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November 15, 2010

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Covenant Not To Compete: Section 197 Intangible
By Kevin T. Eagan

 

In a recent case, the Tax Court discussed the deductibility of payments made in exchange for a covenant not to compete in connection with the redemption of a minority shareholder’s stock.  Specifically, the Court stated that the payment must be capitalized and amortized over 15 years, regardless of the length of the covenant agreement.  This article will provide a brief description of the current laws, as well as a discussion of the court case, and its possible implications for taxpayers.

When redeeming the stock of one of its shareholders, it is very common for a corporation to include a covenant not to compete as part of the transaction.  The covenant generally prevents the shareholder from engaging in the same business and in the same market as the corporation for a certain period of time.  

Prior to August 11th, 1993, covenants not to compete were deductible over the period of time to which the covenant applied.  However, since that date, such agreements are subject to the rules of Section 197 provided they were entered into in connection with an acquisition of an interest in a trade or business, or a substantial portion thereof.  In general, IRC Section 197 provides that the adjusted tax basis of an applicable Section 197 intangible should be amortized over 15 years. 

Discussion of the Court Case

In the case of Recovery Group v. Commissioner, TC Memo 2010-76 (4/15/10), the taxpayer redeemed the stock of a 23% shareholder.  The redemption included a payment to the shareholder to enter into a covenant not to compete for one year.  Recovery Group argued that the 23% interest was not a substantial portion of their trade or business, and therefore, was not subject to Section 197.  Accordingly, the company deducted the payment over the one year term of the agreement.  The IRS argued that the percent interest was irrelevant in the determination of whether the covenant fell under Section 197, and the payment should be amortized over 15 years. 

Not only did the Tax Court agree with the IRS that the percent ownership was irrelevant, it also determined that even if it was relevant, the 23% interest would have been considered substantial anyway.  The Court explained that the only time the “substantial portion” language should be considered is in the case of an asset acquisition.  When transferring a stock ownership interest, a covenant not to compete is a Section 197 intangible regardless of the percent ownership in the trade or business. 

There is an important lesson to be learned within the Recovery Group case.  That is that a stock redemption transaction which includes a covenant not to compete may be deemed to be “entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or a substantial portion thereof” and be considered a Section 197 intangible and amortizable over 15 years.  Ownership percentage will not be deemed a relevant factor in Section 197 classification in such a situation.   Redemptions of minority shareholders will need to be carefully analyzed in light of the IRS and Tax Court position on this case.

All relevant facts must be considered on a case by case basis and we suggest you consult your Marcum LLP tax advisor for a further determination.

 

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