How rollovers can run afoul of anti-churning rules for intangibles

Owners of acquired businesses often roll over a portion of their investments into an ownership stake in the purchasing entity. This is a customary practice, but there’s a limitation: if an owner will hold a greater than 20 percent share of the purchasing entity, pre-acquisition due diligence reviews should include a careful examination of intangible assets. In some cases, the ability of the purchasing entity to amortize those intangibles may be limited by the Internal Revenue Code.

What to look for

In order to prevent businesses from claiming deductions for pre-1993 intangibles, legislators established “anti-churning” provisions that prohibit the amortization of certain assets after a sale or reorganization of the business. If a business, individual, or any related party holds or uses an intangible asset that existed prior to August 10, 1993, the law prevents the holder or user from amortizing the asset. The term “related party” covers the typical family relationships one might think of, including parents, grandparents, children, grandchildren, siblings, and spouses. But it also includes relationships between individuals and business entities where a person or entity owns more than 20 percent of a business. For example, if the acquired entity or its owners owns more than 20 percent of the acquiring entity when the transaction is complete, the acquirer is related to the acquired and cannot amortize pre-1993 goodwill.

What to do about it

When a potential problem is discovered prior to the transaction, the buyer should investigate whether the intangibles are subject to the rules.

When a merger or acquisition may result in the owners of the target holding more than a 20 percent stake in the purchasing entity, due diligence should include a consultation with a professional who is familiar with the anti-churning rules. When a potential problem is discovered prior to the transaction, the buyer should investigate whether the intangibles are subject to the rules. Certain intangibles can be excluded from anti-churning if they can be distinguished from goodwill and have ascertainable lives.

If it turns out that anti-churning applies, the parties may take steps to limit the rollover shares to a percentage below the related party test or explore alternative transaction structures to achieve an amortizable basis step-up. If you have any questions, give us a call.