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Tax Valuation

Intangible Assets

Owners, Assessors Face Off

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By Charles E. Gilliland

A new and potentially potent issue is emerging as an
arena of confrontation between property taxpayers
and assessment officials. The controversy centers on
real estate valuation and the intangible personal
property exemption.

pecifically, some business owners have real-
ized that a portion of their apparent real
estate value may result from intangible

assets like goodwill. In Texas, these intangible assets should be excluded from tax assessments. Faced with the prospect of a dwindling tax base and consequently higher tax burdens on the remaining taxpayers, assessment officials have disputed some of these claimed exemptions. Reviewing the concepts of value and the property tax system's exemption provisions sheds light on this controversy.

Property taxes exact a proportion of taxable property value for government each year. At its inception in an agrarian age, values changed slowly, and most property was held as real estate. Personal property included livestock, household furniture, some equipment and valuable personal effects, such as watches. Assessors and property owners paid little attention to noncorporeal property because few intangible assets existed.

As society and the economy evolved, more wealth became invested in nonphysical assets and intangibles assumed greater importance. In addition to the usual tangible items, individuals began to acquire stocks, bonds, bank accounts and other nonphysical properties. However, discovering and listing such wealth was extremely difficult, if not impossible. Furthermore, establishing the market-tested value for many of those items was a nettlesome problem. As a result, much of this kind of taxable property went untaxed. This dilemma led many states, including Texas, to formally exempt intangibles from the annual property tax levy.

Because property tax rates had been relatively low, Texas taxpayers initially took little note of the intangibles exemption. As effective tax rates have risen, however, owners of unique and complex properties have begun to search for ways to limit overall tax liability. Identifying and eliminating taxes on intangible assets may provide a legal and effective method of cutting property taxes. Attempts to identify intangible value promises to emerge as an

area of controversy in property taxation for some time to come.

Intangibles in Property Taxation

The Texas Property Tax Code defines intangible personal property as

a claim, interest (other than an interest in tangible property), right, or other thing that has value but cannot be seen, felt, weighed, measured, or otherwise perceived by the senses, although its existence may be evidenced by a document. It includes a stock, bond, note or account receivable, franchise, license or permit, demand or time deposit, certificate of deposit, share account, share certificate account, share deposit account, insurance policy, annuity, pension, cause of action, contract, and goodwill. At first, this catalog of exempted items appears to be clear-cut, but reflection reveals potential gray areas. For example, when an operating business sells, how much of the purchase price results from the physical real estate and how much accrues to "goodwill?" Once the question of business operation becomes an issue, the seemingly clear-cut distinction between intangible assets and real estate and tangible assets blurs.

onsider the example of bare farmland. The founder of a well-known agricultural service was fond of saying that "there is more in the man than there is in the land." This assertion recognizes that a superior farmer achieves exceptional results through management skills. The capitalized value of income from such an individual's farming operation would exceed the market value of tangible assets used in the operation. However, an active market for these assets limits land and equipment values. The "extra" value in the farming enterprise accrues to the farmer. That extra value reflects the skill of the farmer and is an intangible asset. Because a competitive market provides independent evidence of value of the tangible assets, this kind of intangible

asset is rarely the subject of controversy in property

taxation.

Complications proliferate when the subject enterprise has a unique characteristic. For example, a franchised hamburger restaurant has exclusive use of the brand name for product plus the advantages conferred by the management system, national advertising campaign, and purchasing power of the franchising organization. Clearly, these advantages confer value on the restaurant enterprise in excess of the value of the building, land and equipment. Basing value on the income stream to such a property risks attributing some of that exempt intangible value to the tangible assets.

Intangibles encompass a wide variety of the business facets that permit recogni. of the enterprise as a functioning entity. Prominent among the intangible items are franchises that create an identity for a business and provide instant credibility. Affiliation with a nationally franchised hotel communicates an expected set of goods and services enticing the public to patronize those establishments authorized to use that name to the neglect of locally owned hostelries of equal quality. Payments made by the hotel to the franchiser provide one indicator of the value implied by the franchise; however, the value of the franchise to the enterprise must exceed the discounted value of these payments in all but the marginal hotel. Otherwise, the hotel owner would be indifferent between maintaining the franchise or letting it lapse. Thus, the capitalized value of franchise payments represents a minimum value for that franchise. However, attempting to establish a defensible estimate of the value of the franchise to the operating enterprise leads to complicated and legally unresolved issues in Texas. The picture becomes even more murky when such nebulous items as goodwill, an assembled workforce and other such assets exert a substantive influence on business value.

Accounting concepts provide some guidance in dealing with these difficult issues by classifying intangibles according to their attributes. Accountants differentiate between intangibles that can be identified or separated and sold independently from the business and those inextricably joined to the going concern. Franchises, patents, copyrights, licenses and even trademarks have the potential of being separated from the business and sold. In essence, these items have achieved status as a distinct asset.

An assembled workforce, established sources of supply and goodwill, however, are examples of assets that cannot be disposed separately from the business. This kind of asset is nonidentifiable and the subject of much dispute in the debate on taxation of intangible assets. In fact, some theorists and property tax administrators dispute the idea that nonidentifiable intangibles deserve recognition as separate assets. They argue that any value generated by those assets is similar to the influence of a spectacular view on land values. It has become an intrinsic part of the operating property and should not be separated. Like the spectacular view, the nonidentifiable intangibles have essentially become part of the real estate. Texas courts have not ruled on these issues.

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Adding complexity to this situation, valuation of intangibles is a vexing problem in itself. To the extent that they could be purchased and sold, identifiable assets present the possibility of direct market valuation. However, the character of nonidentifiable assets preclude the possibility of direct market valuation and require allocation of the value of the entire enterprise to its various assets. Identifiable intangible assets with clearly recognized influences on business income can be valued using traditional cost, sales comparison or income approach techniques. For example, a patent promising to provide measurable returns to a business for a specified period could be sold to another business. An appraiser could estimate the value of that patent by totaling the cost of developing the technology plus legal costs incurred in enforcing the patent less the portion of patent costs already realized.

Cost does not always equal value. Therefore, if similar patents are routinely exchanged in the market, application of the sales comparison approach strongly indicate market value. Such sales are frequently private, however, limiting the information available to appraisers and making sales comparison applications unlikely for estimating the value of intangibles. Finally, the patent's effect on income to the enterprise could be identified and capitalized. Although complicated in the details of application, valuation of identifiable intangible assets can be a straightforward extension of familiar appraisal techniques.

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'onidentifiable intangibles present an entirely different and much more difficult appraisal problem. By definition, these assets have no value apart from the ongoing business. They are inextricably wrapped in going concern value, and valuation must be accomplished indirectly. In essence, the value must be extracted from the business enterprise value. In other words, the enterprise is appraised and values of tangible and identifiable intangible assets are then removed from that unit value. Presumably, the remaining value represents value accruing to nonidentifiable intangible assets. As a practical matter, valuation questions involving intangibles and property taxes probably will involve the income approach to the exclusion of the cost and sales comparison approaches.

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