Tax Court allows postpurchase allocation to covenant not to compete.

When dealing with covenant-not-to-compete issues, whether for financial Statement provisions, return preparation or IRS audits, it is important to remember the decision in Ansan Tool & Manufacturing Co., Inc., TC Memo 1992-121. In this case, the IRS disallowed all deductions for amortization of the covenant not to compete and assessed a Sec. 6661 substantial understatement penalty. The Tax Court, however, found that the economic substance of a covenant not to compete allowed an amount allocated to the covenant to be amortized even though there was no specific allocation provided in the purchase agreements.

In order to settle a bitter dispute between the owners of 50% of Ansan Tool and the president and his, wife, who owned the other 50%, Ansan Tool executed a buy-sell agreement with the president and his wife to acquire their interest. No allocation of the consideration paid specifically for the covenant was included in the agreement, but it provided that "Sellers agree to fully comply with the non-competition agreement attached ... and made part of this Agreement."

The president was Ansan's '"rainmaker' in the sense that he attracted and dealt directly with petitioner's customers ... [and] petitioner's management was concerned that ... [he] might accept employment from a rival metal stamping firm and take clients away from petitioner." The former president continued as "a successful businessman and a persuasive and effective salesman" after the purchase, and "management was genuinely concerned that ... [the former president] possessed the ability to do extensive damage to petitioner's business if he were permitted to compete against it."

Despite the fact that no specific allocation to the covenant was contained in the agreement, the Tax Court found that "the specific rules established by ... courts that involve the valuation of covenants for tax purposes supersede the general standard that permits the Commissioner to bind parties to the form of their agreements." Even though the opening language of the agreement read that "[t]he Purchaser Corporation will purchase and Sellers will sell all of the Sellers [sic] shares of stock in Ansan for the price of One Million Eight Hundred Thousand Dollars ($1,800,000)," this language was "sufficiently ambiguous to allow petitioner to present evidence to establish the intent of the parties to the agreement ... [and petitioner] met its burden by producing the requisite evidence to establish that the parties to the buy-sell agreement required a covenant by [the Sellers] to be included in the agreement and that petitioner would pay for this protection."

Both sides presented expert witnesses as to the value of the covenant. The Tax Court rejected the Service's expert's report and testimony as unreliable, since that expert made "unexplained assumptions" throughout his report and there was "no indication that [he] was sufficiently familiar with petitioner's business operation to render an accurate opinion as to petitioner's worth, or the covenant's value."

Ansan presented two expert witnesses. One applied a rather simplistic approach of measuring the compensation given up by the former president during the term of this noncompetition agreement. The second expert measured the present value of the loss of profits that the company would suffer had the former president been allowed to compete. This expert's analysis demonstrated the economic reality of the covenant. The value of the covenant found by the court based on that second expert's report and testimony was greater than the amount originally allocated by the company to the covenant (though the deductions allowed were limited to those claimed on the return, since the company did not claim an overpayment of tax).