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.
Section 197 Intangible Assets
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:
- Assembled workforce
- Trademarks
- Trade dress, such as unique color, shape, or package design
- Brand name
- Cancelable and noncancelable customer contracts
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:
- Patent technology
- Research and development
- Computer software and mask works
- Databases, including title plants
- Trade secrets, such as formula, processes, and recipes
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:
- Construction permits
- Franchise agreements
- Licensing, royalty, and standstill agreements
- Employment contracts
- Lease agreements
If you are in the marketing and promotions industry, you may find that these assets are an intricate part of your business activity:
- Newspaper mastheads
- Internet domain names
- Noncompetition agreements
- Trademarks, trade names, service marks, and trade-related collaterals, such as unique color, shape, or package design
Artistic-related intangibles typically arise from ownership rights that are protected by copyright. This includes ownership rights to:
- Plays, operas, ballets
- Books, magazines, newspapers, and other literary works
- Pictures and photography
- Music composition, advertising jingles, and song lyrics
- Videos and audiovisual material
How To Calculate Amortization
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.
- In 2022, Gunther purchased a coffee recipe from Starbucks for $15,000 for his coffee shop, Central Perk. He plans to use the recipe and name it The Perky Pike.
- As an intangible asset, recipes are considered trade secrets and can be amortized over a period of 15 years.
- So, Gunther can deduct $1,000 per year for the next 15 years.
$1,000 (deductible amortization expense per year) = $15,000 (asset cost) / 15 years (recovery period)
How Amortization Affects Small Business Taxes
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.
- From our example above, Gunther’s amortization deduction is $1,000 per year for 15 years.
- Let’s assume that Gunther is in the 25% tax bracket.
- When we multiply his marginal tax rate by the amortization deduction; we arrive at his annual tax savings of $250. He can deduct this amount from his taxable income when he prepares his tax return.
$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.
Where Amortization Is Reported
Entity Type | Schedule/Tax Form |
|---|---|
Partnership | Form 4562, Part VI & Form 1065, Page1, Line 20 |
S corporation (S-corp) | Form 4562, Part VI & Form 1120S, Page 1, Line 19 |
C corporation (C-corp) | Form 4562, Part VI & Form 1120 Page 1, Line 26 |
Sole Proprietorship | Schedule C, Part V |
Frequently Asked Questions (FAQs)
Can amortization be used for tangible personal property?
No, the process of amortization is used strictly for intangible assets, such as goodwill, copyrights, and patents. Tangible assets—such as office equipment, plumbing, or machinery—are subject to Section 179 and depreciation.
What is the relation between business startup cost and amortization?
Business startup costs are treated a little differently than intangible property. If your business is up and running, in the first year, you can deduct up to $5,000 as an expense. The remaining amount of your company’s startup cost is amortized over 15 years.
What is the connection between amortization and loans?
Amortization of loan payments and amortization of intangibles are unrelated even though they use the same term. While amortization is used in the tax world to spread the cost of intangible assets, it’s also the term used to separate loan payments into interest vs principal in the finance world. You can use Excel to create loan amortization schedules.
Bottom Line
Amortization is used on your company’s tax return when your business files Form 4562.
If you own eligible property, you can use amortization to lower your company’s taxable income and increase your overall bottom line. Don’t miss out on this very valuable expense; identify the intangible property you own, amortize, and then deduct. And if you’re looking for more information on how amortization fits into the overall picture, take a look at our article on how to calculate small business taxes for additional detail.
