8 min read
Businesses hold two types of assets: tangible and intangible. Most business owners are familiar with their tangible assets, the things of value that they can hold and see like their office building, vehicles, supplies, materials, furniture, equipment, and cash. Intangible assets, however, are just as relevant and even more important for some businesses than tangible assets.
So, business leaders must understand what their intangible assets are and how to approach them when it comes time to file taxes.
What Are Intangible Assets?
Intangible assets are assets that have no physical nature. They cannot be held or seen.
Examples of intangible assets with which you are likely familiar include brands, brand recognition, legal agreements, and goodwill. Intellectual property (IP) is also considered an intangible asset. Intellectual property includes things like patents, trademarks, trade secrets, copyrights, digital assets, and franchises.
For tax purposes, intangible assets also include the following items:
- Annuity, endowment, and insurance contracts
- Computer software
- Customer lists
- Debt instruments
- Mortgages and Leases
- Nonfunctional currency
- Ownership and financial interests
- Stocks, equities, mutual funds, and exchange-traded funds (ETFs)
- Workforces and employees
Two types of intangible assets exist: definite and indefinite. Definite intangible assets include contracts or legal agreements that have an "expiration date" of sorts. Indefinite intangible assets include brands or ideas that will last indefinitely.
Are Intangible Assets Taxable?
Intangible assets have no recorded value and are not included on a business's balance sheet. So, many business leaders assume they are not taxable. This, however, is a false assumption.
The value of intangible assets can be taxable when a transaction occurs involving them. So, intangible assets become taxable when they are bought or sold. Additionally, revenue generated from intangible assets is taxable and money spent to obtain or create intangible assets is typically deductible.
What Are Intangible Taxes?
The term "intangible tax" refers to taxes on intangible assets. According to Merriam-Webster Dictionary, intangible taxes are, "a tax imposed on the privilege of owning, transferring, devising, profiting by, or otherwise dealing with or benefiting from intangibles."
5 Tips for Taxing Intangible Assets
1. Know When Intangible Taxes Are Relevant
Most businesses possess intangible assets. Your business name, brand, trademark, brand recognition, customer loyalty, unique value proposition, and other intellectual property are all intangible assets of your business. Most businesses, however, do not list these assets or worry about calculating their value, unless they've bought or sold an intangible asset or are attempting to calculate an accurate business value.
- Market Approach - The market approach is a method that searches the market for similar intangible assets and sets a comparable value. This approach is challenging, however, due to limited available data.
- Income Approach - If intangible assets produce a revenue stream, then the income approach can be used. With this method, you can consider the estimate of the potential revenue generated by the asset to determine a value.
- Cost Approach - The cost approach attempts to estimate how much it would cost to produce a similar or replacement (i.e. substitution) for the intangible asset, and uses this estimate as a value.
These valuations are most relevant for valuing an intangible asset for the purposes of selling, purchasing, or valuing a business. For tax purposes, you will use the amount your business spent acquiring an intangible asset or earned selling an intangible asset.
Intangible assets typically only appear on a company's balance sheet when they have been acquired or sold. In these cases where a transaction occurs, intangible assets can be relevant for tax purposes. Selling an intangible asset is revenue, and the income from the asset might be taxable. Likewise, purchasing an intangible asset is a business expense and can sometimes be considered a deduction. Intangible asset expenses and earnings are sometimes but not always taxable, so it is essential to understand the tax code surrounding intangible assets to determine whether yours are taxable or deductible.
2. Sale of Intangible Assets Treatment and the Tax Rate for Intangible Assets Income
Generating an income from selling or licensing intangible assets is an excellent way to make money, but it is a complicated legal and accounting process. Before any agreements are made or transactions are completed, your business will likely need to hire an intellectual property lawyer to guide you through the legal processes associated with intellectual property contracts. Additionally, you'll need to work with a certified public accountant to calculate and determine the proper value of your intangible assets.
Royalties from licensing agreements are typically considered business income, while revenue generated from the sale of an intangible asset might be considered capital gains, instead of regular income. As a result, the income generated from selling intangible assets is typically subject to the capital gains tax. The amount subject to capital gains tax is calculated by subtracting the cost (or the asset's basis) from the total sale price.
The capital gains tax rate differs based on the total income and the length of time the intangible asset was held by your business. If an intangible asset was held for less than a year, then it is subject to the short-term rate. If an intangible asset was held for a year or longer, then it is subject to the long-term rate. Capital gains tax rates have a cap of 20%, but most businesses end up paying less.
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3. Deducting and Amortizing Intangible Assets Costs
To reduce your overall tax bill, your business can often deduct business-related expenses to calculate a lower total for taxable income. Deductions are usually treated in one of three ways:
- The total expense is immediately deductible in the tax year it was incurred.
- The total expense is capitalized, and the total deduction is spread out over time (amortized).
- The total expense is capitalized and no deduction is allowed.
Regarding intangible assets, businesses are often required to capitalize expenses that were paid toward:
- Acquiring or creating an intangible asset for the business.
- Creating or improving an intangible asset distinct or separate from the business.
- Creating or improving for the purpose of future benefits beyond the tax year when the cost is incurred.
- Facilitating the creation or acquisition of an intangible asset (i.e. related accounting or legal fees).
Costs associated with intangible assets that the IRS requires businesses to capitalize for deductions include:
- Prepaid costs (i.e. insurance or rent)
- Privileges, memberships, and certifications
- Permit and professional license costs
- Trademark, copyright, and patent costs
- Any costs paid to external parties for the origination, creation, renewal, or renegotiation of financial interests associated with intangible assets.
4. Capitalization Exceptions: 12-Month Rule for Prepaid Expenses
While IRS Section 197 is fairly thorough, exceptions to the capitalization requirement do exist for some intangible assets.
Some intangible assets costs do not need to be capitalized and amortized if the total cost is $5,000 or less.
The 12-month rule is another exception. With the 12-month rule, capitalization is not necessary for any amount spent on the creation of intangible assets, facilitation of the creation of intangible assets, or on any benefit or right regarding intangible assets that does not extend beyond the earlier of the following:
- 12 months after the date when the right or benefit begins, or
- The end of the tax year after the tax year during which the payment is made.
In these cases, a taxpayer can completely deduct a prepaid expense in the current tax year with capitalizing costs.
It is important to note, however, that the 12-month rule does not apply to amounts that are amortizable under Section 197 or to expenses paid for the creation of financial interests.
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5. Know Your Local Tax Code
While some tax rules regarding intangible taxes are federal, state and local regulating bodies have their own sets of tax codes that pertain to intangible assets. These geographically-dependent variations in tax codes further complicate intangible taxes. So, business owners must use due diligence when dealing with intangible assets to ensure compliance at all levels.
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Most businesses possess and deal with intangible assets in one form or another. Some industries where businesses are heavily reliant on intangible assets include consumer products and services, technology, healthcare, entertainment, and automotive. No matter what industry your business operates in, the valuing and handling of intangible assets is essential to success and compliance with tax rules and regulations.
If you are struggling to adequately manage the value and taxation of intangible assets in your business, an outsourced expert could help immensely. With outsourced accounting, you'll have an entire back-office team working for your business. We can help you value your intangible assets, determine their taxability, and ensure you have the proper deduction schedules set up for tax filing.