars, buildings, and furniture), and intangible. Intangible assets (the IRS calls them "property") are not something you can touch. Types of intangible assets include stocks and bonds, franchises, product licenses, and goodwill (the reputation or brand identity of a business), and intellectual property.
One common type of intangible asset owned by businesses is intellectual property, products of the human intellect that are protected from unauthorized use by others. IP, as it's usually abbreviated, includes patents, copyrights, trademarks, and trade secrets.
How Intangible Assets Are Amortized
Amortization is similar to the straight-line method of depreciation, with equal amounts of annual deductions over the life of the asset.
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. These intangible assets must usually be amortized over 15 years. You must amortize these costs if you hold the 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 property, this amount doesn't qualify for a Section 179 expense deduction for depreciation.
Applicable Intangible Assets
For purposes of Section 197, intangible assets include:
- 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)
- Any item similar to items (3) through (7)
- A license, permit, or other right granted by a governmental unit or agency (including issuances and renewals)
- An agreement or covenant not to compete or non-compete agreement entered into in connection with the acquisition of an interest in a trade or business; and
- A franchise, trademark, or trade name
- A contract for the use of, or a term interest in, any item in this list.
You can't amortize items 1 through 8 that you created rather than acquired unless you created them in acquiring assets that make up a trade or business or a substantial part of a trade or business.
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.
Amortizing Business Startup Costs
One important use of amortization is for your costs for business startup and organization. Startup costs are those directly related to your startup; organizational costs are those for organizing a corporation, partnership, or an LLC organized as a partnership. The costs must be for the year that your business begins, and the amortization period begins with the month when your business starts, for 15 years.
You may be able to deduct up to $5,000 of startup costs and $5,000 or organizational costs in the first year and then amortize the balance. See this article on How to Deduct Startup Costs on Business Taxes for more information.
How to Claim Amortization on Your Tax Return
To deduct amortization expenses for the year on your business tax return, use Form 4562, Part VI for the tax year you acquired the property. You just need to complete the form for the first year you are claiming the amortization expense.
Disclaimer. These IRS regulations for amortizing business property are complex, and each business situation is different. You will need a tax professional to make sure you take this expense correctly.