In our August 2010 edition (Vol. 5, No. 2), we reported on the Tax Court case Recovery Group, Inc. The taxpayer had redeemed the stock of a 23% shareholder and separately paid him for a one-year covenant not to compete. The taxpayer deducted the cost of the covenant since its benefit was limited to one year. Historically, the cost of a covenant not to compete has been amortized over the term for which it is in force and the taxpayer's deduction would have been appropriate. In 1993, however, Congress enacted IRC Section 197 which provides that if intangible assets, such as a covenant not to compete, are acquired as a part of the acquisition of a trade or business, the intangible assets must be amortized over 15 years regardless of their useful life. The Tax Court held that the redemption of the shares of a corporation that is engaged in a trade or business constitutes the acquisition of a trade or business, so the 15 year rule applies.
The taxpayer appealed the Tax Court's decision to the United States Court of Appeals for the First Circuit. That court agreed with the Tax Court. Both the Tax Court and the First Circuit held that the percentage of the corporation's shares that are acquired in the transaction is not relevant. As long as the corporation is engaged in a trade or business, any covenant not to compete acquired in connection with any acquisition of its stock is subject to the 15 year amortization rule of IRC Section 197. This rule presents a potential trap for taxpayers and their advisors because the result is counter-intuitive. Of course, students of the tax law know all too well that many tax results are counter-intuitive.
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