How To Calculate the Amortization of Intangible Assets

Classification and Tax Implications

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Intangible assets are items a company owns but that have no physical form. They can’t be touched, but they can be of substantial value to a small business. They also increase your profit because they can be written off as an expense over a period of years through a process called “amortization.” Intangible assets represent an important item for many businesses, and some could not operate without these assets.

Key Takeaways

  • Intangible assets are assets that don’t have a physical form.
  • Intangible assets include proprietary software, contracts, and franchise agreements.
  • The IRS requires you to amortize intangible assets over 15 years or 180 months.
  • Straight-line depreciation is the usual method used to calculate amortization.

What Are Intangible Assets?

Small businesses own two types of assets. The first type of asset is tangible assets. Tangible assets are items you can touch, such as equipment, inventory, and a company car.

Intangible assets are items that have no physical form, and businesses usually expect them to provide benefits for at least one year. They have value because they will provide businesses with revenue during future time periods. Intangible assets provide a business the right of use. Some examples are goodwill, patents, copyrights, and a customer base.

How Intangibles Are Classified

Intangible assets have either a definite or indefinite useful life. An intangible asset has a definite useful life if there are legal, technological, contractual, or regulatory factors that limit its useful life. An example might be proprietary software a business bought from another business. Its life would be limited because technology would advance over time to improve the software. The asset’s value would decline, or deteriorate, over time. Another example might be a contract or franchise agreement that eventually expires.

Intangible assets with a definite life must be amortized for income tax purposes.

If an intangible asset has economic value to your business over time, without deterioration, then that intangible has an indefinite life. Intangible assets with an indefinite life should not be amortized.

Section 197 of the IRS tax code lists and defines the following assets as intangibles with an indefinite life assuming you created the assets as a substantial part of buying the business.

  1. Goodwill
  2. Going concern value
  3. Workforce in place
  4. Business books, records, computer systems and records, lists of information on current and prospective customers
  5. Patents, copyrights, formulas, designs, and similar items
  6. A customer-based intangible
  7. A supplier-based intangible
  8. Any item similar to items listed in numbers 3-7
  9. A license, permit, or similar rights
  10. A non-compete covenant
  11. Any franchise, trademark, or trade name
  12. A contract for the use of any item on this list

Even though the assets listed above have an indefinite life, you must amortize them over 180 months, or 15 years, and, in general, use the straight-line depreciation technique. IRS Publication 535 has the details about classifying assets for amortization.

You can report your yearly amortization deductions via Part VI of IRS Form 4562.


Amortization vs. Depreciation

Accounting for tangible and intangible assets is different from accounting for normal business operating expenses. This is because tangible and intangible assets are assumed to have useful lives of more than one year.

For your tangible assets, you use the process of depreciation to gradually write off their expenses over a period of time. Depreciation is the reduction in value of a physical asset with the passage of time due primarily to wear and tear. Depreciation can also be defined as the recovery of the cost of property you own over several years.

You’ll use amortization instead of depreciation for intangible assets. Amortization is the process of reducing certain intangible assets in value over time due to a deterioration in their value. Both use the accounting method of straight-line depreciation, for tax purposes, to accomplish their goal.

Determining the Life of Intangible Assets

It is more difficult to determine the useful life of an intangible asset than a tangible asset. For intangible assets with an indefinite life that were acquired rather than created by your business, the amortization period should be 15 years, per the IRS. 

If the intangible assets have a definite life, then you have to determine their useful life for tax purposes. Consider these factors:

  • The asset’s expected use
  • The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate
  • Any legal, regulatory, or contractual provisions that may limit useful life
  • Any legal, regulatory, or contractual provisions that enable renewal or extension of the asset’s legal or contractual life without substantial cost
  • The effects of obsolescence, demand, competition, and other economic factors
  • The level of maintenance expenditure required to obtain the expected future cash flows from the asset

How To Calculate Amortization

The main method of calculating amortization for an intangible asset is the straight-line method. It would be confusing for a company to try to write off the cost of an intangible asset with a definite life in any other way.

Let’s look at an example of the amortization of an intangible asset. A small children’s clothing shop, Kidz Klothes, purchased their business from a shop that was going out of business. Along with the shop came a permit, which was valued at $15,000 when the new business was making the purchase. The new owners have determined that the permit is only valuable for three years after they begin to use it. The permit has no residual value. Here is the amortization table for the permit’s value:

Amortization Expense Recorded Cost Accumulated Amortization Book Value
Year 0 Purchase $ 3,750 $ 15,000 $15,000
Year 1 $ 3,750 $ 15,000 $11,250
Year 2 $ 3,750 $ 15,000 $ 7,500
Year 3 $ 3,750 $ 15,000 $ 3,750

The cost of the permit is divided by four to get the recorded cost based on the accounting conventions. The book value of the asset on the balance sheet is reduced every year by the amount of amortization. The amount of amortization is often meaningless because the estimate of the value of the asset is often no more than a guess.

The revenue-based method is sometimes used for intangible assets, but it cannot be reported to the IRS. The revenue-based method is much more subjective in nature and tries to determine how much and how long an intangible asset generates its own revenue stream.

How To Claim Amortization for Taxes

You’ll report yearly amortization deductions to the IRS in Part VI of Form 4562. Amortization instructions to file business taxes are in Publication 535.

Frequently Asked Questions (FAQs) 

Where do you record the amortization of intangible assets?

The amortization of intangible assets is recorded on the balance sheet by reducing the book value of each asset amortized.

How do you value intangible assets?

It is difficult to value intangible assets because each is unique. You can use a market-based approach, where you determine what a buyer would pay for the asset. A cost-based approach would determine how much it would cost to replace the asset. A revenue-based approach determines how much revenue the asset brings in.