Why Semantics Matter in Noncompete Pacts

The amortization schedule of a noncompete agreement is settled when a tax court dives deep into a rule definition.

Mr. E (E) owned 23% of the stock of Recovery Group Inc. (RGI). An agreement between E and RGI called for the company to pay the partial owner a total of $805,363.33. Of that total, $400,000 was for a “non-competition and non-solicitation” agreement that prohibited E from engaging in “competitive activities” from July 31, 2002, through July 31, 2003. The remainder of the payment was in exchange for E’s stock in RGI.

The Internal Revenue Service determined that the noncompete covenant was an amortizable intangible under Section 197 of the tax code, meaning it was amortizable over 15 years, beginning with the month of acquisition.1 However, RGI amortized the noncompete agreement over a 12-month term, and as a result the dispute wound up in U.S. Tax Court.

At issue was whether the covenant was entered into in connection with the acquisition of an interest in a trade or business or substantial portion thereof.2 The court held that it was, and therefore found in favor of the IRS.3

Beyond Semantics

RGI contended that E’s 23% interest stock was not substantial. That is, the company said the “interest in a trade or business” must mean a 100% interest and that the term thereof contained in the rule definition modifies the word interest. RGI also asserted that a noncompete covenant gets 15-year amortization only if it is obtained in an acquisition of a 100% interest in a trade or business, or in an acquisition of a substantial portion of an interest in a trade or business.

The IRS saw it differently. The agency maintained that the term thereof modifies trade or business, not interest. In addition, the IRS said that a covenant not to compete gets 15-year amortization if it is obtained in an acquisition of any interest. So in the case of RGI, the interest included the 23% acquired by the company related to the redemption of E’s stock. Indeed, the court reasoned that if “an interest” meant “the entire interest,” then a redemption could never trigger
Section 197(d)(1)(E) — an untenable result.

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There was further parsing of the definition. RGI asserted that the antecedent of the word thereof is “interest,” so 15-year amortization is required when a noncompete covenant is entered into with respect to an acquisition of an entire interest or a substantial portion of an interest. However, the IRS determined that the antecedent of the word thereof is “trade or business.” As a result, said the IRS, 15-year amortization is required when a noncompete agreement is entered into in connection with an acquisition of an interest in a trade or business or assets constituting a substantial portion of a trade or business. Again the court agreed with the IRS.

Congress’s purpose in enacting Section 197(d)(1)(E) was to impose 15-year amortization both when a stock acquisition includes a covenant not to compete and when a substantial asset acquisition includes such a covenant. RGI’s interpretation would impose 15-year amortization in the case of an acquisition of an entire stock interest or a substantial stock interest, but find the statute silent about asset acquisitions. Under the reading of the statute preferred by the court, the question whether an acquisition is substantial arises only with reference to asset acquisitions. To be sure, when a covenant not to compete is entered into in connection with a stock acquisition — substantial or not substantial — the covenant constitutes an amortizable Section 197 intangible.

The court pointed out that even if the word thereof modified “interest,” RGI’s argument that a 23% stock interest is not substantial is not “well-supported.” Moreover, the “anti-churning” portion of Section 197(f)(9), which is triggered in the case of a 20% stock interest, might suggest that that level of interest would be considered substantial. If that’s the case, then the 23% interest owned by E would also be substantial.

Misplaced Decision

The court had previously held, in Frontier Chevrolet Co. v. Commissioner, 116 T.C. 289 (2001), aff’d. 329 F.3d 1131 (9th Cir. 2003), that a redemption of stock qualifies as “acquisition of an interest in a trade or business” and rejected the argument that the statute requires the acquisition of an interest in a new or different business. RGI’s citation of Frontier Chevrolet Co. is misplaced: that decision says nothing that would assist RGI.

Accordingly, the court concluded that RGI’s redemption of 23% of its stock from E was an acquisition of an interest in a trade or business. Therefore, the noncompete covenant is a Section 197 intangible, and RGI must amortize the cost of the covenant not to compete over 15 years.

Contributor Robert Willens, founder and principal of

Robert Willens LLC,

writes a weekly tax column for CFO.com.


Footnotes


1 Section 197(a) provides that 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 basis of such intangible ratably over the 15-year period beginning with the month in which such intangible was acquired.
2 See Section 197(d)(1)(E).
3 See Recovery Group, Inc. et al. v. Commissioner, T.C. Memo. 2010-76.

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