Can You Deduct Worthless Goodwill on Your Tax Return? Internal Revenue Code Section 197 Creating Ill Will
There is a lot of discussion about goodwill nowadays. And it is generating a lot of ill will among accountants. There is good reason. FASB now requires a write down of goodwill for any impairment. On the other hand, the Internal Revenue Code, Section 197, requires the systematic amortization of goodwill on a straight-line basis over fifteen years. But what happens if you discover that your company has no goodwill from a financial accounting standpoint. Can you then write off the goodwill on your tax return and take the deduction? In order to address this puzzling question, let's first review the relevant portions of Internal Revenue Code Sec. 197, dealing with the Amortization of Goodwill and Certain Other Intangibles:
(a) General rule
A taxpayer shall be entitled to an amortization deduction with respect to any amortizable section 197 intangible. The amount of such deduction shall be determined by amortizing the adjusted basis (for purposes of determining gain) of such intangible ratably over the 15-year period beginning with the month in which such intangible was acquired.
(b) No other depreciation or amortization deduction allowable
Except as provided in subsection (a), no depreciation or amortization deduction shall be allowable with respect to any amortizable section 197 intangible.
And then the Code discusses the treatment of intangibles that become worthless:
(f) Special rules
(1) Treatment of certain dispositions, etc.
(A) In general
If there is a disposition of any amortizable section 197 intangible acquired in a transaction or series of related transactions (or any such intangible becomes worthless) and one or more other amortizable section 197 intangibles acquired in such transaction or series of related transactions are retained -
(i) no loss shall be recognized by reason of such disposition (or such worthlessness), and
(ii) appropriate adjustments to the adjusted bases of such retained intangibles shall be made for any loss not recognized under clause (i).
The above section states that if there were any other intangibles acquired in the same or related transaction, then the amortizable section 197 intangible (for example, goodwill) deemed worthless could not be written off as a loss for tax purposes; rather, the tax bases of other amortizable section 197 intangibles—acquired in the same or related transaction as that in which the amortizable section 197 intangible deemed worthless was acquired—would be adjusted. Presumably, if goodwill were the worthless intangible, and if any other intangibles were purchased along with goodwill, then the bases of the other intangibles would have to be increased in amounts totaling the basis of the disposed goodwill. Consequently, no immediate loss of the entire amount of the worthless goodwill would be allowed to be recognized. Instead, by increasing the bases of the other associated amortizable section 197 intangibles, the impairment of goodwill, in effect, would be recognized over their remaining amortizable lives.
What does this all mean? Assume on December 31, 2006, you purchased all the assets of a business, and recognized two amortizable section 197 intangibles: $15,000 goodwill; $30,000 going concern value. Under section 197, you would be allowed to amortize these amounts over 15 years, resulting in annual amortization of $1,000 of goodwill and $2,000 of going concern value, for a total section 197 amortization expense of $3,000 each year. Now assume on December 31, 2009, you deem goodwill to have a zero value. Under section 197, you would be required to increase the basis of going concern value by $12,000, resulting in an adjusted basis of $36,000. On December 31, 2010, you would still amortize $3,000 in total section 197 amortization expense. In essence, the amount of worthless goodwill continues to be amortized, but under the guise of another related intangible (here, going concern value), without any change to the total amount of amortization nor the period of amortization.
However, what section 197 fails to address is a not too uncommon situation: what if there were no other intangibles in the purchase transaction?! What if goodwill were the only amortizable section 197 intangible acquired and then it was deemed worthless? Since there would be no other retained intangibles whose bases could be adjusted, would it then be permissible to recognize a loss? In the Internal Revenue Code's own inimitable, customary, mysterious manner of exposition, IRC Sec. 197 is suspiciously silent on that situation.
Federal Regulation §1.197-2 provides a little more detail and insight regarding the Internal Revenue Service's treatment of losses on the disposition of amortizable section 197 intangibles:
g) Special rules.
(1) Treatment of certain dispositions.
(i) Loss disallowance rules.
(A) In general. No loss is recognized on the disposition of an amortizable section 197 intangible if the taxpayer has any retained intangibles. The retained intangibles with respect to the disposition of any amortizable section 197 intangible (the transferred intangible) are all amortizable section 197 intangibles, or rights to use or interests (including beneficial or other indirect interests) in amortizable section 197 intangibles (including the transferred intangible) that were acquired in the same transaction or series of related transactions as the transferred intangible and are retained after its disposition. Except as otherwise provided in paragraph (g)(1)(iv)(B) of this section, the adjusted basis of each of the retained intangibles is increased by the product of—
(1) The loss that is not recognized solely by reason of this rule; and
(2) A fraction, the numerator of which is the adjusted basis of the retained intangible on the date of the disposition and the denominator of which is the total adjusted bases of all the retained intangibles on that date.
(B) Abandonment or worthlessness. The abandonment of an amortizable section 197 intangible, or any other event rendering an amortizable section 197 intangible worthless, is treated as a disposition of the intangible for purposes of this paragraph (g)(1), and the abandoned or worthless intangible is disregarded (that is, it is not treated as a retained intangible) for purposes of applying this paragraph (g)(1) to the subsequent disposition of any other amortizable section 197 intangible.
Herein, the Regulation details how the basis of the retained amortizable section 197 intangibles would be adjusted: i.e., by allocating the worthless or disposed intangible's basis to those of the retained intangibles on a pro-rata basis. And reading below that section, buried deeper in the Regulation, you would discover that the regulation then goes on to say the following regarding worthless or disposed amortizable section 197 intangibles where other retained intangibles from the purchase transaction were not present:
(ii) Separately acquired property. Paragraph (g)(1)(i) of this section does not apply to an amortizable section 197 intangible that is not acquired in a transaction or series of related transactions in which the taxpayer acquires other amortizable section 197 intangibles (a separately acquired intangible). Consequently, a loss may be recognized upon the disposition of a separately acquired amortizable section 197 intangible [my italics].
In other words, if goodwill were the only amortizable section 197 intangible acquired in the transaction or series of related transactions, then, theoretically, if it were deemed worthless, it could be written off, since there would be no bases to adjust of other existent amortizable section 197 intangibles from that same purchase transaction.
At this point, you may wonder what evidence is needed to demonstrate that goodwill is worthless? Good question. Apparently, if you file bankruptcy or go out of business, you would presume that would constitute sufficient evidence of the worthlessness of goodwill. But can goodwill be written off before the occurrence of those events or in their absence? You could not simply try to sell goodwill on ebay, and then claim to the IRS that since you had no buyers, it is worthless. Could you simply undertake the Goodwill Impairment Test of SFAS No. 142 to demonstrate its worthlessness? That is, could you estimate the fair values of all identifiable assets and liabilities, then estimate the fair value of the company, and if the fair values of the net assets equal or exceed the fair value of the company, claim that there is no goodwill? Although this approach might be a hard sale to make to an Internal Revenue Service agent, nevertheless, at least theoretically, it appears to have some validity, because it is precisely the approach recognized by the Financial Accounting Standards Board to measure any impairment of goodwill! And in the absence of any other specific guidance from the Internal Revenue Service, it may be the most authoritative approach available to the taxpayer.
Since the Goodwill Impairment Test of SFAS No. 142 is relatively recent, it will be interesting to follow the findings of any future tax court cases involving the Internal Revenue Service's challenge to this FASB approved method of measuring goodwill as well as to any other taxpayer's method of substantiation of the worthlessness of goodwill.
This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice. For further information, please consult appropriate professional advice from your attorney and certified public accountant.
Have a tax or an accounting question? Please feel free to submit it to William Brighenti, Certified Public Accountant, Hartford CPA Accountants. For information and assistance on any tax and accounting issue, please visit our website, Accountants CPA Hartford, and our blog, Accounting and Taxes Simplified.