Expert answer:Code Section – Tax

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Tax Court Memoranda (Archive), Recovery Group, Inc., et al. v.
Commissioner., U.S. Tax Court, CCH Dec. 58,184(M), T.C. Memo. 2010-76,
99 T.C.M. 1324, (Apr. 15, 2010)
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Recovery Group, Inc., et al. v. Commissioner.
U.S. Tax Court, Dkt. Nos. 12430-08; 29314-07; 29321-07; 29326-07; 29333-07; 29335-07; 29336-07; 29385-07,
TC Memo. 2010-76, April 15, 2010.
[Appealable, barring stipulation to the contrary, to CA-1.—CCH.]
SUBSEQUENT DEVELOPMENTS: 2011-2 USTC ¶50,541, (CA-1) aff’d TC.
[ Code Sec. 197]
Amortization: Covenant not to compete: Intangible property.–
The cost of a covenant not to compete entered into between a minority shareholder and an S corporation
upon the complete redemption of the minority shareholder’s stock, representing a 23-percent interest in the
company was a Code Sec. 197 intangible, amortizable over fifteen years. The cost of the anti-competition
covenant could not be amortized over its one-year term. The covenant was entered into in connection with
an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof. The
minority shareholder’s 23-percent interest constituted an interest in a trade or business, even though the interest
represented a partial interest. Furthermore, the corporation failed to demonstrate that the 23-percent interest was
not a substantial interest.—CCH.
[ Code Sec. 6662]
Penalties, civil: Accuracy-related penalty: Substantial understatement: Reliance on tax professionals.–
The accuracy-related penalty under Code Sec. 6662 attributable to a substantial understatement of tax was not
imposed on the S corporation because the taxpayer satisfied the reasonable cause and good faith exception of
Code Sec. 6664(c). Even though the taxpayer’s reliance on case law was misplaced, and the taxpayer did not
adequately disclose the item at issue, the taxpayer’s accountants were competent professionals with sufficient
expertise to justify the taxpayer’s reliance.—CCH.
Peter L. Banis and D. Sean McMahon, for petitioners; Paul V. Colleran, for respondent.
RECOVERY GROUP, INC., ET AL.,
Respondent.
1
Petitioners v. COMMISSIONER OF INTERNAL REVENUE,
Recovery Group, Inc. (RG), an S corporation, redeemed all of the stock held by E, a minority shareholder
and employee. In addition to paying E for his 23-percent interest in the company, RG also paid E
$400,000 to enter into a 1-year covenant not to compete. RG deducted the cost of the covenant not to
compete over its 12-month term. The IRS determined that RG could not immediately deduct the covenant
not to compete and determined built-in gains taxes under I.R.C. sec. 1374 and accuracy-related penalties
for RG under I.R.C. sec. 6662. The disallowed deductions increased the taxable income flowing through
RG to its shareholders, and the IRS also determined deficiencies in the shareholders’ tax.
Held: The cost of the covenant not to compete may not be amortized over its 1-year term; the covenant is
an amortizable I.R.C. sec. 197 intangible and must be amortized over 15 years.
Held, further, RG reasonably relied on competent, fully informed professionals to prepare its tax returns
and thereby satisfies the reasonable cause and good faith exception of I.R.C. sec. 6664(c) and avoids
liability for the accuracy-related penalty.
MEMORANDUM FINDINGS OF FACT AND OPINION
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2
GUSTAFSON, Judge: These cases are before the Court pursuant to section 6213(a)
for redetermination
of deficiencies in tax and penalties for 2002 and 2003, which the Internal Revenue Service (IRS) determined
against Recovery Group, Inc. (Recovery Group), and its shareholders. The determination against Recovery
Group, an S corporation, was made pursuant to section 1374 (see infra note 5) and was as follows:
Deficiencies
Docket
No.
Petitioner
Recovery Group, Inc.
12430-08
Accuracy-Related
Penalties
Sec. 6662
2002
$46,138
2003
$70,011
2002
$9,288
2003
$14,022
The IRS determined the following deficiencies in the Federal income taxes of Recovery Group’s shareholders:
Petitioner(s)
Robert J. & Yvonne M. Glendon
John S. & Mary V. Sumner
Stephen S. Gray & Linda Baron
Michael & Barbara Epstein
Anthony J. Walker & Pamela S.
Mayer
Andre & Helen Laus
Parham Pouladdej
Total
Docket No.
29314-07
29321-07
29326-07
29333-07
2002
$2,599
2,824
20,790
1,970
2003
$2,825
3,071
22,603
-0-
29335-07
29336-07
29385-07
1,695
5,197
10,395
45,470
1,431
4,494
11,301
45,725
All of the disputed deficiencies result from the IRS’s determination that the cost of a covenant not to compete
must be amortized over 15 years. The IRS determined accuracy-related penalties against Recovery Group only;
it determined no penalties against the subchapter S shareholders.
The issues for decision are:
1. Whether Recovery Group may amortize the cost of a covenant not to compete over its 12-month term or
whether it must amortize that cost over 15 years pursuant to section 197(a). We find that the covenant is an
amortizable section 197 intangible, and we sustain respondent’s determination that it must be amortized over 15
years.
2. Whether Recovery Group is liable under section 6662 for accuracy-related penalties on the underpayments
that result from disallowance of the excess deductions it took by amortizing the covenant not to compete over
its 12-month term. We find that because Recovery Group reasonably relied on its accountants to prepare its
returns, it had reasonable cause and acted in good faith in filing its returns and is not liable for the penalties.
FINDINGS OF FACT
The parties do not dispute the facts in these cases that relate to the amortization of the covenant not to compete,
but they do dispute the facts related to the accuracy-related penalty. We incorporate by this reference the
stipulation of facts filed June 24, 2009, and the attached exhibits.
Recovery Group is a “turn-around, crisis-management business” providing consulting and management services
to insolvent companies, together with services as bankruptcy trustee, examiner in bankruptcy cases, and
receiver in Federal and State courts. Recovery Group had its principal place of business in Massachusetts when
it filed its petition in this Court.
3
Employee/Shareholder’s departure
In 2002 James Edgerly, one of Recovery Group’s founders, employees, and minority shareholders, informed
its president, Stephen Gray, that he wished to leave the company and to have his shares bought out and settle
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various debts between himself and the company. Mr. Gray, who is also a founder and shareholder, discussed
the departure with the remaining shareholders and developed a framework for the buyout. He then asked the
company’s accountant, Ron Orleans, to calculate the buyout numbers and tell Mr. Gray how the transaction
should work. Mr. Gray explained to Mr. Edgerly the structure and the financial details of the proposed buyout
agreement. Mr. Edgerly considered the offer and then accepted it.
Mr. Edgerly held 18,625 shares of Recovery Group stock, which represented 23 percent of the outstanding
stock of the company. The agreement between Mr. Edgerly and Recovery Group called for the company to pay
him a total of $805,363.33, in payment of which the company gave him a $205,363.33 check and a $600,000
promissory note payable over three years. The company and Mr. Edgerly itemized the buyout payment as
follows:
Description
Stock purchase price
Noncompetition payment
Company’s debt to stockholder (principal)
Company’s debt to stockholder (interest)
Company’s note payable to stockholder (principal)
Company’s note payable to stockholder (interest)
Shareholder’s debt to company
Total due from company to stockholder
Amount
$255,908
400,000
25,000
2,553
122,177
11,976
(12,250)
805,364
The “Noncompetition payment” was for a “noncompetition and nonsolicitation agreement” that prohibited Mr.
Edgerly from, inter alia, engaging in competitive activities from July 31, 2002, through July 31, 2003; and the
$400,000 that Recovery Group paid for the covenant was comparable to Mr. Edgerly’s annual earnings.
Mr. Orleans, Recovery Group’s accountant, was involved with the buyout throughout. As is noted above, he
calculated the buyout amounts. Mr. Gray, Recovery Group’s president, did not discuss the tax implications of
the buyout with Mr. Orleans when he asked him to compute the numbers. When Recovery Group executed the
buyout, Mr. Gray did not consider the tax ramifications of the deal; but he understood that some portion of the
buyout payment was tax deductible while the remainder was not. Deductibility was not a consideration in his
structuring the deal; rather, he assumed that the tax results would be what the accountants determined.
Recovery Group’s accountants
Mr. Orleans began practicing as an accountant in 1973 and has been a certified public accountant (C.P.A.) since
1976. At his accounting firm—Kanter, Troy, Orleans & Wexler, LLP—Mr. Orleans was the relationship partner
assigned to Recovery Group. He was responsible for overseeing Recovery Group’s accounting operations and
managing the preparation of Recovery Group’s financial statements and tax returns. Mr. Orleans worked with
Donald Troy, a tax specialist at his firm. Mr. Troy was licensed as a C.P.A. in 1986, and he held a bachelor’s
degree in accountancy and a master’s degree in taxation. During the years in issue, Mr. Troy was the accounting
firm’s tax director.
Preparing Recovery Group’s returns
Mr. Orleans relied upon Mr. Troy to make the technical decisions on how Recovery Group’s tax returns should
be prepared, and Recovery Group relied upon the accountants to make these decisions correctly.
When considering how to report Recovery Group’s expense for the covenant not to compete on its tax returns,
Mr. Troy consulted case law, together with the statutory language, regulations, and legislative history of section
197. He concluded that the covenant not to compete was not a section 197 intangible and thus was exempt
from that section’s 15-year amortization period. Accordingly, he prepared Recovery Group’s returns to amortize
the covenant not to compete ratably over its 12-month term. Since that 12-month term straddled the two years
2002 and 2003, he allocated the $400,000 between those two years (rather than over the 15 years 2002 through
2016)—i.e., roughly five-twelfths of the total ($166,663) in 2002 and the remainder, approximately seven-twelfths
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($233,337), in 2003. Those amounts constituted less than 2 percent of Recovery Group’s deductions reported on
the returns for those years.
4
Approving Recovery Group’s returns
Each year, Mr. Orleans presented the tax return for Recovery Group to Mr. Gray. Mr. Gray held brief discussions
with Mr. Orleans during those meetings, but he did not ask specific questions or closely review the returns
prepared by the company’s accountants. Rather, he asked Mr. Orleans whether the returns represented what
the company had to file, and he accepted Mr. Orleans’s representations that they did. Mr. Gray did not discuss
tax issues with Mr. Troy or specifically approve tax decisions he made, nor did he question Mr. Orleans about
the positions taken in the returns or seek a second opinion on his accountants’ work. Rather, because Mr. Gray’s
expertise is in business areas other than accounting and taxes, he left accounting and tax decisions to the
professionals at the accounting firm that the company had hired. Mr. Gray did not review or inquire into the tax
treatment of the covenant not to compete, which was reflected on pages 19 and 27 of the 50-page 2002 return
and on pages 18 and 26 of the 55-page 2003 return.
Mr. Orleans signed the returns as the preparer, and Mr. Gray signed them as Recovery Group’s president.
Recovery Group timely filed its returns for the years in issue.
Notices of deficiency
The IRS determined that the covenant not to compete was an amortizable section 197 intangible, amortizable
over 15 years beginning with the month of acquisition. Consequently, the IRS partially disallowed Recovery
Group’s deductions for the cost of the covenant not to compete, allowing amortization deductions of only $11,111
for 2002 and $26,667 for 2003, and disallowing $155,552 for 2002 and $206,667 for 2003.
determined accuracy-related penalties against Recovery Group for 2002 and 2003.
5
The IRS also
The disallowance of most of the deductions claimed for the covenant for each year increased Recovery Group’s
income for each year and hence each shareholder’s share of Recovery Group’s income. In notices of deficiency
issued in October and November 2007 to the shareholders, the IRS determined deficiencies for the shareholders
accordingly. The shareholders’ deficiencies all turn on the appropriate treatment of the covenant not to compete,
and they require no separate analysis.
The IRS issued a notice of deficiency to Recovery Group in March 2008. The shareholders and Recovery Group
all timely filed petitions in this Court.
OPINION
As a general rule, the IRS’s determinations are presumed correct, and the taxpayer has the burden of
establishing that the determinations in the notice of deficiency are erroneous. Rule 142(a); Welch v. Helvering [ 3
USTC ¶1164], 290 U.S. 111, 115 (1933). Similarly, the taxpayer bears the burden of proving he is entitled to any
disallowed deductions that would reduce his deficiency. INDOPCO, Inc. v. Commissioner [ 92-1 USTC ¶50,113],
6
503 U.S. 79, 84 (1992).
With respect to a taxpayer’s liability for penalties, section 7491(c) places the burden
of production on the Commissioner.
I. Covenant not to compete
The principal issue in these cases is whether the covenant not to compete that Recovery Group and its departing
23-percent shareholder entered into was, for purposes of section 197(d)(1)(E), “entered into in connection with
an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof”. Recovery
Group contends that the 23-percent interest it acquired by redemption was not a substantial interest and is
therefore outside the reach of section 197. In support of its argument, Recovery Group cites Frontier Chevrolet
Co. v. Commissioner [ Dec. 54,336], 116 T.C. 289, 294-295 (2001), affd. [ 2003-1 USTC ¶50,490], 329 F.3d
1131 (9th Cir. 2003), which held that a redemption of 75 percent of a corporation’s stock qualified as the indirect
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acquisition of an interest in a trade or business for purposes of section 197; and Recovery Group urges that its
23-percent acquisition is not on a par with the obviously substantial 75-percent acquisition in Frontier. To resolve
this issue, we consider first the nature of a covenant not to compete and then the provisions of section 197.
A. Intangible assets
The residual goodwill of a business is an intangible asset that is deemed to have an unlimited useful life, so that
it cannot be amortized by the business that developed that goodwill. Houston Chronicle Publg. Co. v. United
States [ 73-2 USTC ¶9537], 481 F.2d 1240, 1247 (5th Cir. 1973); sec. 1.167(a)-3(a), Income Tax Regs. (26
C.F.R.). Rather, that component of value remains with a business until the business ceases or is disposed of;
and until then no tax benefit is obtained from the expense of developing the goodwill or for the value that is
allocated to that intangible. However, an intangible asset that can be valued distinctly and that has a measurable
useful life is distinguishable from residual goodwill and may be amortized over its useful life. See Newark
Morning Ledger Co. v. United States [ 93-1 USTC ¶50,228], 507 U.S. 546, 566 (1993).
One such intangible is a covenant not to compete (or a “noncompetition covenant”), which is a “promise,
usu[ally] in a sale-of-business, partnership, or employment contract, not to engage in the same type of business
for a stated time in the same market as the buyer, partner, or employer.” Blacks’s Law Dictionary 420 (9th
ed. 2009). Someone purchasing a business or buying out a departing shareholder-employee’s share of a
business may benefit from the seller’s assurance that he will not thereafter undermine the business by using
his status in and familiarity with the business—that is, his assurance that he will not carry out with him, when
he leaves, the intangible assets of the business (such as know-how, or customer relationships, or the identities
of suppliers). Thus, a covenant not to compete may have real and important value. See Annabelle Candy Co.
v. Commissioner [ 63-1 USTC ¶9146], 314 F.2d 1, 7-8 (9th Cir. 1962), affg. [ Dec. 24,889(M)], T.C. Memo.
1961-170.
A covenant not to compete is an intangible asset that, unlike goodwill, does have a limited useful life, defined
in the terms of the covenant; and the cost of obtaining such a covenant is, therefore, amortizable ratably over
the life of the covenant, apart from the statute at issue in these cases ( section 197). Warsaw Photographic
Associates, Inc. v. Commissioner [ Dec. 41,822], 84 T.C. 21, 48 (1985); O’Dell & Co. v. Commissioner [ Dec.
32,414], 61 T.C. 461, 467 (1974). See generally sec. 1.167(a)-3, Income Tax Regs.
However, intangible assets in general—and covenants not to compete in particular—do present opportunities
for distortion and abuse in reporting one’s tax liability. While the cost of purchasing a shareholder’s stock is a
capital expenditure that does not yield any tax benefit until the stock is disposed of, the cost of a covenant not
to compete will be promptly amortized over its life (again, apart from section 197). This dynamic creates a taxmotivated incentive for a buyer to prefer that the money changing hands in a buyout transaction be characterized
as paid for a covenant rather than for shares of stock.
7
B. Enactment of section 197
In the Omnibus Budget Reconciliation Act of 1993 (OBRA), Pub. L. 103-66, sec. 13261, 107 Stat. 532, Congress
enacted section 197 to simplify the law regarding the amortization of intangibles. H. Rept. 103-111, at 777
(1993), 1993-3 C.B. 167, 353. In an attempt to eliminate controversy between taxpayers and the IRS regarding
the tax treatment of the cost of acquiring an intangible asset, Congress established a fixed period for ratably
amortizing that cost—recognizing that some of the intangibles so amortized will have useful lives longer than that
period, and some will have useful lives shorter than that period. Id. at 760, 1993-3 C.B. at 336.
Congress excluded self-created intangibles from section 197 (unless they were created in connection with a
transaction involving the acquisition of a trade or business or a substantial portion thereof), id., and Congress
specifically included certain covenants not to compete as “amortizable section 197 intangibles”. Prior law had
allowed taxpayers to amortize those covenants under section 167 over the life of the covenant. Id. New section
197(a), however, required amortization over 15 years—a requirement applicable to covenants not to compete
that are described in subsection (d)(1)(E).
C. Statutory language
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Section 197 provides, in pertinent part:
SEC. 197. AMORTI …
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