Covenant Not To Compete – Not Good for Seller or Buyer

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I used to really like the word “covenant”.  It had a certain majestic ring to it.  Then Congress enacted Code Section 197 and I stopped liking it so much, particularly when it was followed by the words “not to compete”.  Very early in my career, I was comparing a “confidential offering memorandum” to the general ledger of a real estate partnership.  I asked the controller where the “development fee”, “sponsor guaranty fee”, “asset management fee” and “damned if I can remember fee” were.  He sat me down and patiently said “You know all these things in this book.  Those are just names that they give to the money that they take.”  Of course those names had tax significance and when you devise a tax structure it would be much better if you create a transaction trail (with invoices, checks, etc.) that conforms to the structure rather than expecting a kid just out of college to fix it all with journal entries, but times have changed.  Back in those days the pen might have been mightier than the sword, but if you wanted to move tax effects around you best have a pencil and some green analysis paper.

So how did I become disenchanted with the covenant not to compete ?  Well there was a time when goodwill was not deductible, depreciable, amortizable, anythingable, it just sat there.  On the plus side though, the seller gotcapital gains treatment for it.  “Covenant not to compete” on the other hand was deductible over the term of the agreement.  Often the paymentcorresponded with the agreement term so it was a simple deduction as it was paid.  The seller on the other hand had to pick up ordinary income.  So you really didn’t have a deal until the allocation was done.  People found a way around the non-deductible nature of goodwill.  You didn’t sell goodwill, well maybe there was a little there. You sold specific intangible assets like a customer list.  That would have a limited useful life making it depreciable.  Customer list was pretty obvious and in some businesses there were actuallyrules of thumb about what accounts are worth.  Planners came up with other things like “supplier relationships” and “work-force in place”.  There was a lot of litigation with the IRS saying that a lot of this stuff was inseparable from goodwill and then further arguments about what the useful life was if it wasn’t.  Section 197 simplified things.  It basically said that all the names that people were giving to things to avoid calling them goodwill were “197 intangibles”.  You get to write them off over 15 years.  The seller more likely than not would get capital gains treatment except for “covenants not to compete”.  Those were amortizable over 15 years just like the customer list and ”the brilliant way we arranged the cubicles”, but they were ordinary income to the seller.  Screw that.  No more covenants not to compete as far as I was concerned.

You can tell from the recent decision that Recovery Group, Inc did not check with me before they did their planning.  James Edgerly was one of the founders and owned 23% of the stock.  Recovery Group was an S Corporation.  He asked to be redeemed.  The company paid him $255,908 for his stock.  One of the themes of my blog has been that a partnership (or a LLC’ that is taxed like a partnerships) is often a much better vehicle than an S Corporation.  Redemption of an owner at a gain is an example.  With an S corporation you end up with no tax benefit to the S corporation.  A partnership on the other hand could if it made the proper election allocate the gain among its assets and have increased deductions.  At any rate what Recovery Group, Inc did was pay Mr. Edgerly $400,000 for a one year covenant not to compete.  The covenant period straddled two tax years so they deducted $166,663 in 2002 and $233,334 in 2003. I don’t know what happened to the $3.00. By the time its in Tax Court, its all lawyers and stuff like the missing $3.00 doesn’t bother them.  The IRS allowed $11,111 in 2002 and $26,667  in 2004.  IRS maintained that the deduction for the covenant not to compete should be spread over 15 years.

Most of the material in the case is what I call “lawyerly”.  Both sides agree that if Mr. Edgerly’s covenant is a ”197 intangible”  that it should be deducted over 15 years.  Both sides agree that if Mr. Edgerly had been selling the whole business that the covenant would be a “197 intangible”.  The taxpayers didn’t think that in this situation the covenant was a “197 intangible”.  Here is the crux of the argument in legalese:

The IRS argued that the “substantial” modifier only applied if there were assets being purchased.  They further argued that even if “substantial” applied to a stock acquistion, 23 % was substantial.  I have two disappointments with the ultimate decision which is summed up here:

We disagree with Recovery Group’s contention that, in the context of stock acquisitions, I.R.C. § 197(d)(1)(E) only applies to acquisitions considered at least “substantial.” The first disappointment is that the taxpayers lost and my professional bias is to root for the taxpayers except when they are being really lame.  The other is that because the decision just turns on the definition we don’t have the Court telling us whether 23% is substantial or not, which could be useful information.  This was a First Circuit decision upholding a Tax Court decision.  I thought the discussion of the development of Section 197 was a pretty good one and recommend this case as a good read to my fellow tax nerds.