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Deduction for covenant not to compete allowed after accounting firm break-up.

Accountant H worked for the firm of DPH.H owned 10% of DPH's outstanding stock; P, DPH's president and general manager, owned the other 90%.

In 1992, H and P developed differences in opinions as to how DPH should be managed. As a result, H wanted to leave the firm. However, H and P could not agree on the treatment of H's DPH clients.

After a year of negotiations, H and P signed an agreement under which H agreed to pay DPH in return for the firm turning over 180 clients to H's new corporation (HA). The name of DPH was changed to DP, and H received additional DP stock. H's DP stock was then redeemed and the former clients were transferred to H. DP and P individually agreed not to solicit any of the transferred clients for 36 months, and DP and P agreed to provide limited "transitional" consulting services to H and HA.

On its 1993-1995 returns, HA amortized the portion of the payment attributable to the covenant not to compete as an ordinary and necessary business expense and deduction, and deducted the amount related to the consulting services.

The IRS disallowed these deductions. In a memorandum decision, the Tax Court (opinion Swift, J.) allowed the deduction for the costs related to the covenant not to compete but denied the deduction for the consulting services costs.

Covenant Not to Compete

Under Sec. 162(a), a taxpayer may deduct all ordinary and necessary expenses incurred in carrying on a trade or business. Generally, amounts paid for covenants not to compete are amortized over the life of the covenants as current business expenses. Amounts paid, however, for goodwill or for a business's going concern value generally are treated as nondeductible capital expenditures.

To be respected for Federal income tax purposes, covenants not to compete should reflect economic reality.

The division between H and P was acrimonious and strained, and we are satisfied that P could have made a strong effort to compete for the 180 clients transferred to H. P was an experienced and successful accountant who, after the division, was the president and sole shareholder of DP. The covenant not to compete to which P and DP agreed, and for which H paid $190,000, reflects economic substance, and the $190,000 represented a reasonable amount for the covenant. Based on prior years, the clients protected by the covenant represented approximately $600,000 in annual gross receipts. The $190,000 for the three-year covenant not to compete is properly amortizable as an ordinary and necessary business expense.

Consulting Services

H contends that the amount paid for the right to receive consulting services from P and DP was necessary to aid in the division of the accounting practice.

The IRS contends that (1) P and DP provided little, if any, consulting services, (2) H did not satisfy the burden of establishing a need for the services and (3) P's and DP's (or its predecessor, DPH's) services occurred before the division and therefore HA cannot deduct them as startup expenditures. We agree with the Service. H was an experienced accountant and had good relationships with the clients. The credible evidence does not establish the need for any such services.

Further, any payment that H made to P and DPH for consulting services before the division of DPH is not a deductible startup expenditure of H's individual accounting practice or of HA's accounting practice; see Sec. 195.

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Article Details
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Author:Fiore, Nicholas J.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Aug 1, 2000
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