Category: Miscellaneous Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Re: Customer List Background Taxpayer is the former shareholder of a liquidated corporation. An unrelated party purchased the right to service the former customers of the liquidated corporation in exchange for a percentage of future sales related to those customers. In some respects, the transaction has the appearance of a royalty arrangement. The goal of the purchaser is to be able to currently deduct the percentage of sales paid to the seller. The goal of the seller is to avoid imposition of self-employment tax. Issues 1. Are the percentage-of-sales payments currently deductible by the buyer? 2. Is the seller subject to self-employment tax on receipt of such payments? Answers 1. The buyer must amortize each payment made under the agreement over a 15-year period starting on the date the payment is made. Any reasonable convention can be used to avoid having multiple amortization periods with respect to payments made during the same taxable year. 2. Notwithstanding the buyer's treatment, I see no reason the seller's payments should be subject to self-employment tax. Discussion: The Buyer's Transaction It seems to me the threshold issue is whether the transaction is controlled by Section 197. Is the right to service the former customers of the liquidated corporation a Section 197 intangible? The term Section 197 intangible is defined at Section 197(d) and includes among other things so-called "customer-based intangibles". IRC Section 197(d)(1)(C)(iv). The term "customer-based intangibles" means..."any other value resulting from future provision of goods or services pursuant to relationships (contractual or otherwise) in the ordinary course of business with customers". IRC Section 197(d)(2)(A)(iii). This seems to squarely hit the present situation. Section 197(e)(4) and (e)(4)(D) provide authority for the IRS to prescribe regulations to exclude from the definition of the term "Section 197 intangibles" rights acquired outside the context of the acquisition of the assets of a trade or business (or a substantial portion thereof) which rights have a duration of less than 15 years. Proposed Regulation Section 1.197-2(c)(13) provides as follows. (13) Rights of fixed duration or amount. (i) Section 197 intangibles do not include any right under a contract or any license, permit, or other right granted by a governmental unit if the right-- (A) Is acquired in the ordinary course of business and not as part of a purchase of a trade or business; (B) Is not described in sections 197(d)(1)(A), (B), (C)(ii), (iv), or (vi), (E), or (F); and (C) Either-- (1 ) Has a fixed duration of less than 15 years; or (2 )Is fixed as to amount and the adjusted basis thereof is properly recoverable (without regard to this section) under a method similar to the unit-of-production method. I see three large obstacles to applicability of this exception. 1. The regulation is only in proposed form. 2. Arguably the customer list of the liquidated corporation (i.e., the client relationships) would be a substantial portion of this or any trade or business. 3. At least one of the excluded items set forth at clause (B)"is not described in sections 197(d)(1)(A), (B), (C)(ii), (iv), or (vi), (E), or (F)"appears to apply to this situation. Recall that the definition of the term "customer based intangible" resides at Section 197(d)(1)(C)(iv). I think it is inescapable that the rights in question are customer based intangibles. On balance, I think these three obstacles, particularly the latter one, remove this exception from the taxpayer's reach in this matter. It has been suggested that the contingent nature of the payment streami.e., payment based on a percentage of future salesperhaps removes or mitigates the obligation to capitalize and amortize these amounts on the part of the buyer. I see nothing in the literature to support that theory. The committee reports and regulations address contingent payments directly. 1. The Committee Reports on P.L. 103-66 (Omnibus Budget Reconciliation Act of 1993) provide in pertinent part as follows. Special rules.-- Determination of adjusted basis.--The adjusted basis of a section 197 intangible that is acquired from another person generally is to be determined under the principles of present law that apply to tangible property that is acquired from another person. Thus, for example, if a portion of the cost of acquiring an amortizable section 197 intangible is contingent, the adjusted basis of the section 197 intangible is to be increased as of the beginning of the month that the contingent amount is paid or incurred. This additional amount is to be amortized ratably over the remaining months in the 14-year amortization period that applies to the intangible as of the beginning of the month that the contingent amount is paid or incurred. Note: this portion of the committee reports was written when the legislation provided a 14-year amortization period as opposed to the 15-year period that was finally enacted. 2. Proposed Regulation §1.197-2(f)(2) provides as follows. (2) Treatment of contingent amounts--(i) Amounts added to basis during 15-year period. Any amount that is properly included in the basis of an amortizable section 197 intangible after the first month of the 15-year period described in paragraph (f)(1)(i) of this section and before the expiration of this period is amortized ratably over the remainder of the 15-year period. For this purpose, the remainder of the 15-year period begins on the first day of the month in which the basis increase occurs. Any reasonable convention may be used to determine the month in which the basis increase incurs, provided that the method selected is used consistently for all amortizable section 197 intangibles acquired in the same transaction (or series of related transactions) and that it does not result in any amount being added to basis earlier than the midpoint of the period (for example, annual, semi-annual, or quarterly) selected. It seems clear from the foregoing that the contingent payment stream does not change the tax treatment for the buyer. Discussion: The Seller's Transaction I believe the seller should have capital gain on the disposition of the customer list and thus not be subject to self-employment tax by virtue of Section 1402(a)(3)(A). As I understand it, the taxpayer sold all rights to the customer list in exchange for a stream of payments measured by future sales. If the customer list is a capital asset, then the transaction should give rise to capital gain. Section 1221 defines capital asset in the negative by providing essentially that a capital asset is anything except for certain enumerated items. The only exception that comes close to the present situation is Section 1221(2) which provides that a depreciable asset used in the taxpayer's trade or business cannot be a capital asset. Section 197(f)(7) provides that an amortizable Section 197 asset is considered depreciable property. Despite these two sections, I still believe the customer list is a capital gain asset in the hands of the shareholder. In order for Section 1221(2) to apply, the asset must be used in the taxpayer's trade or business. The customer list was used in the trade or business of the taxpayer's corporation. I think that distinction is sufficient to support capital gain treatment and thus avoid imposition of self employment tax. Even if the taxpayer lost the capital gain argument, then I think Section 1402(a)(3)(C) applies. This rule excludes from self-employment tax gain from the sale of assets which are not inventory or held for sale to customers in the ordinary course of business. This rule is intended to encompass (among other things) gain that would be Section 1231 gain but for the fact that the asset was not held for the requisite holding period. Alternative Structuring Ideas As I understand it, it is critical both to buyer and seller that the buyer be able to currently deduct the payment stream to the seller. Section 197 and its related regulations are very broadly drawn and clearly aimed at the purchase of customer lists and similar assets. If there is an actual transfer of legal ownership of the customer list, I believe that Section 197 treatment is virtually unavoidable. I gave consideration to suggesting that the seller retain ownership of the customer list and simply lease or license it to the buyer in exchange for the stream of payments currently contemplated. Proposed Regulation Section 1.197-2(b)(11) provides that a contractual right for the use of a Section 197 asset is itself a Section 197 asset. Thus, payment for such a right would be treated as payment for a Section 197 asset and thus subject to the 15-year amortization requirement. Mechanically speaking, the buyer is required to amortize each payment over 15 years. Since the payment stream will stretch out over a period of 8 years, the buyer will not recover his entire cost for a period of 23 years. Would it be acceptable economically to restructure the deal as an installment sale whereby the total amount paid to the buyer (including an interest factor) would approximate the payment stream based on the percentage of sales methodology? If the interest rate on the note were set at some high but not unreasonable level, this would push 15-year amortization dollars into deductible-as-paid interest amounts. In addition, this plan would allow the buyer to start the 15-year amortization period for the whole amount at the inception of the deal. In order to provide comfort to both parties, perhaps the note could be written with adjustment clauses tied to actual percentage of sales figures. If this alternative is attractive, some further research should be done to determine the best way to structure the adjustment clauses in order to maximize the buyer's up-front basis in the acquired intangible. One final thought. What is the value of the customer list established through liquidation of the corporation? Since the corporation must pay tax at the corporate level on this value as a result of the liquidation, basis in the customer list is thereby established in the hands of the seller. The existence of a pre-established value will influence your ability to use an installment sale under which the total payments (including interest) would be pegged to the total amount expected to be paid under the percentage-of-sales arrangement. Also, have you considered how to recover the taxpayer's basis in the customer list? |
