By: Jeffrey D. Jones, CBI, ASA, CBA

Assessing officers need to be aware of the various categories of intangible assets and/or intellectual properties that may be owned by businesses, because these items often impact the value of the total enterprise for taxation purposes. Some intangible assets can be sold separate from a business enterprise and some can not. Understanding the nature of intangible assets owned by a business and their value enables an assessing officer to properly classify these assets for taxation or to separate these assets from taxable tangible assets. For those who appraise businesses and business assets, it is important to have an understanding of how to value these properties. This article is intended to describe the main attributes of intangible assets and intellectual properties and review the appraisal approaches used to determine their value. The selection of the appraisal methods and procedures used to determine value is beyond the scope of this article.

Attributes

In Gordon Smith and Russell Parr's book, Valuation of Intellectual Property and Intangible Assets, they define intangible assets as:

"all the elements of a business enterprise that exist after monetary and tangible assets are identified."

From a layman's point of view, all intangible assets are often referred to as the "Big Pot Theory Of Goodwill. For an intangible asset to exist from a valuation, accounting and legal perspective, it must possess certain attributes. First, there must be a specific bundle of legal rights associated with the existence of any intangible asset. Secondly, an intangible asset must be able to produce an economic benefit. The bundle of legal rights will include the following requisite attributes:

• Subject to specific identification and recognizable description.
• Subject to legal existence and protection.
• Subject to the right of private ownership, and must be legally transferable.
• Tangible evidence of manifestation of the existence of the intangible asset (e.g., a contract or a license or a registration document).
• It must have been created or have come into existence at an identifiable time or as the result of an identifiable event.

• Some measurable amount of economic benefit to its owner measured in any of several ways, including net income, net operating income, or net cash flow
• the ability to enhance the value of other tangible or intangible assets with which it is associated.

Intangible assets of similar nature and function can be categorized for general asset identification and classification purposes. The most common categorization of intangible assets includes the following:

• Technology related (e.g., engineering drawings)
• Customer related (e.g., customer lists)
• Contract related (e.g., franchise agreement, non-compete agreement, supplier contracts)
• Data processing related (e.g., computer software)
• Marketing related (e.g., trademarks and trade names)
• Location related (e.g., leasehold interests)
• Going concern value (e.g., a trained and assembled work force, established distribution)
• Goodwill related (e.g., reputation and repeat business generating excess benefits beyond the tangible assets and other identifiable intangible assets.

There is a specialized classification of intangible assets called intellectual properties. Intellectual properties manifest all of the legal existence and economic value attributes of other intangible assets. However, because of their special status, intellectual properties enjoy special legal recognition and protection. Intellectual properties are created by human intellectual and/or inspirational activity. Such activity is specific, conscious and attributed to the activity of identified specific individuals. Because of this unique creation process, intellectual properties are generally registered under, and protected by, specific Federal and state statutes.

Intellectual properties are generally grouped into like categories similar in nature, features, method of creation, economic benefits and legal protection. The most common categorization of intellectual properties include the following:

• Creative (e.g., copyrights)
• Innovative (e.g., patents)

Appraisers are often called upon to determine the value of intangible assets. Usually, the objectives of an appraisal include one or more of the following:

• To determine the Market Value of the transferred intangible assets.
• To determine the Fair Value of a royalty or license fee for the continued use of the intangible assets.
• To determine the reasonable period of time over which payments should be made with respect to the transfer of the subject intangible assets. The time period should reflect the wasting, or value diminution, if any, of the subject intangible assets.

When the use of the appraisal will be for tax related matters, the applicable tax codes that relate to the value and amortization of intangible assets include the following:

IRS Code Section 167 (a) allows as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear and obsolescence of property used in the trade or business, or held for the production of income.

IRS Code Section 167 (a)-3 specifically permits the depreciation of intangibles, except goodwill and going concern value, provided it meets a three part test:

• The asset must be isolated and separated from residual goodwill.
• The taxpayer must establish that the intangible asset in question will have value in the production of income for only a limited period.
• The length of that limited period must be susceptible to being estimated with reasonable accuracy.

IRS Code Section 1060 sets forth the requirements for purchase price allocations and the reporting thereof on form 8594 in descending hierarchy of four tiered categories of assets.

Temporary regulations 1.338(b)-2T(c)(1) sets forth the allocation of purchase price to the four tiered categories of assets and specifically states that the basis allocated to assets, except those assets in Class IV, cannot exceed their Fair Market Value. The four tiers are:

Class I - Cash, demand deposits and other items designated by the Service

Class II - Certificates of deposits, U.S. Government securities, readily marketable stock or securities, foreign currency and other items designated by the Service

Class III - All remaining assets of the target corporation, both tangible and intangible, excluding Class I, Class II, and Class IV

Class IV - Intangible assets in the nature of goodwill and going concern value

IRS Code Section 197, which was part of the Revenue Reconciliation Act of 1993, provides a uniform 15 year amortization period for specified intangible assets acquired after August 10, 1993, and on an elective basis to all property acquired after July 25, 1991. Intangible assets that must now be amortized over 15 years include: goodwill, going concern value, work force in place, information base, know-how, customer and supplier based intangibles, licenses, permits, or the rights granted by a governmental agency, covenants not to compete and franchises, trademarks or trade names.

Intangible assets are dominant factors that touch all of our lives. These assets are frequently the most important assets among the collection of assets that are held by companies. The proper valuation of intangible assets has become an important issue with shareholders, management, investors and the taxing authorities. Shareholders and management need to know the underlying value of their assets for proper management and tax considerations. Owners and investors who are selling and acquiring companies need to know the value of the intangible assets for establishing acquisition value. Owners, investors and the taxing authorities are becoming increasingly aware of the importance of properly allocating value to the intangible assets for purposes of determining the life of the assets and amortization of related cost.

Valuation Approaches

The market value of intangible assets can be established by using methods within the three traditional appraisal approaches of Asset Based Approach, Market Approach and Income Approach. Asset Based methods will use procedures that determine the actual cost of creating and marketing the intangible asset, and then add a reasonable return on the investment. While reimbursement of direct cost is an underlying requirement, most owners will concur that cost reimbursement methods do not provide sufficient rewards to undergo the task of developing intangible assets.

Income Approach Methods will include the development of a royalty fee or licensing fee based on sales or some other unit of measure. The Income Approach has its theoretical basis in the Principle of Future Benefits, which states that value is based upon the buyer's perception of future economic benefits. Methods within this approach will measure incremental economic income earned by the subject firm associated with the use of the intangible assets and then convert the incremental benefits into a value using market rates of return expressed as multipliers, capitalization rates or discount rates.

Market Approach Methods include the direct correlation of fees charged by competitive forces and the use of market ratios from guideline assets. For instance, franchisors frequently use the direct correlation of franchise fees charged by competitive guideline franchisors, in determining what the market is willing pay for similar franchises. Market Ratios or Factors can be developed from financial information obtained from guideline intangibles. These Market Ratios can then be applied to the intangible asset to determine its value.

The final opinion of value will be based upon a correlation of the appraisal approaches utilized, and a synthesis of the appraisal methods deemed to best represent the property being appraised.

Goodwill and Going Concern Value:

Perhaps the most confusing and misunderstood of all intangible assets are those assets known as Goodwill and Going Concern Value. The "Big Pot Theory Of Goodwill" lumps all of the intangible assets together. For valuation purposes, all of the amortizable intangible assets are usually identified and valued using standard appraisal methodology. Modern business valuation concepts have been developed in response to the federal tax-driven requirements. The business community in the U.S. has used the goodwill category to lump unamortized assets together for convenience, because desegregation had little benefit. There has been no need to segregate non-amortizable intangible asset values such as Brand Value, Trademark Value, Going Concern Value, Goodwill Value, Customer Lists, and other related intangible assets. In the past, these were non-amortizable assets included in Class IV for allocation of purchase price purchase, as set forth in Temporary regulations 1.338(b)-2T(c)(1)

The courts have treated Goodwill and Going Concern Value as separate kinds of intangible property and, accordingly, have found Going Concern Value where there was an absence of Goodwill. The American Society of Appraisers has adopted the following definitions for Going Concern and Going Concern Value:

"Going Concern - An operating Business Enterprise"

"Going Concern Value -

1. The value of an enterprise, or an interest therein, as a going Concern.

2. Intangible elements of value in a business enterprise resulting from factors such as having a trained work force, an operational plant, and the necessary licenses, systems and procedures in place."

Goodwill is composed of two major components. The first component is reputation, customer patronage and similar factors. The second component is that these factors must produce an economic benefit in excess of a normal return on the tangible and amortizable intangible assets. If the economic benefits are insufficient, there can be no goodwill value.

However, there can be Going Concern Value even where the earnings do not provide an excess return on the investment of the tangible and amortizable intangible assets. An example of an acquisition that would have Going Concern Value without Goodwill Value would be where an acquirer makes an acquisition of a non-profitable or marginally profitable business or business interest, based on anticipated synergism resulting in either a reduction in overall cost or increased production without additional fixed costs that will result in increased profits to the acquirer.

A method used by the courts in determining the existence and value of Goodwill and Going Concern in the sale of a business is the residual method. In using this method, the Fair Market Value of all the net tangible assets and amortizable intangible assets are determined and compared to the price. If the net Fair Market Value of all of the tangible assets and amortizable intangible assets are less than the price paid, the difference is to be attributed to Goodwill and/or Going Concern Value.

Conclusion

Being able to identify intangible assets and intellectual properties is the first step in understanding the nature of these assets and determining their value. For an intangible asset to exist from a valuation, accounting and legal perspective, it must possess certain attributes. First, there must be a specific bundle of legal rights associated with the existence of any intangible asset. Secondly, an intangible asset must be able to produce an economic benefit.

Intellectual properties manifest all of the legal existence and economic value attributes of other intangible assets. However, because of their special status, intellectual properties enjoy special legal recognition and protection. Because of this unique creation process, intellectual properties are generally registered under, and protected by, specific Federal and state statutes. The most common categorization of intellectual properties are the creative and the innovative.

Owners, investors and the taxing authorities are becoming increasingly aware of the importance of properly allocating value to the intangible assets for purposes of determining the life of the assets and amortization of related cost.