EXPANSIVE DEFINITION OF GOODWILL IN LIKE-KIND EXCHANGES

Under Code Section 1031, taxpayers can exchange property of like-kind without incurring current gain - that is, they can defer gain recognition by rolling over their tax basis into the replacement property. While most often applied to real property, such exchanges can include exchanges of trade or business property.

The goodwill or going concern value of a business is per se not property that can be like-kind and thus cannot qualify for Section 1031 nonrecognition. Therefore, in the exchange of a business property, the taxpayer needs to identify what portion of the business assets are in the nature of goodwill.

A recent article in the publication Business Entities discusses the IRS treatment of intangibles in Section 1031 exchanges. Determining which intangible assets are part of goodwill and which are not is a difficult task. The term “goodwill” has generally been defined as the expectancy of continued patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor. The term “going concern value” has generally been described as the additional value that attaches to property because of its existence as an integral part of an ongoing business activity.

Prior to the enactment of Code Section 197 relating to the amortization of goodwill and other intangibles, there was frequent litigation about which intangible assets were part of goodwill. In Newark Morning Ledger, 507 US 546 , 123 L Ed 2d 288 (1993) the Supreme Court noted that the value of every intangible asset is related, to a greater or lesser degree, to the expectation that customers will continue their patronage (i.e., goodwill). Nevertheless, for purposes of amortization, the Supreme Court held that a taxpayer who is able to prove that a particular asset can be valued and has a limited useful life that can be ascertained with reasonable accuracy may still depreciate the asset's value over its useful life.

Code Section 197 ended the debate about which intangible assets were separate enough from goodwill to be amortizable. However, the issue of separateness remains for purposes of Section 1031, and the IRS continues to be expansive in categorizing intangible assets as part of related to goodwill, so as not to qualify for like-kind exchange treatment.

For example, in TAM 200602034, the IRS held that a taxpayer's trademarks and trade names were a component of goodwill or going concern value, and thus their exchange could not qualify for like-kind exchange treatment. In Memorandum 20074401F, the IRS determined that a taxpayer's advertiser accounts and subscriber accounts were closely related to goodwill and could not be distinguished from the taxpayer's trademarks and trade names, and thus were ineligible for like-kind exchange treatment.

Therefore, taxpayers engaged in Section 1031 exchanges with trade or business property can expect IRS resistance to like-kind treatment for many of the intangible assets of the business. Whether the IRS' broad sweep up of intangible assets into goodwill is legally appropriate remains to be seen.

Source: IRS Applies Expansive Definition of Goodwill for Section 1031 Purposes, Authored by Holly Belanger, Business Entities (WG&L)

LIKE-KIND EXCHANGE PERMITTED WITH PARTNERSHIP INTERESTS

Internal Revenue Code Section 1031 allows taxpayers to swap a business or investment property for a new business or investment property without recognizing gain on the exchange. However, these “like-kind” exchange rules do not apply to exchanges of partnership interests (Code Section 1031(a)(2)(D)).

In a recent private letter ruling, the IRS did allow partnership interests received by a taxpayer in exchange for real property to qualify for like-kind exchange treatment. However, this was not a major departure from existing law.

In the private letter ruling, the taxpayer received 100% of the partnership interests in the partnership. In that situation, the IRS was comfortable in looking through the received partnership and treating the taxpayer as having received the underlying assets of the partnership. Since the underlying partnership-owned property was of like-kind to that exchanged away by the taxpayer, like-kind exchange treatment was allowed. The IRS noted that by acquiring 100% of the partnership interests, the partnership was deemed to have liquidated and distributed its assets to its partners, and thus the acquisition was essentially an acquisition of partnership assets.

Therefore, the effect of the ruling was not to open the door to like-kind exchanges of partnership interests, but simply to acknowledge the pass-through/disregarded entity treatment that arises when 100% of the partnership interests are being transferred. Nonetheless, the ruling is helpful since the IRS is acknowledging such pass-through treatment for Section 1031 purposes.

As with all private letter rulings, the ruling is only binding on the IRS as to the taxpayer that submitted the ruling. Nonetheless, such rulings are typically (but not always) indicative of the IRS’ approach to the subject matters of the ruling.

PLR 200807005