The following article is reprinted from The M&A Tax Report, Vol. 12, No. 6, January 2004, Panel Publishers, New York, NY.


By Robert W. Wood and Dominic L. Daher

Here at The M&A Tax Report, we've long noted the tendency of clients and M&A professionals (but surely never the tax lawyers, ahem...) to continually fuss with the allocation of covenants not to compete. A recent case — and one emanating from our beloved Ninth (a.k.a. Crazy California) Circuit Court of Appeals serves to underscore the lines in this ever developing (but never ending) debate.

In Burien Nissan, Inc., et. al. v. Commissioner, No. 02-70039, Tax Analysts Doc. No. 2003-23144, 2003 TNT 207-48 (9th Cir., Sept. 16, 2003), the Ninth Circuit concluded that the Tax Court was well within its bounds to mandate that payments for a covenant not to compete be amortized over fifteen years, despite the fact the covenant only lasted for five years. But I'm getting ahead of myself.

Just the Facts, Ma'am

The case started out simply enough-Donald Johnston and Gary McLaughlin each owned a 50% stake in Burien Nissan, a Seattle car dealership. In 1990, Burien entered into a stock purchase agreement with Johnston. The terms of the deal were pretty standard. Burien agreed to purchase Johnston's interest in the dealership, and he agreed to enter into a noncompete agreement with Burien. Much to Johnston's chagrin, the deal was never consummated, and Johnston's stock was never purchased.

In 1993, the parties gave it another shot. They allegedly revived the 1990 agreement by way of addendum. Under the alleged 1993 addendum (or entirely new contract, depending on whose story you believe), Johnston entered into five year noncompete contract with Burien, and Burien agreed to redeem Johnston's stock. Burien promised to pay Johnston roughly $45,000 up front and roughly $350,000 in equal monthly payments over the term of the agreement. Heck, Burien even went so far as to sign a promissory note for the $350,000 in future payments. The agreement was executed in January of 1994. Shortly thereafter, Burien got around to cutting Johnston a check for $45,000. Burien thought it best to amortize this payment over a fifteen year useful life. On the other hand, Burien decided to deduct (rather than capitalize) the remaining $350,000 in monthly payments it made to Johnston. Not surprisingly, the Service did not agree with Burien's characterization of the monthly payments. If you believe the Service, these monthly payments were actually amortizable over fifteen years, rather than being currently deductible.

Tax Court Calls Dirty Pool and the Ninth Circuit Agrees

As it turns out, The Tax Court was not particularly amused with Burien's characterizations of these payments either (gee, there's a surprise). After being caught with his hand in the till so to speak, Burien argued that if the monthly payments were not currently deductible, surely they were at least amortizable over five years (the length of the noncompete agreement) rather than over fifteen years (as the Service would have you believe). Burien went so far as to try to convince the Tax Court that the agreement had actually been effective in 1990 (long before Section 197's effective date in 1993). If you believe Burien's side of the story, what took place in 1993 was nothing more than a mere addendum to the 1990 contract. Burien even went so far as to trot out the actual 1993 contract which was plainly marked "addendum".

The Tax Court wasn't buying the Burien's argument that the agreement with Johnston was actually entered into in 1990 rather than 1993. Instead, the Tax Court found that the 1990 agreement was contingent on various events, not the least of which was Burien's promise to pay Johnston in thirty monthly installments (which Burien breached).

Accordingly, says the Tax Court, there was no event which fixed the parties' duties and responsibilities under the 1990 agreement (for that matter, Johnston had not even executed the 1990 agreement). Hence, the Tax Court determined with relative ease that Burien did not actually enter into (and hence did not have the ability to amortize) the noncompete agreement with Johnston until 1993. Of course, by that time Section 197 had been enacted and Burien was now required to amortize the agreement over the statutorily prescribed fifteen year useful life.

To ice it off, the Tax Court sustained the accuracy-related penalties the Service hit Burien with under Sections 6662(a) and 6662(b)(1). In doing so, Judge Ruwe admitted that he was not convinced that Burien reasonably relied on its return preparer in reporting the items at issue. The record did not contain any evidence of what specific information Burien gave its return preparer, but Burien clearly mischaracterized the key elements of these transactions (of course, it's likely Burien made the same representations to its return preparer).

Going to the Ninth Circuit, the taxpayer found relief was denied once again. The Ninth Circuit affirmed the Tax Court, concluding that the Tax Court did not err in finding that Burien acquired the covenant after the effective date of Section 197. Well, as the saying goes, better luck next time.

Noncompetes: Do the Tax Issues Ever End?, by Robert W. Wood and Dominic L. Daher, Vol. 12, No. 6, M&A Tax Report (January 2004), p. 1.