Welcome back, in the last set of videos we discussed depreciation, which is one of the three cost recovery methods outlined in the Internal Revenue Code. Recall that depreciation deals with deducting the cost of business use tangible personal and real property, other than land, over a specified period of time. In this set of videos, we will look at amortization and depletion. Amortization deals with deducting the cost of business use intangible personal and real property while depletion deals with deducting the cost of natural resources over a period of time. The core principle is the same under all three methods. If we use an asset whose expected life is greater than one year, then we need to capitalize its cost and then recover its cost over time. Generally speaking, we cannot immediately expense the cost of a long-lived asset. Although, as we saw with depreciation, some exceptions exist. So let's dive into amortization. Again, amortization is used to recover the cost of business use intangible assets. The Internal Revenue Code sections applicable to intangible assets are Section 197 and Section 195. Section 197 identifies the types of intangible assets eligible for amortization while Section 195 discusses the amortization of startup expenditures. I'll discuss each in turn. First, Section 197 intangibles are intangible assets that are acquired or purchased from another party and used in a taxpayer's trade or business. This category includes assets such as trademarks, trade names, non-compete covenants, copyrights, patents, licenses, goodwill, and the going-concern value of a firm. Importantly, self-created intangibles are generally not amortizable. For example, the soft drink company Coca-Cola has one of the most valuable trademarks in the world. It's built up and nurtured over decades of marketing and consumer satisfaction initiatives. However, Coca-Cola has internally created this intangible trademark of Coca-Cola. So technically, this trademark name is not an asset on Coca-Cola's balance sheet and thus, it is not amortizable. However, Coca-Cola has purchased other companies and brands in the past like Minute Maid or to Odwalla Juice, Fuze Beverage and Honest Tea. To the extent these acquired companies had special formulas, patents, licenses, goodwill, and valuable trade names, Coca-Cola would capitalize these intangibles on its balance sheet. That is, record them as assets and then amortize these intangibles over time. The nice thing about intangible assets is that they're amortized using straight line recovery over 180 months or 15 years beginning in the month the intangible asset is acquired. And we use 15 years regardless of the actual economic useful life of the intangible. So because this rule is rather rigid, it makes the calculation quite easy. Here, we actually ignore whether we think the trademark of a certain acquired company is good for 10 years or if it's good for 20 years or 50 years. We just amortize it over 15 years. Now, there are a couple of exceptions here for patents and copyrights under Section 197. These will actually be amortized differently depending on whether the patent or copyright was purchased or self-created. If it was purchased, we amortize it like the other Section 197 intangibles straight line over 180 months or 15 years beginning in the month the intangible asset was acquired. However, for internally created patents, we will amortize them over 20 years. While for internally created copyrights, we can amortize them over the life of the author plus 70 years. So a very, very long amortization period. Another set of intangibles relates to startup expenses under Internal Revenue Code Section 195. What are startup expenditures? Well, these are costs related to investigation and operating expenses, but before the business actually begins operations. That is, their expenses incurred to start-up the business, but before the business has actually started-up officially. Interestingly, these are considered intangibles as opposed to regular operating expenses because technically, they are incurred before the business begins operations. That is, before the business has a tax return. Once a business begins operations, such operating expenses are simply deducted as ordinary and necessary business expenses. So there's no issue there. But before a business actually starts operations, there are costs incurred. But since, technically, there is no business, the costs are not immediately deductible. Some examples of start-up expenditures that business owners need to keep track of before starting the their business include marketing survey costs. Advertising related to opening the business, analyzing various facilities, training employees before the business starts. Travel and other expenses related to securing distributors, suppliers, or customers, and hiring personnel and outside consultants. You can see that all of these expenses are the type that are incurred before the business begins. So how do we account for them? How do we deal with these expenses that are not deductible as operating expenses, since technically, the business hasn't started its operations? Well, businesses can immediately expense the first $5,000 of start-up expenses. Then, any remaining amount over $5,000 that was spent for start-up purposes can be amortized over 180 months beginning in the month the business begins operations. However, there's a wrinkle here, the $5,000 immediate expense is phased out, or reduced, dollar-for-dollar when total start-up expenses exceed $50,000. That is, for every dollar that the total start-up expenses go over $50,000, that's $1 less of the $5,000 that can be immediately deducted. Here's an example. We have Fox Company that incurred $51,000 of start-up expenses in the current year and it began operations in November of the current year. So what is the total deduction the Fox can claim related to the start-up expenses? First, from a high level, what kinds of costs might be included in the $51,000? Well, maybe Fox spent this money on surveying a few possible retail locations before settling on one. Maybe spending money on a few months rent on the selected location before the business opened in November. Maybe hiring and training some personnel, and maybe advertising the opening of the new business. So what can Fox do in terms of claiming an immediate deduction and amortizing these expenses? Well, Fox would like to immediately expense $5,000. However, it has incurred start-up expenses greater than $50,000. It's incurred $51,000 of total start-up expenses. Therefore, it must reduce the $5,000 immediate expense deduction dollar for dollar that exceeds $50,000. Here, Fox can elect to immediately expense only $4,000 or the $5,000 maximum amount eligible for expensing, minus the phase-out amount of $1000. Reflecting the fact that the $51,000 exceeds the $50,000 threshold by $1,000. So for every dollar Fox incurred in start-up costs above the $50,000 threshold, that's a dollar less of the $5,000 that Fox can immediately deduct. Okay, so Fox immediately expenses $4,000, but it had $51000 in total start-up costs. What amount can Fox now amortize? Well out of the $51,000 total costs, $4,000 is immediately deducted. This leaves $47,000 that's eligible for amortization. Fox will amortize this amount straight line over 180 months in the month it begins operations or starting in November. So we take $47,000 in divided by 180 and get $261.11 per month of amortization. Since the business began operations in November of the current year, and assuming Fox will be a December 31 calendar year end taxpayer. Then we multiply the $261.11 by two months to obtain the first tax years worth of amortization or $522.22. Note that in the next tax year, Fox can claim an entire years worth of amortization, or $261.11 cents times 12 months. And it can do so for the next 14 full years. And then, in the last year, technically the 16th tax year, Fox will amortize $261.11 times 10 months to claim the remaining amortization deduction. So in all, the total first year deductions related to the start-up expenses are the $4,000 immediate deduction plus the two months worth of amortization for a total of $4522.22. A few last items relating to Section 195 intangibles. To qualify for this expensing and amortization treatment, the taxpayer and start-up expenses cannot be deducted. Instead, they'll be capitalized and actually sit on the company's balance sheet as an asset and not be amortized. The only time the company would be able to deduct these costs is if the business ceases operations and actually liquidates. So of course, not claiming the election is not an ideal situation. Since the business did incur costs and then effectively has to wait to ever obtain any deductions. So from a tax efficiency perspective, it's more advantageous to make the selection to immediately expense as much of the intangible costs as one can. Then amortize the rest over 15 years. Then let the costs sit on the balance sheet unamortized as an asset. In all, we've discussed the amortization of intangible assets. Section 197 intangibles are amortizable when purchased straight line over 180 months beginning in the month of acquisition. Only internally created patents and copyrights are also amortizable. Section 195 allows start-up expenses to be immediately deductible up to $5,000 subject to phase out if the total start-up expenditures exceed $50,000. Any amount that is not immediately deducted would be eligible for amortization straight line over 180 months starting in the month the business begins operations. However, it's important that if the taxpayer desires the immediate expense and amortization treatment of Section 195, he or she must make the election on the business's first year tax return.
