The First Circuit Court of Appeals, affirming the Tax Court, held that a covenant not to compete must be amortized over 15 years rather than its one-year term.
Recovery Group Inc. was an S corporation that provided services to insolvent companies. To buy out the interest of one of its founders, Recovery redeemed all of his stock, which represented 23% of all the corporation’s stock. The buyout agreement included a noncompete covenant. Recovery amortized the covenant over its life of 12 months. The IRS determined that the covenant was an IRC § 197 intangible and therefore amortizable by Recovery over 15 years. Recovery petitioned the Tax Court.
Section 197(d)(1)(E) specifies that a section 197 intangible includes “any covenant not to compete (or other arrangement to the extent such arrangement has substantially the same effect as a covenant not to compete) entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof.”
Recovery argued that “interest in a trade or business” means a 100% ownership interest and that “thereof” modifies “interest in a trade or business,” so that 15-year amortization would apply only to acquisition of a “substantial portion” of a trade or business. The IRS argued that “thereof” modifies “trade or business,” so that 15-year amortization would apply to the acquisition of any interest in a trade or business. The Tax Court sided with the IRS and held that the covenant must be amortized over 15 years.
The First Circuit rejected Recovery’s argument that section 197(d)(1)(E) applies only to stock acquisitions considered substantial. It said the legislative history indicates that Congress was trying to prevent taxpayers from taking a quick deduction of part of the costs of stock acquisitions by understating the value of stock and overvaluing covenants not to compete. Thus, Congress required covenants related to stock acquisitions to be included in the definition of section 197 intangibles and intended for the provision to be applied to acquisitions of any shares of corporate stock, not just 100% acquisitions, the court said.
Consequently, the First Circuit concluded that section 197(d)(1)(E) applies to a covenant acquired as a result of the redemption of 23% of the company’s stock.
By Laura Jean Kreissl, Ph.D., assistant professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.