Noncompete agreement entered into contemporaneously with stock redemption.

Under proposed Sec. 197 regulations, the IRS surprised tax practitioners in its treatment of a covenant not to compete entered into between a corporation and a shareholder on the corporation's redemption of the shareholder's stock. The proposed regulations treat the noncompete agreement as an amortizable Sec. 197 intangible, but generally disallow a deduction under Sec. 162(k).

Background

Sec. 197, enacted as part of the Revenue Reconciliation Act of 1993 (RRA), includes in the definition of a"section 197 intangible" amortizable over 15 years "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." (Emphasis added.) The Conference Report to the RRA provides that, in the case of a covenant not to compete, "an interest in a trade or business includes not only the assets of a trade or business, but also stock in a corporation that is engaged in a trade or business or an interest in a partnership that is engaged in a trade or business."

There is no indication in Sec. 197's legislative history whether a noncompetition agreement entered into between a corporation and a shareholder, whose stock is redeemed by the corporation, was intended to constitute a Sec. 197 intangible. The legislative history is clear that, to determine whether a noncompetition agreement is a Sec. 197 intangible, an interest in a trade or business includes stock in a corporation. However, a stock redemption normally is not thought of as an acquisition by the redeeming corporation of an interest in itself. Nor does the legislative purpose of Sec. 197 (which, generally, is to eliminate controversies over whether a purchaser of a business or an interest therein acquired an amortizable intangible asset or unamortizable goodwill) assist in this determination. This issue, in connection with covenants not to compete, was intended to remain, as indicated by the following language in the RRA Conference Report:

As under present law, to the extent that the amount paid or incurred under a covenant not to compete (or other similar arrangement) represents additional consideration for the acquisition of stock in a corporation, such amount is not to be taken into account under this provision but, instead, is to be included as part of the acquirer's basis in the stock.

There is also no indication in Sec. 197's legislative history that amortization of an intangible asset, included within the definition of a Sec. 197 intangible amortizable over 15 years, could otherwise be disallowed.

Proposed Sec. 197 Regulations

Prop. Regs. Sec. 1.197-2(b)(9) provides that, with respect to covenants not to compete and other similar arrangements, an acquisition of an interest in a trade or business "may be made in the form of. . . a stock acquisition or redemption...." (Emphasis added.) Accordingly, under the proposed regulations, a noncompete agreement entered into in connection with a stock redemption is a Sec. 197 intangible. Although this position is not in accord with the view expressed by several professional tax groups and corporate tax practitioners in letters and comments submitted to the IRS before the regulations were proposed, it did not come as a surprise.