Portion of Payment to Former Shareholder Characterized as Consulting Expense Had to Be Amortized

A began operating a cardroom and entertainment business as a partnership. Eventually, he incorporated the business, operating a restaurant and cardroom business through T, a wholly owned corporation. In Year 1, the building in which T operated its business was demolished and its business operations ceased.

In Year 1, a group of investors purchased 90% of the stock in T. In Year 2, T opened a restaurant, bar and deli. To continue with the cardroom business, T was required to obtain a gaming license. Because of difficulties encountered in obtaining the license, many investors eventually sold their stock in T.

By Year 3, B owned 90% of T. In February of Year 3, A agreed to sell his 10% stock ownership in T to B. Subsequent to the sale, B would own 100% of the T stock. The sale of the stock was to occur when T opened for business to the general public as a licensed gaming or cardroom business.

Also in February of Year 3, A and T entered into an agreement entitled "Agreement of sale of goodwill and covenant not to compete" (Agreement). Pursuant to the Agreement, T acquired A's goodwill and A entered into a covenant not to compete in connection with the sale of goodwill in exchange for a monthly payment. The Agreement would become effective when T acquired all gaming or cardroom licenses necessary to open the business and actually opened for business as a gaming establishment. The payments would continue until the earliest of A's death, A's purchase of T stock that A had a conditional right to repurchase, or A's violation of the noncompetition agreement.

In Year 3, to ensure the continued patronage of T's customers, A and T orally agreed that A would greet players in the game rooms. In each of October, November and December of Year 3, T paid A; from each payment, a portion was characterized as "wages" and a portion as "consulting expenses." T deducted the entire payment, and A reported it as ordinary income.

Analysis

It appears that, subsequent to entering into the Agreement, T and A entered into an oral agreement that modified the Agreement. Under the oral modification, T would pay A a set amount each month to greet players in the game room, and the amount paid under the Agreement would be reduced by that amount. To the extent this payment was reasonable for the service provided, T may deduct the payment. To the extent it does not represent a modification or payment for services, the payment would be included as an amount paid under the Agreement.

Sec. 197

A taxpayer is entitled to an amortization deduction for amortizable Sec. 197 intangibles. The deduction is determined by amortizing the intangible's adjusted basis over a 15-year period, beginning with the month in which the intangible was acquired. No other depreciation or amortization deduction is allowed for amortizable Sec. 197 intangibles.

A "Sec. 197 intangible" includes goodwill and any covenant not to compete entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business. An acquisition may be in the form of a stock acquisition. Under the stock purchase agreement and the Agreement, the covenant not to compete was entered into in connection with B's purchase of A's stock. Accordingly, the goodwill and covenant not to compete are Sec. 197 intangibles.

An "amortizable Sec. 197 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 or an activity described in Sec. 212. The goodwill and covenant not to compete were acquired by T after Aug. 10, 1993, and are held by T in connection with its trade or business.

An "amortizable Sec. 197 intangible" does not include goodwill created by a taxpayer. A Sec. 197 intangible is created by a taxpayer, to the extent the taxpayer makes payments or otherwise incurs costs for its creation, production, development or improvement, whether the actual work is performed by the taxpayer or by another person under a contract with the taxpayer entered into before the contracted creation, production, development or improvement occurs. There is no indication that the goodwill purchased from A was created by T.

Under anti-churning rules set forth in Sec. 197(f)(9), an amortizable Sec. 197 intangible asset does not include (among other things) goodwill acquired by a taxpayer after Aug. 10, 1993, if the goodwill was held or used at any time on or after July 25, 1991 and on or before August 10, 1993 by the taxpayer or a related person. A person is related to any person if the related person bears a relationship to such person specified in Sec. 267(b) or 707(b)(1), in which "20 percent" is substituted for "50 percent." Because A owned only 10% of the T stock in Year 3, the anti-churning rules are not applicable.

Conclusion

Because the amounts paid pursuant to the Agreement were paid for amortizable Sec. 197 intangibles, T is entitled to begin amortization of amounts properly capitalized when the Agreement became effective.

Field Service Advice 200106006 (10/17/00)