Sale of Intangible Assets Is Potential Gift Transfer

Facts: During negotiations for the purchase of a business, the parties will sometimes agree that the seller will not operate a competing business within a specified distance for a specified period of time. When there is a significant difference between the capital gains rate and the higher marginal ordinary income rates, allocations to such a covenant not to compete which were contained in the purchase agreement were ordinarily respected because of the differing tax consequences to the buyer and to the seller.

Consideration paid for a bona fide covenant not to compete represents ordinary income to the seller and an amortizable deduction to the buyer for the duration of the covenant. However, consideration paid for stock represents a capital gain to the seller to the extent that the consideration exceeds the seller's basis in the stock but yields no corresponding benefit to the buyer. Sonnleitner v. Commissioner, 598 F.2d 464 (5th Cir. 1979).

Thus, when the capital gains rate was substantially less than the higher marginal ordinary income rates, the seller wanted more of the purchase price allocated to the stock so gain would be taxed at the capital gains rate. However, the purchaser wanted more of the purchase price allocated to the covenant so he would be entitled to amortization deductions.

Now that there is a semblance of parity between ordinary and capital gains tax rates for virtually all purposes, generally the seller will no longer suffer any tax disadvantage if more of the purchase price is allocated to the covenant not to compete. Thus, covenants not to compete must be scrutinized closely in order to ascertain whether allocations thereto lack economic reality.

Law: A covenant by the seller of a business that he will not compete with the purchaser for a limited period after the sale may be merely a protective device to insure the conveyance of goodwill. In that event, the entire sum received by the seller represents the proceeds from the sale of his capital assets and, correspondingly, the purchaser's investment in such assets. If this is the case, the purchaser would not be entitled to an amortization deduction pursuant to Treas. Reg. section 1.167(a)-3. However, where amounts paid under a covenant not to compete are intended to compensate the seller for lost earnings, they constitute ordinary income to the seller, Sonnleitner, 598 F.2d at 466, and are amortizable by the purchaser. Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959).

While the courts previously normally deferred to the parties allocation of the purchase price between the stock purchase and the purchase of the covenant not to compete, it has long been recognized that the Service is not bound by the allocation but can look to the substance of the transaction. Dixie Finance Co., Inc. v. United States, 474 F.2d 501 (5th Cir. 1973); Commissioner v. Court Holding Co., 324 U.S. 331 (1945). Now that there are no adverse tax consequences to the seller resulting from the allocation (while advantageous tax consequences result to the buyer because of allocations to covenants not to compete), it is anticipated that courts will more closely scrutinize such allocations. Thus, facts surrounding allocations to covenants not to compete should be closely scrutinized to ascertain whether the covenant comports with economic reality and is separable from goodwill.

In determining the tax consequences of the sale or purchase of a covenant not to compete, courts have looked at several factors. The first of these factors is whether the compensation paid for the covenant is separable from the price paid for goodwill. Where goodwill and the covenant not to compete are closely related, the benefits of the elimination of competition may be permanent or of indefinite duration and, hence, the value of the covenant is not exhaustible or a wasting asset to be amortized over a limited period. Marsh & McLennan, Inc. v. Commissioner, 51 T.C. 56 (1968), aff'd on other grounds, 420 F.2d 667 (3d Cir. 1969).

Another factor examined has been the objective intent of the parties. When there was a substantial lack of parity between ordinary and capital gains rates, in determining whether the amount allocated to the covenant should be respected, courts looked at whether the covenant played a real part in the negotiations. Annabelle Candy Co. v. Commissioner, 314 F.2d 1 (9th Cir. 1962). Further, the courts looked at whether either party was attempting to repudiate an amount knowingly fixed by both as allocable to the covenant, the calculable tax benefit of which may fairly be assumed to have been a factor in determining the final price. Commissioner v. Danielson, 378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967). However, due to the parity in tax rates, these factors are relatively insignificant at the present time.

The most important factor is whether the covenant is economically real, that is, whether the covenant is the product of bona fide bargaining rather than a sham. The economic reality theory is primarily concerned with business realities which would cause reasonable persons, genuinely concerned with their economic future, to bargain for the covenant not to compete.

Among the facts to be considered are whether the seller could actually compete with the purchaser. Where the seller is, objectively, likely to be a competitor, courts will probably sustain allocations to the covenant. See Illinois Cereal Mills, Inc. v. Commissioner, T.C. Memo. 1983-469, aff'd, 789 F.2d 1234 (7th Cir.), cert. denied, 479 U.S. 995 (1986) (seller retained technical and physical resources, relationships with customers and economic resources sufficient to compete with the purchaser); Sonnleitner, 598 F.2d at 468 (seller had business contacts, demonstrated selling ability and had threatened to compete).

However, where there are objective indications that the seller is unlikely to compete with the purchaser, allocations to the covenant not to compete are less likely to be respected. Krug v. Commissioner, T.C. Memo. 1981-522 (the seller was ill and lacked the financial resources to compete); Major v. Commissioner, 76 T.C. 239 (1981) (covenant had minimal value where the purchaser felt he could get his own customers and the seller was of advanced age and had health problems); Schulz v. Commissioner, 294 F.2d 52 (9th Cir. 1971) (payments made on a covenant not to compete were nondeductible payments for goodwill where the covenantor did not intend to manufacture the product, did not have the contacts and background necessary to successfully compete and economic conditions were such that it was unlikely that he could successfully compete); Forward Communications Corp. v. United States, 608 F.2d 485 (Ct. Cl. 1979) (seller would need a new FCC license to compete which it was unlikely to obtain); General Insurance Agency. Inc. v. Commissioner, 401 F.2d 324 (4th Cir. 1968) (covenantor was not considered serious competition because of her inability to successfully manage the company).

Numerous additional factors have also been considered by courts in reaching a determination concerning the economic reality of a covenant not to compete. Montesi v. Commissioner, 40 T.C. 511 (1963), aff'd, 340 F.2d 97 (6th Cir. 1965) (covenants were only entered into with some shareholders and each covenant was for the same amount irrespective of the shareholder's stock ownership so the covenants were real); Ackerman v. Commissioner, T.C. Memo. 1968-254 (most conclusive factor establishing economic reality of covenant was that it terminated in the event of the covenantor's death); Howard Construction, Inc. v. Commissioner, 43 T.C. 343 (1964), acq., 1965-2 C.B. 5 (purchaser showed lack of concern about covenant when he testified that he was concerned that the sellers might purchase a similar business because of their proven ability but the covenant only prohibited the sellers from managing a similar business); Dixie Finance Co., 474 F.2d 501 (among other factors, the court found the covenant lacked economic reality because the purchaser did not police the agreement to ensure the seller abided by its terms).

In addition, the amount allocated to the covenant not to compete may not reflect economic reality. The taxpayer has the burden of proving that he is entitled to the deduction. Welch v. Helvering, 290 U.S. 111 (1933). Courts have frequently found that covenants have no value or, at least, substantially less value than the purchaser attributes to them. ¹ The same factors as above have been considered for this purpose. Further, courts have looked at the actual contract negotiations to determine if the parties intended the covenant to have any value. For example, if the parties agreed to pay a certain amount for the assets of the seller and the purchase price is not altered when a covenant not to compete is later added, the covenant has no or minimal value. Forward Communications, 608 F.2d at 492; Dixie Finance, 474 F.2d at 505. Further, where the amount allocated to the covenant is in excess of its reasonable value, while the amount allocated to the stock purchase is less than its fair market value, courts have refused to allocate any portion of the purchase price to the covenant. Dixie Finance, 474 F.2d at 504-05.

Finally, there are situations where both covenants not to compete and employment contracts are utilized for the same parties. In such an event, each asset should be examined to determine if it has value and a determinable life separate and distinct from goodwill or going concern. If it is determined that both assets are amortizable, they should be evaluated further to ascertain whether the intangible assets overlap in coverage and thus, value, since employment contracts may convey similar benefits as a covenant not to compete for the same time frames.

In conclusion, covenants not to compete are not amortizable unless the objective facts demonstrate that the parties intended to allocate a portion of the purchase price to the covenant not to compete at the time they executed their formal sales agreement, that the amount allocated to the covenant corresponds to the loss of earnings anticipated by the seller as a result of not competing in the market and that there is economic reality to the covenant not to compete.