Recently, on July 26, 2011, the United States Court of Appeals decided the issue of whether a Covenant Not to Compete should be classified as a Section 197 Intangible or if a taxpayer can amortize the cost of a Covenant Not to Compete over the duration of the Non-Compete. This issue was decided in the case of Recovery Group, Inc. v. Commissioner of Internal Revenue, 652 F.3d 122 (2011).
Facts of the Case
In 2002, James Edgerly (the “Employee”) and minority shareholder owned 23% of the company’s outstanding shares decided to leave Recovery Group (the “Company”). Company agreed to purchase Employee’s shares for approximately $250,000. Employee also agreed to sign a Covenant Not to Compete for a period of one year and Company paid Employee $400,000 for the Covenant, which was equal to Employee’s salary for one year. On its tax return, Company amortized the amount paid for the Covenant over 12 months, which was the duration of the Covenant. This was challenged by the IRS and resulted in Company appealing the IRS’s determination.
Issue of the Case
Should Company amortize the Covenant over the period of the Non-Compete (1 year) or over the 15-year period as stated in Section 197?
Section 197 entitles taxpayers to claim “an amortization deduction with respect to any amortizable section 197 intangible.” 26 U.S.C. § 197(a). The cost of an “amortizable section 197 intangible” must be amortized “ratably over the 15-year period beginning with the month in which such intangible was acquired.” No other depreciation or amortization deduction is allowed with respect to any “amortizable section 197 intangible.”
On the other hand, intangible assets not classified as “amortizable section 197 intangibles” are not within the purview of I.R.C. § 197 and are not subject to this section’s mandatory fifteen-year amortization period. Rather, depreciation and amortization for such non-section 197 intangible assets may be allowed under the rules of other code provisions, such as I.R.C. § 167, provided the asset complies with the requirements set forth therein.
Company argued that Section 197 only applies when there is a complete or substantial acquisition of Company’s stock, compared to a mere minor acquisition of stock. The Tax Court disagreed with Company and ruled that the Covenant was entered into in connection with acquisition of stock, which would establish it as a Section 197 intangible.
Section 197(d)(1)(E) specifically mentions covenants not to compete provided that it’s entered into in connection with the acquisition of an interest in a trade or business or a substantial portion thereof. Company was essentially arguing that the “substantial portion thereof” related to “the acquisition of an interest.” Hence, according to Company’s argument, a Covenant Not to Compete is only a Section 197 intangible when the entire portion or substantial portion of the Company’s stock is acquired.
Both the Tax Court and Court of Appeals disagreed with Company’s argument. By analyzing Congress’s intent when the statute was passed, the Court of Appeals found that Non-Compete Agreements are Section 197 intangibles requiring a 15-year amortization. If a Covenant Not to Compete was not a Section 197 intangible, any time a company would acquire another company’s stock, the company would opt to overstate the value of the non-compete agreement and understate the price of the stock in order to receive a tax windfall. Section 197 was enacted to decrease the tax benefit of such a scenario. Further, Section 197 was enacted to simplify the law regarding the amortization of intangibles and reduce the voluminous amount of litigation in this area.
A Covenant Not to Compete is a Section 197 intangible subject to 15-year amortization period. The Company could amortize the Covenant Not to Compete over 15 years rather than 1 year in order to receive a tax benefit.