The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 4, November 2001, Panel Publishers, New York, NY.


By Robert W. Wood

Noncompete agreements are features of virtually every acquisition. Such agreements have long been a negotiating topic in practically every deal, as well as a subject of considerable interest to tax professionals. Long positioned between the extremes of compensation expense (and compensation income) on the one hand and the treatment of intangibles on the other, there is a decided tension in negotiating such agreements. And, there are often competing tax concerns.

Section 197 Review

A few Section 197 basics are in order. Section 197 requires the capitalization of the costs of certain intangible assets, including goodwill and going concern value. I.R.C. §197(a). Section 197 allows a deduction for the amortization of Section 197 intangibles acquired through the purchase of a trade or business, or an activity described in Section 212 of the Code. Reg. §1.197-2(e). Section 197(a) permits the cost basis of a Section 197 intangible to be amortized over 15 years. A Section 197 intangible may not be depreciated under any other section of the Code. Reg. §1.197-2(a)(1). The 15-year amortization begins with the month in which the asset was acquired.

The basis of a Section 197 intangible asset that is purchased in a taxable transaction to which Section 197 applies is the asset's cost basis. H.R. Rep. No. 213, 103rd Cong., 1st Sess. 696 (1993). Suppose the asset is purchased for cash and a contingent note, so that the amount of the contingent note is not included in the asset's beginning tax basis? Here, as payments are made on the note, the payments will be added to basis. The increase in basis from the contingent payments will be amortized over the remaining 15 year life of the intangible asset. Id. The increase in basis will not have a separate or new 15 year life of its own. Where an asset that would otherwise be defined as a Section 197 intangible is created by the taxpayer (a "self-created intangible"), the regulations provide that such intangibles are excluded from the application of Section 197. Reg. §1.197-2(f).

Covenants Not to Compete

Covenants not to compete are included in the definition of Section 197 intangibles, where a covenant not to compete is entered into in connection with the direct or indirect purchase and sale of an interest in a trade or business. Reg. §1.197-2(b)(9). The transfer of an interest in a trade or business includes the transfer of assets that comprise a substantial portion of a trade or business, a stock acquisition, or the transfer of a partnership interest where the partnership is engaged in a trade or business. Reg. §1.197-2(b)(9). The amount paid for a covenant not to compete is capitalized and amortized over 15 years.

In the case of a covenant not to compete entered into as part of the acquisition of a departing stockholder's interest in a corporation, the dispositions or the cancellation of redeemed stock of a corporation will not result in the acceleration of the 15-year life of a covenant not to compete. Reg.§1.197‑(g)(1)(B)(iii).

Arms' Length Bargaining

Section 197 aside, the real development of the tax law applicable to covenants not to compete has come in the case law, and there is a consistent flow of interesting cases. Recently, the Tax Court decided Bemidji Distributing Co., Inc. v. Commissioner, T.C. Memo 2001-260 (2001). There, the Tax Court faced deficiencies arising from a 1992 sale of assets by Bemidji (a beer distributor) to another beverage company for just over $2 million. The buyer, Bravo, required that the purchase agreement between it, Bemidji and Bemidji's president and sole shareholder (Mr. Langdon) allocate $1.2 million of the purchase to two agreements, with Mr. Langdon individually. The first was a $200,000 two-year consulting agreement, and the second was a $1 million five-year covenant not to compete. Nothing was allocated to various intangibles, including goodwill, going concern value, or exclusive distribution rights with two major brewers.

When the case made it to Tax Court, only two issues remained: (1) whether all or a part of Bravo's payment to Mr. Langdon for the covenant was a disguised payment for intangibles; and (2) whether a portion of Bemidji's payment of sales expenses was a nondeductible constructive dividend to Mr. Langdon, paid to obtain the covenant not to compete and the consulting contract. If the answer to question no. 1 was that in fact part of the payment to Mr. Langdon was a disguised payment for intangibles, it followed that that payment would be taxable to Bemidji, and would be a nondeductible dividend to Mr. Langdon.

Corporate tax planners should begin breaking out into a sweat on seeing the issues, since there was significant potential for double taxation.

To resolve these issues, the Tax Court laboriously went through the history of the business, the history of discussions over potential sale, and the history of the nature of the sale that was ultimately consummated. The purchase agreement between Bravo and Bemidji allocated $817,461 to Bemidji's tangible operating assets and accounts receivable, $200,000 to the two-year consulting agreement with Langdon, and $1 million to the five year covenant with Langdon. Nothing was allocated to Bemidji's intangibles.

Indeed, the purchase agreement was hardly eloquent in stating that: "No additional consideration shall be due from Buyer to Seller for Seller's Intangible Property, such assets to be transferred from Seller to Buyer in consideration of the benefits to be derived by Seller under the remaining provisions of this Agreement." The Tax Court stated that Langdon did not negotiate with Bravo over this allocation, because he knew that Bravo's offer to purchase was contingent upon the execution of a covenant not to compete. We are told that he accepted Bravo's proposal that full value for the intangibles be allocated to the consulting agreement and the covenant.

A notice of deficiency was issued in which the Service asserted that Bemidji failed to report $1.2 million of income received from Bravo. In the alternative, the Service argued that the selling expenses incurred by Bemidji were improperly allocated, and these expenses attributable to the consulting agreement and covenant (or, 59.48%) were a constructive dividend to Mr. Langdon, not deductible by Bemidji.

A notice of deficiency was also issued to Mr. Langdon personally, determining that 59.48% of the selling expenses was a constructive dividend to him. Before trial, the Commissioner conceded that Mr. Langdon's consulting agreement had a value of $200,000. At the trial, the Commissioner also conceded that the covenant had a value of $121,000.

What is a Covenant Worth?

The Tax Court succinctly notes that the amount of the deficiencies turn on the value of the covenant. The amount allocated to the covenant is taxed to the shareholder as ordinary income, of course, but escapes tax at the corporate level. In the case of the amount properly allocated to intangibles, on the other hand, any amount in excess of basis would be taxable to the corporation as a capital gain. When distributed to the shareholder, it is treated as a nondeductible dividend and again taxed to the shareholder. This, of course, is the essence of double taxation. The same dichotomy exists in the case of the consulting agreement.

The Tax Court in Bemidji went on to note that the buyer's interests are not adverse, as the buyer can ratably deduct the cost of the covenant not to compete over its life (here, five years). The more that is allocated to the covenant, said the Tax Court, the greater the tax benefit to all parties.

Section 1060 generally mandates the use of the residual method of purchase price allocation. See Temp. Reg. §1.1060-1T(a)(1); and I.R.C. §338(b)(5). However, since Section 1060(a) has since 1990 stated that:

"If in connection with an applicable asset acquisition, the transferee and transferor agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, such agreement shall be binding on both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate."

This amendment was made as part of the Omnibus Budget Reconciliation Act of 1990. The Tax Court in Bemidji went through the legislative history, most of which merely repeated the necessity for adverse interests. The court unearthed some of the important case law dealing with tax allocations. Notably, the court reviewed Buffalo Tool & Dye Manufacturing Co. v. Commissioner, 74 T.C. 441 (1980), in which the Commissioner challenged a contractual allocation. The court in Buffalo Tool & Dye stated that the two relevant tests were:

(a) The contractual allocation has "some independent basis in fact or some arguable relationship with business reality such that reasonable [persons], genuinely concerned with their economic future, might bargain for such agreement." If the answer to this question is yes, the agreement may be upheld.

(b) If the allocation by the buyer and the seller of a lump-sum purchase price is unrealistic, then neither the Commissioner nor the Tax Court is bound to accept it.

Ultimately, then, it is a factual inquiry and yet one that is inherently subjective. The Tax Court in Bemidji noted that the Commissioner had originally argued that neither the consulting agreement nor the covenant not to compete had any economic reality. As noted, though, by the time of trial the Commissioner had conceded that the consulting agreement was worth $200,000 (the amount the taxpayer allocated to it), and that the covenant had an economic reality of $121,000 (considerably short of the amount claimed by the taxpayer). The Tax Court set its task as simply establishing the value of the covenant.

Valuation Factors

Many factors are relevant in determining the value of a covenant, and there is considerable case law on the point. The following circumstances have been considered in evaluating a covenant, including:

The taxpayer in Bemidji relied upon these factors, and did not offer an expert witness. The Commissioner, on the other hand, did not discuss the factors at trial or in its brief, and instead relied on the testimony of an expert witness to establish value. The Tax Court considered the enumerated factors as well as the facts of the case and the expert's testimony. After an exhaustive analysis of the applicability of the factors to the facts at hand and Mr. Langdon's own circumstances, the court turned to the expert opinion. The expert concluded that the fair market value of the covenant not to compete was $121,000. The court noted that this valuation assessment was based on a number of assumptions "of dubious validity."

Some of the assumptions were simply strange (to put it charitably) on their face. For example, the expert assumed only a 45% likelihood that Langdon would actually compete in the first year, and then assumed decreasing percentages of likelihood in subsequent years. The court noted, though, that if Langdon had begun to compete in the first year, it would be reasonable to increase the amount of loss that Bravo would have experienced several years out, rather an decreasing them.

Another dubious tendency the expert had was to "[pile] discounts upon discounts." The court noted that the expert assumed a potential 50% loss of business if Mr. Langdon competed. The expert then cut this 50% loss in half on the ground that Mr. Langdon would need six months of start-up time. The court found this assumption would not apply under either of the two most likely scenarios: if Langdon had bought an existing distributorship or gone to work for one.

For those who have not seen an expert skewered of late, reading the Bemidji opinion is satisfying if only for that reason. The IRS' expert is thoroughly broiled in the opinion, only a brief sampling of which is noted here. Ultimately, the Tax Court rejected the Commissioner's $121,000 valuation for the covenant as "unrealistically low and built upon faulty assumptions." On the other hand, the taxpayer (who did not offer an expert, something the court noted more than once), asserted that the covenant was worth $2,247,992. This also, said the court, is "totally unrealistic, inasmuch as it exceeds the entire purchase price of the business."

Faced with such aggressive arguments, each in their own right, the court's side that it had to "use our best judgment, based upon the record sketchy as it may be." The court ultimately concluded that the covenant not to compete had a fair market value of $334,000. The remaining $666,000 (out of the $1 million in question) represented the other intangibles.

Lessons Learned

There are a number of lessons to be learned from the Bemidji case, some of which may go beyond the scope of this newsletter. First and foremost, the case contains useful reminders about the obvious tax incentives that apply in this context, and the importance of documentation (something that was neglected here). There seems little question that a far greater case could have been made for the allocation the taxpayer was seeking had the documents been more carefully considered.

Of course, the taxpayer was being aggressive enough that no amount of documentation would likely have spelled IRS agreement on the question. That is where the subsequent lessons of the case come in. Use of expert testimony and focus on a reasonable figure seem obvious points. Indeed they are. The fact that the taxpayer was arguing for an allocation that was actually in excess of the purchase price for the entire business speaks for itself. It invited (indeed begged) the court to cut it down. Not using an expert at all was also highly risky. It was a windfall that the Tax Court found the Commissioner's expert to be so shoddy. Many taxpayers are not so lucky.

Disguised Stock Payments?

In Thompson v. Commissioner, T.C. Memo 1997-287 (1997), the sole issue before the court was how much, if any, could the taxpayers deduct for certain covenants not to compete entered into as part of an acquisition. The focus of the Tax Court's investigation was whether the amount paid for the covenants not to compete was a disguised payment for stock.

In reviewing this issue, the court focused on whether the existence of employment contracts entered into by the grantor of a covenant not to compete significantly negated the value of a covenant not to compete. The case before the Tax Court involved covenants not to compete entered into prior to the enactment of Section 197 of the Code. However, the issue of whether the amount paid for a covenant not to compete is a disguised payment for stock retains an unfortunate degree of vitality after the enactment of Section 197.

In Thompson, the target company, State Supply, was engaged in the distribution of beauty supply products in several states as a master distributor, with a number of subdistributors. Group One Capital, Inc. ("Group One"), an investment company, sought to acquire State Supply. Group One used a multiple in the range of three and a half to four times earnings in determining a price to offer for the shares of the target company.

The buyer learned through its due diligence that State Supply had 1986 pretax earnings of approximately $1.5 million. On June 2, 1987, Group One offered in writing to purchase all of the stock of State Supply for $6 million. The offer proposed that the stock purchase be accomplished by a cash merger with a new corporation to be organized by Group One. There were no provisions for any covenants not to compete in the offer.

At the time of the acquisition, Robert F. Beaurline, president of State Supply, owned approximately 20 percent of State Supply. Betty Holliday, chairman of the board of directors of State Supply, owned approximately 30 percent of State Supply. During its due diligence Group One discovered that Holliday had been with State Supply for 26 years (since its inception), and had developed extensive relationships with customers over those 26 years as the "right arm" of the founder of State Supply. Holliday had sufficient money to go into competition with State Supply after the sale of her stock to Group One.

Group One also discovered that Beaurline had been in the beauty supply business for 36 years. He had been with State Supply for eight years, knew the suppliers and customers very well, was well known in the beauty supply industry, and had served as master of ceremonies for manufacturers' sales meetings and beauty shows. Before the sale of the target, if a customer had a serious problem, the customer would call Beaurline or Holliday.

After making the offer, Group One concluded that it had to have noncompete agreements from Holliday and Beaurline in order to lower the risk to their investment. Moreover, as a condition of the acquisition loan, the bank required that Beaurline and Holliday execute noncompete agreements with the target. Therefore, covenants were entered into with Beaurline and Holliday. Beaurline and Holliday also entered into one-year employment agreements with the company. The amount due under the two covenants not to compete totaled $2.5 million.

Following the merger, State Supply elected to be taxed as an S corporation for federal income tax purposes. It claimed amortization deductions for the Beauline and Holliday covenants. The IRS disallowed in full the amortization deductions claimed with respect to the covenants not to compete.

Amortization of Covenants Prior to Section 197

Prior to the enactment of Section 197, taxpayers could generally amortize intangible assets over their useful lives. Intangible assets having ascertainable values and limited useful lives, the duration of which could be ascertained with reasonable accuracy, were subject to amortization. Newark Morning Ledger Co. v. United States, 507 U.S. 546 (1993); Citizens & Southern Corp. v. Commissioner, 91 TC 463 (1988), aff'd, 919 F.2d 1492 (11th Cir. 1990). Covenants not to compete qualified as amortizable intangible assets since such covenants usually have limited useful lives and values stated in the agreement. Warsaw Photographic Associates v. Commissioner, 84 T.C. 21 (1985); O'Dell & Co. v. Commissioner, 61 T.C. 461 (1974).

Economic Reality

The amount a taxpayer pays or allocates to a covenant not to compete is not controlling for tax purposes, and the Tax Court has strictly scrutinized an allocation if the parties do not have adverse tax interests. As in other areas of the tax law, the IRS subscribes to the notion in this context, too, that adverse tax interests deter allocations which lack economic reality. Lemery v. Commissioner, 52 T.C. 367 (1969), aff'd per curium, 451 F.2d 173 (9th Cir. 1971); Wilkoff v. Commissioner, 636 F.2d 1139 (6th Cir. 1981); Haber v. Commissioner, 52 T.C. 255 (1969), aff'd. per curiam, 422 F.2d 198 (5th Cir. 1970). Economic reality has been defined as some independent basis in fact or some arguable relationship with business reality so that reasonable persons might bargain for such an agreement. Courts apply numerous factors in evaluating a covenant not to compete. These include the following:

If an examination of the foregoing factors indicates economic reality in the covenant not to compete arrangement and the consideration given for it, then the courts have been likely to find likewise. For other cases discussing the importance of these factors, see Molasky v. Commissioner, 897 F.2d 334 (8th Cir. 1990), aff'd. in part and rev'd. in part, T.C. Memo 1988-173; Warsaw Photographic Associates, Inc. v. Commissioner, supra; Furman v. United States, 602 F.Supp. 444 (D.C. S.C. 1984), aff'd. without published opinion, 767 F.2d 911 (4th Cir. 1985). See also, Beaver Bolt, Inc. v. Commissioner, T.C. Memo 1995-549 and the cases cited therein.

Effect of Employment Agreement on Value of Covenant Not to Compete

In Thompson v. Commissioner, T.C. Memo 1997-287 (1997), the parties each called expert witnesses to give their opinions about the value of the covenants. The IRS argued that the employment agreements entered into by Holliday and Beaurline effectively prevented any possibility of competition for the year they were in effect. Once the possibility of competition is eliminated for the first year after the sale, argued the IRS, the value of the noncompete agreements was greatly reduced (the highest risk of competition coming in the first year after the sale). The Tax Court disagreed, citing Peterson Machine Tool, Inc. v. Commissioner, 79 T.C. 72 (1982), aff'd., 54 A.F.T.R.2d 84-5407 (10th Cir. 1984).

The court in Peterson Machine Tool stated that:

"The fact that [the grantor of the covenant] signed an employment contract with [the company] for the duration of his covenant not to compete is entitled to weight, but is not determinative. [Citations omitted.] There was always the possibility that [the grantor and the company] could breach the employment contract or that [the grantor] could be terminated for cause. In either case he could, absent a covenant, have engaged in competition. Furthermore, the fact that the employment contract contained its own restrictive covenant is of no moment since [the grantor] testified that the employment contract and covenant not to compete were both part and parcel of the stock-sale transaction."

Accordingly, the Tax Court in Thompson concluded that noncompete agreements and the employment agreements, which were entered into at the same time and refer to each other, is "part and parcel of the stock-sale transaction." The court gave the existence of the employment contracts some weight in its considerations. Contrary to the Revenue Service's arguments, though, the employment contracts were not determinative in considering the possibility of competition in the first year. Based on the factors listed above, when the court analyzed whether the noncompete agreements had economic reality, the facts overwhelmingly establish a strong need, and a correspondingly high relative value, for the noncompete agreements. Thus, the court sustained the taxpayers' claimed value for the covenants not to compete.

Planning Potential

Acquiring companies may have been reluctant in some cases to enter into both employment agreements and covenants not to compete with key employees of a target company, notwithstanding the business necessity that often cries out for this course of action. The concern is generally that the existence of an employment contract could significantly impact the capital cost recovery from the noncompete agreement.

Fortunately, the Tax Court in cases such as Thompson and Peterson clarifies that even where the employment agreement and the noncompete agreement are entered into simultaneously and refer to one another, the covenant's value will not be greatly impacted by the existence of the employment agreement. That means that properly structured covenants not to compete, with the deductions claimed for their amortization, will be sustained. That's good news.

In C.H. Robinson, Inc., et al. v. Commissioner, T.C. Memo 1998-430 (1998), the court underscores the importance of maintaining this distinction. In this case, C.H. Robinson, Inc. and Meyer Customs Brokers, Inc. were engaged in the business of rendering customs brokerage services. The president and sole shareholder of the Meyer company (Mr. Meyer) was a well-respected and well-known customs broker. Accordingly, C.H. Robinson, Inc. and its subsidiary, C.H. Robinson International, began negotiations to acquire Meyer's assets, including its goodwill. The closing occurred in 1990, with C.H. Robinson International making a cash payment of $300,000 to Meyer Customs Brokers, plus paying $1.3 million to Meyer individually under a three-year covenant not to compete. For each of the years 1990 through 1992, Mr. Meyer received an additional $292,000 under the covenant.

On top of the covenant not to compete, Mr. Meyer entered into a three-year employment agreement, calling for contingent salary bonuses, depending on whether Robinson International reached its net profit goals for each of the respective years. Mr. Meyer received annual payments of $250,000 as bonuses for 1990 through 1992. International deducted these payments (as well as the amounts paid to Meyer under the covenant) as ordinary business expenses. The IRS disallowed the deductions, asserting that they were nondeductible capital expenditures.

Covenant Too Rich

In Tax Court, the IRS view was upheld, the Tax Court concluding that payments for the covenant represented nondeductible capital expenditures because the payment relating to the covenant did not reflect economic reality. The court concluded that the $1.3 million paid to Mr. Meyer at the closing (in addition to the $300,000) was effectively a payment for the company's assets. After all, the two cash payments, $1.3 million plus $300,000, closely resembled the original terms by which International was to pay $1.5 million for the target's assets. This particular feature of the case, which seems obvious, should be a strong warning to those who argue back and forth about an allocation of purchase price following an original statement that a particular price would be paid for the assets.

The Tax Court in C.H. Robinson, Inc. went on to hold that the additional payments under the covenant not to compete were deductible business expenses, finding that they did reflect economic reality. The court noted that Mr. Meyer had sufficient capital available and the ability to start a new customs brokerage business to compete with International. This real life ability to compete is often a factor in these cases, making the courts willing to allocate significant dollars to a covenant not to compete.

Finally, the Tax Court concluded that the annual salary bonuses were properly deductible, constituting ordinary and necessary business expenses. The court found that these payments constituted reasonable compensation. The court also noted that the company's earnings depended primarily on Mr. Meyer's efforts. Meyer maintained all of the former clients of Meyer Customs Brokers, and managed the expansion of the company post-acquisition. The court also found that the bonuses paid to Mr. Meyer were comparable to his annual salaries prior to the acquisition.


The lesson of all of these cases seems clear. First, one should be realistic in allocating amounts between a covenant not to compete and salary or bonus amounts. More importantly, one should be realistic in allocating payments between a covenant not to compete and the purchase price for assets. If there is a dispute, use an expert, and have good verification of how values were reached.

Noncompete Agreements, Vol. 10, No. 4, The M&A Tax Report (November 2001), p. 1.