Tax News
Worthless Intangibles and Section 197(f)(1)
May 01, 2011
Administrative Actions
Recently the IRS released CCA 20111101F where it rejected several arguments raised by the taxpayer that worthless goodwill associated with acquired Section 197 intangibles (in this case franchises) should be deductible under Section 165 of the Code. The facts of the ruling were not too elaborate.  The taxpayer acquired certain assets from an automotive dealer including goodwill related to five different franchise rights. Subsequent to the sale, the taxpayer received notice that two of the franchises were being terminated.  The taxpayer claimed that the goodwill associated with the franchises was worthless and that it should be entitled to a Section 165(a) deduction.

Chief Counsel disagreed.  Counsel pointed out that Section 197(f)(1) provides that 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, then (i) no loss may be recognized, and (ii) appropriate basis adjustments must be made to the retained intangibles.  The taxpayer raised two arguments why this section should not apply to its facts.  First it reasoned that because the purchase agreement specifically allocated goodwill value to the different franchises, Section 197(f)(1) should not apply.  Second, it reasoned that the spirit of Section 197(f)(1) did not contemplate the type of franchises acquired by the taxpayer. The IRS disagreed with both arguments. First it had an issue with the evidence provided by the taxpayer and second it concluded that there was no indication whatsoever that the spirit of Section 197(f)(1) contemplated an exemption from the statute for the franchise at issue.

There are couple of lessons that investment funds could draw from this ruling. When acquiring target companies, private equity funds often buy Section 197 intangible assets or make Section 338(h)(10) or 754 election to step up the basis of such assets.  Sometimes these assets become worthless while the fund still has an interest in the portfolio company.  Before it presses on for a worthless intangibles deduction, and before it goes into the time and expense of asking for a ruling on the matter, it is good that the investment fund is familiarized with the Section 197(f)(1) rule and its potentially disadvantageous consequences.  Second, the private equity fund, portfolio company and their attorneys should get their facts straight and should support them by sufficient evidence. In this ruling Chief Counsel noted that the taxpayer was making unsubstantiated claims (in support of its claims the taxpayer produced one undated and unsigned summary sheet).  Arguably, it is not inconceivable that the result might have been different had the taxpayer provided more credible evidence (although the CCA does state that, even if the taxpayer had been able to support its purchase price allocation, the result is the same under Section 197(f)(1) because all of the goodwill was acquired in the same transaction or series of related transactions).   The CCA is attached immediately below.

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Tags: Section 197(f)(1), Worthless intangibles