Noncompetition Payments Are Taxable to Donor of CRUT

The difficult twists and turns associated with creative tax planning are no better displayed than in John T. Jorgl and Sharon Illi, TC Memo 2000-10. Despite the use of a charitable remainder unitrust (CRUT) for effective income and estate planning, this decision demonstrates that economic realities must be thoroughly understood to anticipate the ultimate tax impact.

John Jorgl and Sharon Illi were involved in a successful daycare center operated through a corporation. Jorgl owned 100% of the stock, and he and his wife Sharon were employees of the center. Over the years, the excellent relationships they had established with parents, teachers and staff frequently led to repeat business. As with many taxpayers, the desire for a succession plan involved the sale of the business. The taxpayer, his attorney and accountant determined that a CRUT could provide tax benefits and fulfill a number of personal (and charitable) goals. After contributing the stock to the CRUT, the couple was to receive a lifetime annual annuity of 9% of the trust's value (as measured under the CRUT document). Once the lifetime beneficiaries were deceased, the remainder would go to a charity specifically designated in the memory of a young child who had died of leukemia. The trust was established before negotiations began in connection with a specific transaction to sell the stock.

In initial offerings, the seller had outlined a noncompetition provision for a five-year period and a 100-mile surrounding geographic area. As negotiations with the ultimate buyer progressed, the covenant not to compete became a serious component for the buyer, who feared the potential effect that the husband and wife's popularity could have on the business. Although the actual dollar amount associated with this covenant did not seem to be discussed in detail, the ultimate documentation separated the purchase price for the business into $350,000 for the stock and $300,000 for the agreement not to compete.

The trust received the entire $650,000 of the sale proceeds, despite the allocation between stock and noncompetition payment. Therefore, the taxpayers did not report any income from the transaction in their personal returns. At trial, they testified that the transaction was in substance a sale by the CRUT. The IRS took the position that covenant-not-to-compete payments were not earned by the trust, but instead by the donors as officers, capable of signing a promise to avoid competition in the future.

The Tax Court focused on some rather traditional tax concepts—the notion that noncompetition payments represent consideration for the promise to avoid competitive efforts and, under the assignment-of-income doctrine, such income cannot be transferred to another entity. The court also combined this analysis with an in-depth review of cases dealing with the allocation of value to an agreement not to compete. Such allocations are generally respected if the parties have documentation supporting mutual intent and economic reality supports the allocation. The buyer was aware of potential deductions for a noncompetition payment. However, the buyer was even more concerned with the good health and age of the officers, despite indications that they would be traveling, at least in the near term. The court challenged the notion that a noncompetition agreement with the trustee of the CRUT (a bank) had any economic reality. The court essentially agreed that the allocation to the covenant not to compete was outside of the CRUT, thereby forcing taxable income to those who had promised not to compete and who could produce the most competitive damage to the buyer.

The lessons for tax practitioners are varied and important from a number of perspectives. Despite the tremendous advantages of a stock sale within the mechanism of a CRUT, there are many other details that practitioners must consider throughout negotiations and the ultimate sale of stock owned by a trust. As with any stock transaction, potential buyers are likely to explore the need for noncompetition payments, if for no other reason than to protect their investment and develop more strategic tax planning on their own behalf. Importantly, a promise by specific individuals to avoid competition may direct economic reality back to the donors (and not the CRUT).

In its analysis of case law, the decision is a good refresher of the factors that allow taxpayers to either challenge allocations or be forced to accept them, even if they did not anticipate negative tax consequences. And if a contract fails to allocate purchase price to a covenant not to compete or does so in an ambiguous manner, the taxpayer is left with the need to establish (by a preponderance of evidence) that the Service's determinations are erroneous. The stakes become high with the use of a CRUT designed to avoid taxation by a donor, maximize charitable deductions and increase tax-free growth for the donor's annuity (which is taxable to the donor on future payments).

In the final analysis, it is clear that a well-negotiated arrangement with a sale of corporate stock needs to take into account these principles. To the extent sellers can bargain for lower noncompetition amounts to the buyer's satisfaction, fact patterns similar to Jorgl might be better defended to obtain more tax efficiency in the transaction. A properly negotiated and well-documented allocation satisfactory to both parties is very likely to hold the necessary economic and tax realities to deflect future IRS challenges.

From Christopher C. Adler, CPA, Baltimore, MD