Purchases of stock and a covenant not to compete: a trap for the unwary.

A recent Tax Court Memorandum decision highlights a trap for unwary investors wishing to acquire a corporation and secure a covenant not to compete from the seller. In Miller, TC Memo 1993-55, Purchaser purchased all of the outstanding stock of a heating oil company (Target) for $105,000, under an agreement that included a noncompetition clause. The parties to the agreement allocated $35,000 of the purchase price to the noncompetition clause. Because the clause prohibited the seller from competing for a five-year period, Purchaser amortized the cost of the covenant over that period, taking a $7,000 annual deduction on her personal income tax return for five years.

The Tax Court upheld the Service's disallowance of the deduction on the ground that Target, and not Purchaser, was the true beneficiary of the clause. That conclusion is consistent with earlier cases, such as Markwardt, 64 TC 989 (1975) (breach of seller's oral promise not to compete harms corporation and does not give rise to shareholder deduction). The court likened the payment for the noncompetition agreement to a deemed contribution to capital. In essence, Purchaser paid $70,000 ($105,000 less $35,000) for the Target stock and $35,000 for the covenant. Purchaser then contributed the covenant to capital of Target. On Purchaser's deemed contribution of the covenant to Target's capital, Purchaser's basis in the Target stock would increase from $70,000 to $105,000. Viewed in that way, Target would be entitled to amortize the $35,000 cost of the covenant and Purchaser would have a nonamortizable $105,000 basis in Target stock.

Ignoring state tax consequences, this result might be of little concern for corporate purchasers filing consolidated returns. But, if, as in Miller, the purchaser is an individual, the disallowance is significant, particularly because with a minimum of planning it can be avoided. Rather than agreeing to purchase the stock for the full $105,000, the taxpayer could have agreed to pay $70,000 for the stock and also to make a loan to Target of the $35,000 necessary to secure the covenant not to compete. Target could then purchase the covenant with the borrowed funds. The taxpayer's total investment would have been the same ($105,000), but she would have been able to recoup her investment in the covenant as the corporation repaid the loan. With the covenant treated as a deemed contribution to capital, the taxpayer not only loses the deduction, but is unable to recoup her investment, other than in the form of a taxable dividend.

Another issue (which was not addressed by the court) is that nearly 35% of the purchase price was allocated to the covenant. The IRS stipulated that this allocation was acceptable.