Covenants not to compete.

For legitimate business purposes and occasionally to modify the taxation of a business sale, taxpayers--over time--have used covenants not to compete. Under current law, these covenants may be covered by IRC section 197. Recently the Tax Court considered the application of section 197 to a stock redemption including a covenant not to compete.

Frontier Chevrolet sells and services new and used cars. Roundtree Automotive Group buys and operates auto dealerships. In 1987 Roundtree purchased all of Frontier's stock. Dennis Menholt, an employee/manager of Frontier, was permitted to buy Frontier stock. As of August 1, 1994, Roundtree owned 75% and Menholt 25%. On that date Frontier redeemed all of the remaining stock Roundtree owned for $3.5 million. At the time of the redemption, Roundtree and Frank Stinson, who worked for Roundtree, signed a covenant not to compete. The agreement required Frontier to pay Stinson $22,000 a month for 60 months. Initially, Frontier treated the covenant as a section 197 asset and amortized it over 15 years. In 1999, however, it filed a refund claim, arguing the covenant should be amortized over the 60-month life of the contract. The IRS denied the claim and Frontier sued.

Result. For the IRS. Section 197 provides for the amortization of intangible assets over a 15-year period. Included in the covered intangibles is a covenant not to compete that a taxpayer enters into in connection with the direct or indirect acquisition of a trade or business.

Frontier argued the transaction was not covered by section 197 because it was a stock redemption--not a purchase from an outsider--and it was not a business acquisition because the corporation engaged in the same activities after the redemption as before.

The Tax Court rejected Frontier's arguments. The definition of acquisition is gaining control. Since this transaction included the purchase (redemption) of 75% of the corporation's stock, it involved acquisition of control. (Treasury regulations section 1.197-2(b)(9), effective after the date of this transaction, says an acquisition can take the form of a purchase of assets, stock or the redemption of stock or a partnership interest.)

The court rejected the second part of the taxpayer's argument because the legislative history of section 197 does not indicate it was intended to apply only to new business acquisitions. Therefore, this transaction was an acquisition of a trade or business, and the covenant not to compete was a section 197 asset. The amortization, thus, should be over 15 years rather than over the life of the payments.

In the future, taxpayers should remember this expansive definition of acquisition of a business when agreeing to a covenant not to compete.

* Frontier Chevrolet Co. v. Commissioner, 116 TC no. 23.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.