• One Year Covenant Not to Compete Must be Amortized over Fifteen Years
  • August 24, 2010
  • Law Firm: Loeb Loeb LLP - Los Angeles Office
  • A recent Tax Court case points out a problem with the statutory provisions that govern the amortization of intangible assets. IRC Section 197 was enacted in 1993 to clarify the treatment of intangible assets. Prior to that time, goodwill purchased in connection with the acquisition of a business could not be amortized or deducted for tax purposes. However, taxpayers had made significant inroads in chipping away at this rule by characterizing goodwill as something else, like customer lists or the core deposit base of a commercial bank. If someone agreed to a covenant not to compete in connection with the sale of his interest in a business, the buyer amortized the amount paid for the covenant over its term -- a logical result.

    When it enacted Section 197 in 1993, Congress swept many types of intangible assets into its arena. Any kind of intangible asset covered by Section 197 is amortized on a straight line basis over 15 years. Section 197 covers covenants not to compete that are entered into in connection with an acquisition of an interest in a trade or business or substantial portion thereof.

    This background laid the groundwork for a most unfortunate tax result in Recovery Group v. Commissioner (April, 2010). A founding employee of a company called Recovery Group who owned 23% of the stock decided he wanted to leave the company. A buyout was structured that included a payment of $400,000 in consideration of his agreement not to compete with the company for a period of one year. The company deducted the payment over the 12 month period in which it was made, which encompassed two different tax years. The IRS took the position that the agreement not to compete was covered by Section 197 and had to be amortized over 15 years even though it was only for a term of one year.

    In the Tax Court, the taxpayer’s argument for the non-application of Section 197 was that the 23% interest in the business which it bought back in the transaction was not a “substantial” interest in a business so Section 197 was inapplicable. The court did not believe that the taxpayer read the statute correctly. Section 197 applies if the covenant not to compete was given “in connection with the acquisition of an interest in a trade or business, or a substantial portion thereof.” The court said the “substantial portion” modifies “trade or business” not “interest.” In the court’s view, the term “substantial portion” is limited to transactions structured as asset acquisitions. If you buy the assets of a business, you must acquire a substantial portion of the assets. On the other hand, if the business is operated by an entity, the acquisition of any level of interest in the entity owning the trade or business is sufficient.

    The result was that even though the restriction only applied for one year, the taxpayer had to amortize the $400,000 it paid over 15 years. This was clearly a terrible tax result. This taxpayer would have had a better chance of deducting his payment over 12 months if he had been able to structure the arrangement as a one year consulting arrangement which prohibited the employee from competing during the term of his consulting contract. The regulations provide that an employment arrangement is not subject to treatment as a covenant not to compete under Section 197 if the amount paid is reasonable for the services rendered.