In Recovery Group Big Fat Finance, Inc. v. Commissioner, a corporation redeemed the stock held by one of its shareholders in exchange for cash and a one-year covenant not to compete. The taxpayer amortized the payment for the covenant over its one-year term, but the IRS claimed the covenant was a “section 197 intangible” that must be amortized over 15 years.
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Recognizing that both interpretations were reasonable, the court turned to the legislative history to determine what Congress meant. Section 197 was enacted in 1993 to allow taxpayers to amortize the cost of certain intangibles (such as goodwill and going concern value) over 15 years. The legislative history referred to the severe backlog of cases in audit and litigation in which taxpayers and the IRS argued over whether an intangible existed, the portion of the purchase price allocated to the intangible, and the proper method of recovering the cost of the intangible.
“When I use a word,” Humpty Dumpty said in rather a scornful tone, “it means just what I choose it to mean—neither more nor less.”
—(Through the Looking Glass, Chapter 6)
As a result of this decision, the corporation paid significantly more, on an after-tax basis, for the stock than it anticipated. This case illustrates the critical importance of obtaining professional tax advice at the earliest stage of planning a transaction.
In the case of an asset acquisition, the court believed intangibles would only be transferred if a substantial portion of the business was purchased; this was in contrast to a stock acquisition, where any stock interest would necessarily include a portion of the intangible. Consequently, in stock acquisitions, the purchaser would have an incentive to over-allocate value to the covenant to be able to amortize its cost, in contrast to the amount paid for the stock, which was not recoverable until the stock was sold. This analysis led the court to conclude Congress’ goal of reducing disputes over the existence and value of covenants not to compete would only be met if the statute were interpreted to read: “… an interest in a trade or business or [a] substantial portion [of assets constituting a trade or business].” Thus, a covenant not to compete created in connection with a stock acquisition is a section 197 intangible that must be amortized over 15 years.
The Internal Revenue Code defines a “section 197 intangible” as including: “any covenant not to compete … in connection with an acquisition … of an interest in a trade or business or substantial portion thereof….” The First Circuit Court of Appeals therefore confronted the question of what Congress meant when it used the word “thereof.” Did it modify “trade or business” or “an interest in a trade or business”?
Intangibles are often among a business’s most valuable assets. When a business (or an interest in a business) is acquired, the tax treatment of the intangibles can become a critical economic issue in the deal. Covenants not to compete can create particularly difficult problems.
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