Created Intangibles: Maintenance Deductions and Current Income

Abstract

In response to an article by Calvin H. Johnson, Edrey presents a novel analysis of two aspects of intangibles taxation: (1) whether the costs of creating assets, including goodwill, should be characterized as ordinary or capital in nature; and (2) what the appropriate distinction between capital gains and ordinary income is, and how the gains or losses derived from the disposition of that property should be classified.

Johnson pointed out that there is an asymmetry regarding the taxation of intangibles under existing law. While the costs of creating an intangible are immediately deductible, the profit derived from the intangible’s sale is capital in nature. That asymmetry yields a negative tax that leads to an increase in the internal rate of return — because of the income tax rules — from 10 percent to 25 percent. In terms of economic efficiency and tax equity, those are undesirable results. Johnson suggests that the solution is to consider the intangible’s creation costs as capital, rather than ordinary, and to classify the gain derived from the intangible’s sale as capital. For practical reasons, Johnson reverts to what appears to be an alternate solution: The intangible’s creation costs should be considered ordinary, and the gain from its sale should be taxed as ordinary income.

Edrey agrees with Johnson’s conclusion, but offers a novel, different, accurate, and optimal analysis based on accepted principles of tax theory and business management literature. His suggested analysis is twofold:

First, according to an established insight in business and marketing management — evolve, adapt, grow, or perish — goodwill of a business is graphically depicted as a positive slope. The costs of creating goodwill are necessary to maintaining a company’s constant growth, and they should be regarded as maintaining the existing income-producing process of the company. Thus, those costs should be considered ordinary and necessary expenses.

Second, Edrey classifies the profit or loss produced by the sale creates goodwill as ordinary income in nature. The underlying rationale for the distinction is that the taxpayer creates ordinary in- come by using his factors of production, whereas he makes a capital gain by selling his factors of production.

Next, Edrey offers a three-step test for distinguishing between ordinary income and capital gain or loss when disposing of property. The first step is based on the inquiry of the process that creates a gain or a loss. Edrey explains that gain or loss is caused by a change in the expectation of the present value of the future income stream that the property was expected to produce. For that calculation, a comparison is made between the present value when the property was bought and when it was sold. The second step examines what changed the expectation. The third step identifies what is responsible for creating the causes. If the causes are internal — that is, created by the taxpayer while using his factors of production — the gain is classified as ordinary income. But if the gain is caused by external factors that the taxpayer cannot possibly control, the profit or loss should be treated as a capital gain or loss. When a taxpayer sells the goodwill he created by using his own factors of production, the gain or loss is made by internal causes. Therefore the gains derived from the disposition of those assets should be classified as ordinary income.

Keywords: Tax, Taxation, Intangibles, Goodwill, Capital gains and ordinary income, Deductions