Deducting noncompetition payments in connection with redemptions.

The Sec. 197 proposed regulations issued in January 1997 have raised concerns about deductions relating to a noncompete payment when such payments arise from a redemption. However, careful planning and properly structuring the redemption may actually preserve a deduction that would otherwise be lost.

Sec. 197(d)(1)(E) limits the application of Sec. 197 to situations in which the covenant not to compete was entered into in connection with the acquisition of an interest in a trade or business, regardless of whether stock or assets are acquired. The recently issued proposed regulations offer somewhat conflicting advice on the proper treatment when the payments arise from a redemption. Prop. Regs. Sec. 1.1972(b)(9) suggests such payments would qualify as Sec. 197 intangibles. However, Prop. Regs. Sec. 1.197-2(a)(4) provides that Sec. 197 defers to any other section that would disallow a deduction (other than Sec. 263) and specifically identifies Sec. 162(k), which denies a deduction for costs relating to a redemption (with certain limited exceptions, including interest and ocher related debt acquisition costs).

Sec. 162(k) was enacted as part of the Tax Reform Act of 1986 (TRA). The TRA Conference Committee Report clearly stated that the goal of the legislation was to deny a deduction for costs incurred (regardless of whether incurred by the corporation, a controlling shareholder, a subsidiary or a related party) in a redemption. It was intended to stop the common practice of deducting greenmail payments made to halt hostile takeovers. However, the Senate Committee Report stated that the provision applies to all redemptions, not just hostile situations The Conference Committee Report also stated:"The conferees wish to clarify that, while the phrase 'in connection with [a] redemption' is intended to be construed broadly, the provision is not intended to deny a deduction for otherwise deductible amounts paid in a transaction that has no nexus with the redemption other than being proximate in time or arising out of the same general circumstances." The report went on to suggest that payments made to settle contractual obligations may be outside the scope of the provisions. Any transaction occurring in conjunction with a redemption will certainly be scrutinized; however, the conferees dearly left the door open for properly structured transactions to result in deductions rather than capitalized costs, when it can be established that a fair price is being paid for the stock and for the other contractual agreement. Given the potential for increased scrutiny by the IRS, it is imperative that adequate support and documentation for the values be maintained; the allocation will be respected only if supported by the facts and circumstances.

The monetary value placed on the noncompete agreement is but one of the factors the Service would likely consider in determining the deductibility of payments under Sec. 162(k). A practitioner should not ignore the factors spelled out by the courts prior to enactment of Sec. 197 to determine whether noncompete payments were period costs rather than part of a capital transaction. These factors include (but are not limited to) the payee's age and relative health, his financial condition, whether there has been an expressed interest in competing, whether the payee has retained an interest in the payor, whether the payee has the expertise or ability to compete, and the term over which the payments are to be made.

It does not appear to be necessary to submit Form 8275-R, Regulation Disclosure Statement, when payments under a noncompete agreement are treated as a Sec. 197 intangible, if the agreement arises in conjunction with a redemption. The proposed regulations merely provide that other Code provisions that disallow deductions take priority over the provisions of Sec. 197 Since Sec. 162(k) does not appear to deny a deduction for all noncompete payments proximate in time with a redemption, there is no position contrary to the regulations that must be disclosed.

In summary, current law provides that no deduction will be allowed for the payment of an obligation in connection with a redemption. However, the TRA Committee Reports clearly suggest that a deduction will not be denied merely because a transaction is proximate in time to the redemption. Therefore, it is imperative that a taxpayer build sufficient evidence to support the validity of a noncompete agreement independent of the redemption. This can be accomplished by demonstrating that the noncompete and the stock are fairly valued and the noncompete is rational based on the aforementioned criteria. When the facts support the validity of a noncompete agreement, such payments can be amortized over a 15-year period.

FROM RANDALL W. GUYER, CPA, ELKHART, IND.