Expert answer:tax accounting
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Standard Federal Tax Reporter (2003), Frontier Chevrolet Company,
Petitioner v. Commissioner of Internal Revenue, Respondent., U.S. Court
of Appeals, Ninth Circuit, 2003-1 U.S.T.C. ¶50,490, (May 28, 2003)
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Frontier Chevrolet Company, Petitioner v. Commissioner of Internal Revenue, Respondent.
U.S. Court of Appeals, 9th Circuit; 01-71815, 329 F3d 1131, May 28, 2003.
Affirming a Tax Court decision, Dec. 54,336, 116 TC 289.
[Code Sec. 197]
Deductions: Amortization deduction for intangibles: Covenant not to compete: Section 197 intangible
defined.–
The Ninth Circuit affirmed the Tax Court’s holding that a covenant not to compete, entered into concurrently
with the redemption of 75 percent of its outstanding stock by a taxpayer engaged in the business of selling
and servicing vehicles, was a Code Sec. 197 intangible subject to amortization over a 15 year period. The
redemption was held to be an acquisition of an interest in a trade or business within the meaning of Code Sec.
197. The taxpayer had previously sold all of its stock to a corporation that purchased and operated automobile
dealerships. The noncompete agreement prohibited the company from competing with the taxpayer for five
years. As consideration for the agreement, the taxpayer agreed to make monthly payments over the course
of 60 months in addition to the consideration paid to redeem the outstanding shares of stock. The taxpayer
amortized the noncompetition payments over 15 years but subsequently filed a claim for refund on the basis
that the noncompete payments should be amortized over the 60-month life of the agreement. The taxpayer
argued that it did not acquire an interest in a trade or business because it was engaged in the exact same trade
or business and acquired no other new assets; therefore, the covenant not to compete was not a Code Sec. 197
intangible. The legislative history of Code Sec. 197 provides that an acquisition of stock that is not treated as an
asset acquisition is treated as an indirect acquisition of a trade or business. Thus, when the taxpayer executed
the stock sale agreement, it indirectly acquired an interest in the form of stock, in a corporation engaged in a
trade or business. That the interest acquired was not new, but a continuation of the taxpayer’s existing business,
was irrelevant for purposes of applying Code Sec. 197. Back references: ¶12,455.031 and ¶12,455.31.
[Code Sec. 197]
Deductions: Amortization deduction for intangibles: Trade or business.–
The Ninth Circuit affirmed the Tax Court’s holding that the redemption of 75 percent of its outstanding stock
by a taxpayer engaged in the business of selling and servicing vehicles was held to be an acquisition of an
interest in a trade or business within the meaning of Code Sec. 197. The legislative history of Code Sec. 197
contained no evidence that Congress intended a purchase of stock to be excluded from the meaning of the term
“acquisition” simply because the purchase occurred in the form of a redemption. The legislative history provided
that an acquisition of stock that is not treated as an asset acquisition is treated as an indirect acquisition of a
trade or business. Thus, interest in a trade or business includes not only the direct acquisition of the assets of
the trade or business, but also the acquisition of its stock. Accordingly, when the taxpayer executed the stock
sale agreement, it indirectly acquired an interest in the form of stock, in a corporation engaged in a trade or
business. Back reference: ¶12,455.71.
Peter T. Stanley, for petitioner. Karen D. Utiger, Department of Justice, for respondent.
Before: Trott, Nelson and Thomas, Circuit Judges.
OPINION
TROTT, Circuit Judge: Frontier Chevrolet Company (“Frontier”) appeals the tax court’s decision that I.R.C. §197
(“§197”) applied to a covenant not to compete entered into in connection with Frontier’s redemption of 75% of its
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stock. We agree with the tax court that Frontier’s redemption was an indirect acquisition of an interest in a trade
or business; therefore Frontier had to amortize the covenant under §197.
BACKGROUND
A.
The facts are set forth as stipulated by the parties before the tax court. At the time Frontier filed its petition with
the tax court, it was a corporation with its principal place of business in Billings, Montana. Frontier engaged
in the trade or business of selling and servicing new and used vehicles. Roundtree Automotive Group, Inc.
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(“Roundtree”) was a corporation engaged in the trade or business of purchasing and operating automobile
dealerships and providing consulting services to those dealerships. Frank Stinson (“Stinson”) was the President
of Roundtree and participated in Frontier’s management from 1987 to 1994.
In 1987, Roundtree purchased all of Frontier’s stock. Consistent with Roundtree and Stinson’s policy of
management, Frontier filled the position of its executive manager with one of Stinson’s long-term employees,
Dennis Menholt (“Menholt”). From 1987 to 1994, Roundtree allowed Menholt to purchase 25% of Frontier’s stock
as part of his employment by Frontier. Before August 1, 1994, Roundtree owned 75% and Menholt owned 25%
of Frontier’s stock.
Frontier entered into a “Stock Sale Agreement” with Roundtree effective August 1, 1994. Pursuant to the Stock
Sale Agreement, Frontier redeemed its stock owned by Roundtree using funds borrowed from General Motors
Acceptance Corporation (“GMAC”). Menholt became the sole shareholder of Frontier because of the redemption.
Roundtree, Stinson, and Frontier also entered into a “Non-Competition Agreement” (“covenant”) in connection
with the redemption. The covenant was effective August 1, 1994, and stated in part:
To induce [Frontier] to enter into and consummate the Stock Sale Agreement and to protect the value of
the shares of stock being purchased, Roundtree and Stinson covenant, to the extent provided in Section 1
hereof, that Roundtree and Stinson shall not compete with the automobile dealership, stock of which was
sold to Frontier pursuant to the Stock Sale Agreement.
Section 1 provided that Roundtree and Stinson would not compete with Frontier in the car dealership business
for five years. Furthermore, in Section 1, Roundtree and Stinson acknowledged that the non-compete restrictions
“are reasonable and necessary to protect the business and interest which Frontier … is acquiring pursuant to the
Stock Sale Agreement, and that any violation of these restrictions will cause substantial injury to [Frontier] or its
assignees.” Frontier agreed to pay Roundtree and Stinson $22,000 per month for five years as consideration for
the non-compete restrictions.
Frontier’s GMAC loan caused it to be leveraged with large interest expenses. During the summer of 1994,
Frontier fell below the minimum working capital requirements of its franchisor and had to obtain a special
waiver of working capital requirements to continue holding its franchise. In addition, Stinson and Roundtree
had the ability and knowledge to compete with Frontier in the Billings, Montana automobile dealership market.
Accordingly, Frontier had no known alternative to a non-compete agreement with Stinson and Roundtree to
protect it from their competition. Without the covenant, Frontier may not have been able to raise capital or pay its
GMAC loan.
Frontier amortized the covenant payments under §197 on its 1994 through 1996 federal income tax returns. In
1999, Frontier filed a claim for refund for the 1995 and 1996 taxable years, asserting that the covenant should
be amortized over the life of the agreement and not under §197. Frontier and the Internal Revenue Service
stipulated that the only issue for the tax court was whether Frontier must amortize the covenant not to compete
under §197.
B.
Section 197 provides, in relevant part:
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§197. Amortization of goodwill and certain other intangibles
(a) General rule.—A taxpayer shall be entitled to an amortization deduction with respect to any
amortizable section 197 intangible. The amount of such deduction shall be determined by amortizing
the adjusted bases (for purposes of determining gain) of such intangible ratably over the 15-year period
beginning with the month in which such intangible was acquired.
…
(c) Amortizable section 197 intangible.—For purposes of this section—
(1) In general.—Except as otherwise provided in this section, the term “amortizable section 197 intangible”
means any section 197 intangible—
(A) which is acquired by the taxpayer after the enactment of this section, and
(B) which is held in connection with the conduct of a trade or business or an activity described in section
212.
…
(d) Section 197 intangible.—For purposes of this section—
(1) In general.—Except as otherwise provided in this section, the term “section 197 intangible” means—
…
(E) any covenant not to compete (or other arrangement to the extent such arrangement has substantially
the same effect as a covenant not to compete) entered into in connection with an acquisition (directly or
indirectly) of an interest in a trade or business or substantial portion thereof….
C.
As a matter of first impression, the tax court held that the covenant was a §197 intangible because Frontier
entered into the covenant in connection with the indirect acquisition of a trade or business. The tax court applied
the plain meaning of §197 using dictionary definitions of “acquisition” and “redemption.” According to the tax
court, “acquisition” means “gaining possession or control over something” and “redemption” in the context of
securities means “the reacquisition of a security by the issuer.” Putting the definitions together, the tax court
concluded that Frontier’s redemption was an acquisition within the meaning of §197 because Frontier regained
possession and control over 75% of its stock.
The tax court also noted that §197’s legislative history stated that an acquisition of stock of a corporation
engaged in a trade or business is an indirect acquisition of an interest in a trade or business. In addition, the
tax court pointed out in a footnote that Treas. Reg. §1.197-2(b)(9), issued after the transaction at issue, and
therefore not applicable to this case, specifically provides that taxpayers can make an acquisition under §197 in
the form of a redemption.
JURISDICTION AND STANDARD OF REVIEW
We have jurisdiction pursuant to 26 U.S.C. §7482. We review de novo the tax court’s conclusions of law,
including construction of the tax code. Best Life Assur. Co. of Cal. v. Comm’r [2002-1 USTC ¶50,226], 281 F.3d
828, 830 (9th Cir. 2002).
DISCUSSION
We agree with the tax court that Frontier’s redemption was an indirect acquisition of an interest in a trade or
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business under §197. Frontier, however, argues that it did not acquire an interest in a trade or business
pursuant to the redemption because, both before and after the redemption, Frontier was engaged in the same
trade or business and it acquired no new assets. There are three problems with Frontier’s arguments. First,
Frontier’s argument reads a requirement into §197 that taxpayers must acquire an interest in a new trade or
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business. Section 197, however, only requires taxpayers to acquire an interest in a trade or business. Although
Frontier continued its same business, acquired no new assets, and redeemed its own stock, Frontier acquired an
interest in a trade or business because it acquired possession and control over 75% of its own stock. In addition,
the effect of the transaction was to transfer ownership of the company from one shareholder to another. Menholt,
who previously owned only 25% of the shares, become the sole corporate shareholder.
Second, §197’s legislative history makes clear that “an interest in a trade or business includes not only the
assets of a trade or business, but also stock in a corporation engaged in a trade or business.” H.R. Rep. No.
103-111, at 764, reprinted in, 1993 U.S.C.C.A.N. 378, 995. Here, Frontier acquired stock of a corporation
engaged in the trade or business of selling new and used vehicles. The result does not change merely because
the acquisition of stock took the form of a redemption. Indeed, the substance of the transaction was to effect a
change of controlling corporate stock ownership.
Finally, before enactment of §197, taxpayers could amortize covenants not to compete over the life of the
agreement. Treas. Reg. §1.167(a)-3. On August 10, 1993, however, Congress enacted §197 to govern the
amortization of intangibles. See Omnibus Budget Reconciliation Act of 1993, Pub. L. 103-66, §13261, 107 Stat.
312, 532-40 (1993). Congress passed §197 to simplify amortization of intangibles by grouping certain intangibles
and providing one period of amortization:
The Federal income tax treatment of the costs of acquiring intangible assets is a source of considerable
controversy between taxpayers and the Internal Revenue Service….
It is believed that much of the controversy that arises under present law with respect to acquired intangible
assets could be eliminated by specifying a single method and period for recovering the cost of most
acquired intangible assets….
H.R. Rep. No. 103-111, at 760, reprinted in, 1993 U.S.C.C.A.N. 378, 991. Thus, Congress’ intent to simplify
the treatment of intangibles indicates that §197 treats stock acquisitions and redemptions similarly—both
stock acquisitions and redemptions involve acquiring an interest in a trade or business by acquiring stock of a
corporation engaged in a trade or business.
CONCLUSION
Because Frontier entered into the covenant in connection with the redemption of 75% of its stock, the covenant
was a §197 intangible and Frontier must amortize it over fifteen years under §197. Accordingly, we AFFIRM the
tax court.
AFFIRMED.
Footnotes
1
2
This opinion refers to Roundtree and its predecessor, FS Enterprises, Inc., collectively as “Roundtree.”
The parties do not dispute that they entered into the covenant after the effective date of §197, or that
Frontier held the covenant in connection with the conduct of a trade or business. Accordingly, the
only issue we address is whether a redemption of 75% of a taxpayer’s stock constitutes an indirect
acquisition of an interest in a trade or business for purposes of §197. We need not and do not decide
whether all stock redemptions made in connection with an execution of a covenant not to compete
constitute an acquisition of an interest in a trade or business within the meaning of §197.
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