Preface: Amortization of intangible assets is similar yet different than depreciation. It is governed by a different Section of the IRC and methods are unique to the intangible asset based on the IRC code section relevant to various intangible. This blog is provide an explanation of amortization and namely IRC Code Section 197 relevant to the majority of small business intangible assets.
Amortization of a Businesses Intangible Assets
Amortization is the expensing of intangible asset costs ratably over the intangible assets life. Amortization is governed with Internal Revenue Code (IRC); including section 197 and 195. Section 197 assets have a three factor test 1. They must be listed in Section 197 descriptions, 2. They must have been purchased, 3. They must be held in connection with the conduct of trade of business or investment activity. Factor 1 assets in Code Section 197 include: goodwill, workforce in place, patents, copyrights, formulas, processes, designs, patterns, market share, customer lists, licenses, permits, governmental rights, covenants not to compete, franchise fees, trademarks, trade names, contracts for use of acquired intangibles, and information bases in a business. This is not a comprehensive list of Section 197 assets, but the majority of the typical Section 197 intangibles.
Intangibles in Section 197 are expenses ratably over 15 years, beginning with the month of the acquisition. In businesses where intangibles are purchases along with other business assets, the intangible assets are determined by subtracting the cost of Class 1, Class 2 and Class 3 assets from the purchase price. This information is listed on IRS Form 8594 Asset Acquisition Statement. For example, if a business is purchases $150,000 of intangible assets, including goodwill and patents in a acquisition, the intangible costs would be expensed at say $10,000 for 15 years, and not depreciated at standard MACRS methods of say 7 years at say a 200% declining balance.
Other assets are also amortized that are not in IRC Section 197. These include interests in partnerships, corporations, trusts, and estates, interests in land, computer software, and professional fees incurred in corporate organizations or reorganizations, accounts receivable, and interest in a lease of tangible property, etc.
Start-up expenses can be amortized with IRC Section 195. Code Section 195 expenses require that the expense must be for investigating the creation or acquisition of an active trade or business; for creating an active trade or business, activities engaged in for profit and for production of income before the day business begins, the taxpayer must elect to amortize the start-up expense.
Amortization rules have a few nuances, including amortization of intangible drilling and development expenses of oil or gas wells over a sixty month period under IRC Section 59; IRC Section 171(a) (2) permits the amortization of bond premiums, and disallowed amortizations such as the elections to amortize expenses paid or incurred in creating or acquiring musical compositions or copyrights to compositions is no longer a permissible tax feature in tax years beginning after 2010. Amortization of lease fees can be amortized for the lifespan of the lease too, and not a set amortization span.
Summarized: Amortization expenses differ from depreciation, in the fact that they are in intangible assets vs. tangible assets. Intangible is key here. Typically amortization is on the straight-line expensing method and not MACRS methods applicable to tangible property. When amortizing assets, talk with your CPA for appropriate handling of the intangible.