Amortization is a cost recovery method used to deduct the cost of Section 197 intangible assets over a fixed period. In general, Section 197 intangibles are amortized over a 15-year period using the straight-line method—meaning that the same amount is deducted each year for 15 years. The most common intangible asset is goodwill on the purchase of a business but there are many others that we’ll talk about next.
Intangible assets are property that you cannot see, touch, or feel—these include goodwill, copyrights, and patents and exclude any property that’s self-created. To the untrained eye, this type of property may not have any obvious value. However, most businesses own some type of intangible property—and the cost of this type of property can be deducted using amortization to create tax savings.
Click on the following types of property that you typically can amortize:
Goodwill is a Section 197 intangible that represents the value of the current customer base and other intangibles of a business. When you purchase a business, the cost you pay in excess of the value of the assets is considered goodwill and is amortizable; this is known as purchased goodwill.
A business also has inherent goodwill, which is the value of a business in excess of its separable net assets. This category of intangibles includes:
Technology-based assets are the types of information that businesses own that they tend to keep secret. In the business world, this is called proprietary information. For this asset to have value, it must or have the potential to give the business a competitive advantage or a product differentiation. This includes:
Contract-based intangibles arise from contractual agreements or other legal rights between the business and another entity or persons. As a small business owner, you may already own one or more of the following:
If you are in the marketing and promotions industry, you may find that these assets are an intricate part of your business activity:
Artistic-related intangibles typically arise from ownership rights that are protected by copyright. This includes ownership rights to:
Amortization begins later in the month you purchased the intangible asset, or the month your business begins to generate revenue. To figure out your annual amortization expense, you need to divide the original cost of the asset by 15 years.
A= Original Cost / 15 years
The expense is claimed on Part VI of IRS Form 4562. If you have previously claimed bonus depreciation or Section 179, then you might already be pretty familiar with this form.
Example of How Amortization Works$1,000 (deductible amortization expense per year) = $15,000 (asset cost) / 15 years (recovery period)
The amortization deduction is an expense on your company’s profit and loss (P&L) statement and a deduction on your company’s tax return. Your company’s amortization deduction will create a tax savings and, ultimately, lower your business’s taxable income.
Example of How Amortization Results in Tax Savings$250 (annual tax savings) = $1,000 (annual amortization deduction) x 25% (tax bracket)
The tax savings lowers the cost of the recipe to $750 per year ($1,000 – $250). If he holds this asset for 15 years, he will save a total of $3,750 in taxes. This will lower the overall cost of the recipe to $11,250 ($15,000 – $3,750) from the initial purchase price of $15,000.