Tax alert

Intangibles disposed of at a loss? Loss disallowance a trap for unwary

Loss deferral can occur in unexpected circumstances

Mar 23, 2022
M&A tax services Accounting methods Business tax Private equity

Disposing of intangibles or goodwill at a loss? Loss disallowance rules are a trap for the unwary. 

Many private equity (PE) fund transactions include the acquisition of multiple lines of businesses that are operated and disposed of separately. However, in the event any acquired intangible, or goodwill is subsequently sold or disposed of (e.g., worthlessness), a provision in section 197 may disallow the loss and require the business to continue amortizing the basis over the original 15-year amortizable life. 

Section 197 allows an amortization deduction for goodwill (and other intangibles) over the 15-year period beginning with the month such goodwill is acquired. Generally, goodwill attaches to a group of assets that constitute a trade or business. Like other assets, the sale or disposal of intangibles and goodwill will can result in a loss. However, if a taxpayer acquires multiple section 197 intangibles in a transaction (or a series of transactions), the issue of loss recognition becomes more complex, and may lead to deferral of losses.

The fact pattern:

As a part of a carve-out transaction on Jan. 1, 2019 PE and minority co-investors formed Purchaser (P), an LLC taxed as a partnership, to acquire two separate lines of business (flooring and cabinets) from Target, a publicly traded C corporation. For various reasons, including the likelihood of separate exits of each business, P created new LLCs (F and C) to make the acquisitions. While each LLC was disregarded from P for federal income tax purposes, they each had separate books and records, tradenames, employees, employee identification numbers and separate employee incentive compensation plans. At the time of the acquisition, an appraisal was done that valued the assets of each division, including intangible assets and residual goodwill. The cabinets business included $75 million in goodwill and intangible assets.

On Jan. 1, 2022, P decided to exit the cabinets business after consecutive years of losses resulting from product recalls. The cabinets business has lost of four of its top five customers and the entire executive team. P has found a buyer, but the price is relatively low, resulting in no allocation of purchase price to intangibles or goodwill. P generates a $60 million loss on the sale, all of it related to intangible and goodwill basis. P incurred a true economic loss and intends to recognize a $60 million loss in 2022 to offset income generated by the flooring business. However, the likely result is deferral of the loss, and continued amortization over the remaining 12 years of the original 15-year amortization period.

The loss deferral rule:

Under section 197(f)(1)(A) and Reg. section 1.197-2(g)(1), loss is disallowed to the extent the intangible was acquired in the same transaction (or series of transactions) along with other section 197 intangibles that are retained. Specifically, the regulation reads “[n]o loss is recognized on the disposition of an amortizable section 197 intangible if the taxpayer has any retained intangibles. The retained intangibles … are all amortizable section 197 intangibles … that were acquired in the same transaction or series of related transactions as the transferred intangible and are retained after its disposition.” To the extent disallowed, the taxpayer is entitled to increase the basis in the retained section 197 intangibles, pro rata, by the amount of the disallowed loss.

So, does the section 197 loss deferral rule apply to the example above where P appears to have acquired two separate businesses (flooring and cabinets)? Unfortunately, based upon a plain reading of the code and regulations, the answer is likely yes. The rule does not distinguish between the acquisition of a single business or multiple businesses, even though each business may have completely separate intangibles. Would it have mattered if the businesses were even morse distinct such as a baby food division and a pesticides division?  Based upon a plain reading, the answer would appear no. Do taxpayers have reasonable arguments against such a plain reading?

Arguments against loss deferral

One argument for taxpayers is to attempt to read section 197 in conjunction with section 1060 to define the term “same transaction” more narrowly. Would the fact that each acquisition represented, or could have represented, a separate section 1060 applicable asset acquisition allow a taxpayer to assert they were separate transactions? Arguably the answer is yes.

In order for section 1060 to apply, an applicable asset acquisition must occur, which includes the assets constituting a trade or business. Further, pursuant to Reg. section 1.1060-1(b)(2)(i), an applicable asset acquisition includes the acquisition of a group of assets if it could constitute a separate business under section 355 or if “[i]ts character is such that goodwill or going concern value could under any circumstances attach to such group.”  

First consider the section 355 reference. The section 355 regulations provide numerous examples of separate active trades or businesses. These regulations are referenced by Reg. section 1.1060-1 which shows a clear intent to look at multiple acquired businesses separately. Consider Revenue Ruling 2003-110, 2003-2 C.B. 1083, which addresses the business purpose of a section 355 distribution transaction. In the ruling, Distributing manufactured pesticides and Controlled conducted a baby foods business. If, similar to our example, these businesses had been operated as single member LLCs disregarded from the same owner, would the section 197 loss deferral appear appropriate to a subsequent disposition of one of the two? In the ruling the business purpose was to allow the baby foods business to separate from the pesticides business due to customer reluctance with the affiliation. So, if the baby foods business were sold, resulting in a loss on the acquired baby foods business goodwill, does it seem appropriate to shift the basis in the baby foods goodwill to the pesticides business? To separate the businesses, the taxpayer would need to establish that they are in fact separate businesses that do not rely upon the other, yet if acquired from the same taxpayer, loss on the sale of one business may be deferred until the disposition of the other. Such a result does not seem appropriate. 

Looking to the next aspect of section 1060, a group of assets for which goodwill or going concern would attach. Reg section 1.1060-1(b)(2)(ii) discusses characteristics of goodwill and going concern value. In particular, “[g]oing concern value includes the value attributable to the ability of a trade or business (or a part of a trade or business) to continue functioning or generating income without interruption notwithstanding a change in ownership.”[1] Similarly, “goodwill” is generally understood as the value of a trade or business attributable to expecting continued customer use or patronage.[2] Two separate businesses, even if acquired at the same time, could have separate goodwill and going concern value that are unrelated to each other.  

In our example, the taxpayer acquired two separate businesses with separate legal entities with the expectation of a separate disposition. Each represented or could have represented separate applicable asset acquisitions. The initial valuations broke out the intangibles and goodwill by business, and the recall impacted only the cabinets business. Based upon these facts it would reasonable to argue that each applicable asset acquisition represented a separate transaction or series of transactions. 

Accordingly, it may be appropriate to interpret section 197(f) and Reg. section 1.197-2(g) to apply to each separate trade or business acquired. If, in a singular transaction or series of related transactions, a taxpayer was to acquire multiple business that would each constitute an independent active trade or business under section 355 or section 1060, then the disposal of one entire business while another is retained perhaps should not implicate section 197(f). Unfortunately, while this interpretation may appear a more reasonable approach in circumstances such as these, the plain language of the statute and the regulations make this a difficult position to support at a high level of comfort.

Then could a buyer set up multiple LLCs, each treated as a partnership with substantially the same ownership, to acquire multiple businesses separately and avoid the application of section 197(f)? Planning for the application of section 197(f) is complicated by treating all parties under common control (using a 50% ownership threshold) as a single taxpayer.[3] As such, the creation of separate taxpayers to acquire the businesses does not seem to alleviate the issue. While the rules are slightly different in how deferral occurs, the result is basically the same.

In summary, the application of the section 197 loss disallowance rule may apply even in situations where two separate trades or businesses were acquired in the original acquisition. The statute and regulations do not appear to consider separate acquisitions a material factor. Taxpayers should look closely and move cautiously when looking to write-off or recognize a loss on the disposition of any acquired section 197 intangible, including goodwill.

[1] Reg. section 1.1060-1(b)(2)(ii).

[2] See Reg. section 1.1060-1(b)(2)(ii).

[3] See section 197(f)(9)(C).

RSM contributors

  • Nick Gruidl