Covenant Not to Compete Must be Amortized Over 15 Years

In Frontier Chevrolet Co., 116 TC No. 23 (2001), the Tax Court held that a company had to amortize a covenant not to compete that was entered into in conjunction with a redemption of its stock over 15 years. The court, agreeing with the IRS, considered a redemption to be an acquisition of an interest in a trade or business under Sec. 197 and therefore the noncompete agreement was a Sec. 197 intangible.

Frontier Chevrolet was in the business of selling and servicing new and used vehicles. Roundtree Automotive Group was a corporation in the business of purchasing and operating car dealerships, along with providing consulting services to the dealerships. In 1987, Roundtree purchased all of Frontier's stock. Stinson was involved in the operations of Roundtree from 1987–1994 and was president in 1994. Menholt, a long-time Roundtree employee, was executive manager in Frontier's dealership. Menholt was allowed to purchase 25% of Frontier's stock between 1987 and 1994. In 1994, Menholt owned 25% of Frontier's stock and Roundtree owned the rest. Stinson participated in the management of Frontier's car dealership and Roundtree received monthly payments of $22,000 for management services.

Seven years after the original acquisition, Frontier entered into a stock sale agreement with Roundtree. Effective Aug. 1, 1994, Roundtree's stock was redeemed for $3.5 million; after the redemption, Menholt was Frontier's sole shareholder. Frontier also entered into a noncompetition agreement with Stinson and Roundtree, effective Aug. 1, 1994. The covenant provided that Stinson and Roundtree would not compete with Frontier in the car dealership business in Yellowstone County for five years. As consideration, Frontier agreed to pay Stinson and Roundtree $22,000 per month for 60 months. Frontier amortized the monthly payments over 15 years, but subsequently filed a claim for refund, on the basis that the noncompetition payments should be amortized over the life of the agreement (60 months).

Frontier's argument was that it did not acquire an interest in a trade or business; therefore, Sec. 197 did not apply. The taxpayer stated it was in the same business before and after the redemption and did not acquire any new assets. The IRS's position was that Frontier's redemption of its stock was an acquisition of an interest in a trade or business within the meaning of Sec. 197.

Sec. 197 provides that an amortization deduction is allowed for any amortizable Sec. 197 intangible. A Sec. 197 amortizable intangible is any Sec. 197 intangible acquired by a taxpayer after Aug. 10, 1993 and held in connection with the conduct of a trade or business. Regs. Sec. 1.197-2(b)(9) states:

Section 197 intangibles include any covenant not to compete, or agreement having substantially the same effect, entered into in connection with the direct or indirect acquisition of an interest in a trade or business or a substantial portion thereof. For purposes of this paragraph (b)(9), an acquisition may be made in the form of an asset acquisition (including a qualified stock purchase that is treated as a purchase of assets under section 338), a stock acquisition or redemption, and the acquisition or redemption of a partnership interest.

The Conference Report indicates an interest in a trade or business does not include merely the direct purchase of the assets, but also includes the indirect acquisition of the stock of a corporation engaged in a trade or business. As a result of the stock sale agreement, Frontier acquired an indirect interest in a trade or business. The fact that the interest acquired was not a new interest, but a continuation of Frontier's existing business, was irrelevant for Sec. 197 purposes.

An interesting point not addressed was the definition of "substantial portion thereof." Frontier redeemed 75% of Roundtree's stock and was found to have acquired an indirect interest in the stock of a corporation engaged in a trade or business. The wording of the House Committee Reports and the regulations leads one to believe that there is a cut-off point to what is considered a substantial portion of a trade or business and thus falls under Sec. 197. As a result, a de minimis stock redemption, coupled with a covenant not to compete, should not fall under Sec. 197, and the payments of the covenant would therefore be amortized over the life of the agreement.

Lisa Loychick, CPA, MT, Cohen & Company, LTD, Youngstown, OH