15-Year Amortization for Covenant Payment in Connection with Redemption

The Tax Court ruled that Sec. 197 requires that payments pursuant to a covenant not to compete made in connection with a stock redemption must be amortized over 15 years (Frontier Chevrolet Co., 116 TC No. 23 (2001)). The redemption of one shareholder's stock constitutes an acquisition by the corporation of an "interest in a trade or a business" under Sec. 197.

The case involved the interpretation of Sec. 197(d)(1)(E), which defines a Sec. 197 intangible to include a covenant "entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or a substantial portion thereof." In Frontier Chevrolet, the shares of a 75%-shareholder were completely redeemed, which increased the other shareholder's interest in Frontier Chevrolet from 25% to 100%.

Frontier Chevrolet entered into a five-year covenant with the redeemed shareholder and its president, explicitly in connection with the redemption. Frontier Chevrolet originally filed returns amortizing the covenant payments over 15 years, but filed amended returns claiming a five-year amortization period. It claimed that its business had not changed as a result of the redemption and that it had not acquired any interest in a trade or business. The Tax Court, on the other hand, in siding with the IRS, held that the covenant was amortizable over 15 years under Sec. 197.

There was apparently no issue as to whether a 75% interest constituted a substantial portion of Frontier Chevrolet. This is probably because the increase in the 25%-shareholder's interest to that of sole shareholder would necessarily constitute a substantial portion of the business. In analogous cases, an ownership shift of only a few percentage points can be viewed as "substantial" when it causes a shareholder to obtain voting control of a corporation, such as an increase from 49% to 51%.

The question was whether a redemption constituted an "acquisition" under Sec. 197. The court reasoned that as a result of the redemption, Frontier Chevrolet regained possession over its stock, and thus the transaction constituted an acquisition for this purpose. The legislative history was cited as authority, stating that an interest in a trade or business includes a purchase of stock in a corporation engaged in a trade or business. According to the court, there was no basis for concluding that there should be an exception when the purchaser of the stock would itself be the issuer. The opinion did not address the fact that, unlike a purchase, the corporation was presumably worth less than before the redemption, by the amount of consideration it paid for the stock.

Frontier Chevrolet unsuccessfully argued that, in effect, the 25%-shareholder bought out the 75%-shareholder, because the effect of the redemption was that the former became Frontier Chevrolet's sole shareholder. The court ruled that such was not the form of the transaction. Interestingly, the court did not clarify how it would have ruled if the 25%-shareholder had bought the stock directly, with Frontier Chevrolet entering into the covenant. In such a case, it is possible that a court would look to the "direct or indirect" language of Sec. 197 to reach the same conclusion.

From Michael J. Goldberg, New York, NY