SDSU Partnership Mission Bay Advertising Icon Case MEMO

October 17, 2021To:
Client file
Facts
1. The name of the US client is George’s Software, Inc. (“George’s”)
2. The business, George’s, is an S corporation
3. The corporation is a calendar year end, cash basis taxpayer
4. George’s recently redeemed 23% of the shares from a shareholder Robyn Harley
(“Harley”)
5. As part of the transaction George’s and Harley entered into a Covenant Not to Compete
(“CNC”)
6. The CNC is for a period of one year and is in relation to customer contracts and
relationships
Issues
1. Which code section of the Internal Revenue Code covers the deductibility of a CNC for
George’s?
2. What is the normal period for deducting the costs of a CNC for federal income tax
purposes?
3. Is it possible to deduct the costs in accordance with the term (one year in this case) of the
CNC?
Conclusions
1. §197 of the Internal Revenue Code covers the deductibility of a CNC. The CNC is
considered a Code Sec. 197 intangible.
2. A taxpayer can deduct the cost of a CNC over a 15-year period, beginning in the month
the asset is acquired.
3. Since the CNC is a section 197 intangible that is amortizable over fifteen years, it is not
possible to deduct the costs of the CNC over its duration of one year.
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part. Violation of copyright will be subject to prosecution and considered Academic Dishonesty
Analysis
Which code section of the Internal Revenue Code covers the deductibility of a CNC for
George’s?
As a general rule, under §197, of the Internal Revenue Code, a taxpayer is entitled to an
amortization deduction of any section 197 intangible asset. A CNC 1 is considered to be an
intangible asset that is deductible over a 15-year period, beginning with the month of the asset’s
acquisition.2 George’s is also holding the asset in connection with a trade for the production of
income, another requirement for an asset to be considered a section 197 intangible.
Furthermore, when dealing with any corporate stock acquisition, it does not matter whether the
corporate stock is substantial or not because it will still be considered a “section 197 intangible”
nonetheless.3
Certainly, there are exceptions to these assets which include: financial interests4, land5, computer
software6, certain interests or rights acquired separately7, and some more discussed further
throughout §197(e). §197(f)(1)(B) also discusses the special rule regarding covenants not to
compete, which is that no event shall be treated as disposable before the disposition of the entire
interest.
What is the normal period for deducting the costs of a CNC for federal income tax purposes?
As discussed before, Internal Revenue Code §197 covers the normal period for deducting the
costs of a CNC for federal income tax purposes. §197(a) states that the deductions are “…ratably
over [a] 15-year period…” The deductions also begin within the month the intangible asset is
obtained by the taxpayer.
In the case, Recovery Group, Inc., et al., Petitioners, Appellants v. Commissioner of Internal
Revenue, Respondent, Appellee8, the Internal Revenue Service (IRS) changed the amount of
allowed amortization deductions that Recovery Group had reported in their income tax returns
since they allocated the income from their CNC over a two-year period instead of the correct
1
Refer to §197(d)(1)(E)
Refer to §197(a)
3
Recovery Group, Inc., et al., Petitioners, Appellants v. Commissioner of Internal Revenue, Respondent, Appellee.
652 F.3d 122 (1st Cir. 2011), Affirming the Tax Court, 99 TCM 1324, Dec. 58,184(M), TC Memo. 2010-76.
4
Refer to §197(e)(1)
5
Refer to §197(e)(2)
6
Refer to §197(e)(3)
7
Refer to §197(e)(4)
8
Recovery Group, Inc., et al., Petitioners, Appellants v. Commissioner of Internal Revenue, Respondent, Appellee.
652 F.3d 122 (1st Cir. 2011), Affirming the Tax Court, 99 TCM 1324, Dec. 58,184(M), TC Memo. 2010-76.
2
© 2021. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Violation of
15-year period. As a result, the change in the allowed amortization deductions increased
Recovery Group’s income for each year, and thus the amount of each shareholder’s share.
Is it possible to deduct the costs in accordance with the term (one year in this case) of the CNC?
In Recovery Group, Inc. v. Commissioner of Internal Revenue9, the court found in favor of the
Commissioner regarding the length of the amortization period for a CNC. They analyzed the
requirements and rules regarding an intangible asset under section 197.
The court concluded that Recovery Group’s interpretation of §197(d)(1)(E) was incorrect and
that any CNC “…entered into in connection with the acquisition of any corporate stock, even if
not ‘substantial,’ was considered a ‘section 197 intangible’ amortizable over fifteen years.” The
taxpayer must use the correct IRC §197 rules for its intangible asset and it cannot claim any
other type of depreciation or amortization to align with those rules contradicting the possibility
of the costs to be deductible in accordance with the term of the CNC.
9
Recovery Group, Inc., et al., Petitioners, Appellants v. Commissioner of Internal Revenue, Respondent, Appellee.
652 F.3d 122 (1st Cir. 2011), Affirming the Tax Court, 99 TCM 1324, Dec. 58,184(M), TC Memo. 2010-76.
© 2021. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Violation
of copyright will be subject to prosecution and considered Academic Dishonesty
Background:
Your client, Ricardo Lopez (“Lopez”), Lucy Azziz (“Azziz”) and George Rizzo (“Rizzo”) formed a partnership in 2019
and called the partnership Mission Bay Advertising Icons (“GMBI”). Ricardo and Lucy provide services to the
partnership for their share of the partnership (35% each) and George provided cash of $200,000 for his 30%
interest. In 2019 and 2020 Ricardo and Lucy received guaranteed payments of $350,000 each in 2019 and $40,000
each in 2020. The partnership made a loss of $6500,000 in 2019 and a loss of $1 million in 2020. The losses were
allocated to each of the partners in accordance with their percentage ownership interests in GMBI, i.e. Lopez was
allocated 35% of the losses, Azziz was allocated 35% of the losses and Rizzo was allocated 30% of the losses.
Due to the continual losses experienced by GMBI Rizzo had to continue to inject funds into the partnership to keep
it afloat. After the initial cash of $200,000 by Rizzo in 2019, he injected further funds in 2019 of $500,000 and in
2020 two additional amounts of $400,000 and $600,000 and in 2021 an amount of $10,000. The funds injected in
2019 ($700,000) and 2020 ($1 million) were recorded as loans from Rizzo to GMBI and reflected on the balance
sheet and on the tax return as amount due to partner. The debt was recourse debt and reflected as allocated to
the three partners in the same percentages as the loss allocations for the partners.
Lopez included the guaranteed payment of $350,000 and loss from the partnership of $227,500 on Form 1040 for
the 2019 tax year and included the guaranteed payment of $400,000 and loss from the partnership of $350,000 on
Form 1040 for the 2020 tax year. Azziz included the same information on her Form 1040 for 2019 and 2020.
The capital accounts for all three partners showed 0 as the initial contribution for 2019, i.e. none of them had any
initial contribution recorded, and the losses allocated to them resulted in negative capital accounts. The capital
accounts for the three partners at the end of 2020 also reflected negative capital accounts that had been increased
by the amount of the losses allocated to them in 2020.
In 2021, GMBI ceased operations and had neither a profit or a loss. GMBI would now like to reclassify the debt
due to Rizzo as a capital contribution by Rizzo and file a final federal return for the partnership as the partnership
has terminated.
You can safely assume that there was a signed partnership agreement and there were terms specified for what
needs to occur for an item to be considered a contribution to capital.
GMBI needs advice for the following for the 2021 income tax year:
1.
2.
3.
Is it possible in 2021 to reclassify the debt due to the partner Rizzo as capital contributions from the
partner Rizzo?
Is there any income that should be realized and recognized for the partnership in 2021?
What gain or loss will the partner Lopez realize and recognize on the termination of the partnership,
including the character of that gain or loss?
You research should consider the following (but it is not an exhaustive list):
Hohl et al. v Commissioner (T.C. Memo 2021-5)
IRC §61(a)(12)
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subject to prosecution and considered Academic Dishonesty
Your responsibility:
Prepare a tax research memo addressing the question that has been raised. Please note that if the tax memo is
not in the required format and/or contains very little analysis you will receive a zero (0) for the assignment. All
good faith efforts are capable of receiving a minimum of 60% but less than a good faith effort will be awarded zero
points.
You will need to support your conclusion using primary sources of tax law. Your textbook is NOT primary authority
nor are IRS Publications. Please refer to Chapter 2 for primary authorities. CCH AnswerConnect is not a primary
authority, nor is Google Scholar nor are any other websites you may access. The primary authorities are legislative,
administrative and judicial.
You must use proper citation form in your memo (see Chapter 2 for help with citation form). The form for this
communication should be professional and in the form of a tax research memo (examples posted on Canvas and a
similar example in your textbook). You will see that citations are within the text of the document in the example.
Once a court case has been cited in full, it can be referred to using simply the name in italics.
Please do not quote large amounts from the primary authorities, please put the information in your own words so
the reader can understand the issues easily.
Do yourself a favor and look at the grading rubric before you submit.
This memo should be whatever length you feel is appropriate to resolve the issues. We do NOT use a bibliography
or list of references in a tax research memo. We do not include Background in a tax memo. The Background is
provided so you can identify the facts.
You are required to INDIVIDUALLY prepare this document. Please upload your memo to Canvas before the due
date and time. TurnitIn will be used to check for plagiarism. Late assignments are not accepted.
The grading rubric for Tax memos is posted in Canvas. For this assignment, points are distributed as follows:
Aspects of the memo
Content – facts and issue(s)
Content – analysis
Content – conclusion
Organization
Audience
Style
Mechanics
Referencing
Total
Points
16
30
14
8
8
8
8
8
100
© 2022. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Violation of copyright will be
subject to prosecution and considered Academic Dishonesty