A ruling has been upheld by the Court of Appeals for the First Circuit that a covenant not to compete entered into in connection with a stock redemption was an amortizable intangible under Internal Revenue Code §197.

Recovery Group, Inc., was an S corporation that provided consulting and management services to insolvent companies. One of the company founders decided to leave the company and have the company buy out his shares, which represented 23 percent of the outstanding stock.

The company agreed to redeem all the founder’s shares. At the same time, the founder entered into a one-year noncompete agreement. The amount Recovery Group paid for this covenant not to compete was comparable to the founder’s annual compensation.

The company amortized the cost of the covenant as a tax deduction over its 12-month term. The IRS determined that the covenant was a §197 intangible, amortizable by the company over 15 years.

Recovery Group petitioned the Tax Court, arguing that a covenant not to compete entered into in connection with a stock purchase is not a §197 intangible, unless the covenant is entered into in connection with the acquisition of either all or a “substantial portion” of the corporation’s total stock.

The Tax Court ruled in favor of the IRS, concluding that §197’s “substantiality requirement” applies only to asset acquisitions – not to stock acquisitions.

Consequently, a covenant not to compete entered into in connection with the acquisition of any corporate stock, even if not “substantial,” is considered a §197 intangible amortizable over 15 years.

The appeals court ruling in Recovery Group, Inc., et. al. v. Commissioner, 108 AFTR 2d 2011-XXXX, July 26, 2011, upheld the Tax Court decision.

In the appeal, the First Circuit analyzed the legislative history of §197. In particular, the appeals court noted that, in drafting the legislative language of §197, Congress recognized that allowing taxpayers to deduct and amortize covenants not to compete over their usually short lives provided too much incentive for stock buyers to overstate the cost of the covenant and understate the price of the stock.

Congress thus attempted to reduce this incentive by requiring that the covenant be amortized over a 15-year period.

Furthermore, the court noted that the same concerns are present when the purchaser acquires both a substantial and a less-than-substantial portion of a corporation’s stock. That is, the goodwill and going-concern components are still present even when a nonsubstantial portion of stock is transferred.

Accordingly, a buyer who enters into and pays for a covenant not to compete in connection with the acquisition of a nonsubstantial portion of corporate stock generally has the same opportunity to overstate the cost of the covenant and understate the value of the stock.

The court thus concluded that Congress intended that §197 be made applicable to covenants entered into in connection with the acquisition of any shares of corporate stock, regardless of whether they constitute a substantial portion of the corporation’s total stock.

The court noted that the situation is different in the case of asset acquisitions. A transfer of assets that does not constitute a substantial portion of a trade or business presumably does not encompass the transfer of goodwill or going concern and, consequently, does not pose the same difficult valuation issues as a transfer of assets constituting a substantial portion of a trade or business, the value of which presumably includes goodwill and going concern.

This difference explains why, in the view of the court, Congress chose different tax treatments for (1) covenants executed in connection with the acquisition of at least a substantial portion of assets constituting a trade or business, as opposed to (2) covenants executed in connection with the acquisition of less-than-a-substantial portion of assets constituting a trade or business.

Based on its analysis, the appeals court concluded that §197 should be construed as follows:

“The term ‘§197 intangible’ means … any covenant not to compete … entered into in connection with an acquisition … of

• an interest in a trade or business or
• a substantial portion of assets constituting a trade or business.”

Accordingly, the court held that a §197 intangible includes a covenant not to compete entered into in connection with the acquisition of any shares – substantial or not – of stock in a corporation that is engaged in a trade or business.

Based on this line of reasoning, it is irrelevant whether 23 percent of the stock constituted a “substantial portion” of Recovery Group’s stock.