Recovery Group, Inc. v. Commissioner

United States Court of Appeals
For the First Circuit

No. 10-1886

RECOVERY GROUP, INC., ET AL.,

Petitioners, Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent, Appellee.

APPEAL FROM THE JUDGMENT OF THE
UNITED STATES TAX COURT

Before

Torruella, Circuit Judge,
Souter,* Associate Justice,
and Boudin, Circuit Judge.

Peter L. Banis, with whom Banis, O'Sullivan & McMahon, LLP,
was on brief for petitioners.
Damon W. Taaffe, Attorney, Tax Division, Department of
Justice, with whom John A. DiCicco, Acting Assistant Attorney
General, and Thomas J. Clark, Attorney, were on brief for
respondent.

July 26, 2011

*
The Hon. David H. Souter, Associate Justice (Ret.) of the
Supreme Court of the United States, sitting by designation.
 TORRUELLA, Circuit Judge. The present appeal requires us

to determine whether a covenant not to compete, entered into in

connection with the acquisition of a portion of the stock of a

corporation that is engaged in a trade or business, is considered

a "section 197 intangible," within the meaning of

I.R.C. § 197(d)(1)(E), regardless of whether the portion of stock

acquired constitutes at least a "substantial portion" of such

corporation's total stock. For the reasons stated below, we answer

in the affirmative.

Petitioners-Appellants Recovery Group, Inc. ("Recovery

Group") and thirteen individuals who held shares in said

corporation appeal the United States Tax Court's decision in

Recovery Group, Inc. v. Comm'r of Internal Revenue, T.C. Memo

2010-76, 99 T.C.M. (CCH) 1324 (U.S. Tax Ct. Apr. 15, 2010), which

found in favor of respondent Commissioner of Internal Revenue (the

"Commissioner") concerning the correctness of certain income tax

deficiencies assessed by the United States Internal Revenue Service

(the "IRS") against the appellants.1 These deficiencies resulted

from the finding that a certain covenant not to compete -- entered

into by Recovery Group in connection with the redemption of 23% of

the shares of a former shareholder -- constituted a "section 197

intangible," and, consequently, that Recovery Group had to amortize

1
The tax court, however, ruled against respondent Commissioner of
Internal Revenue regarding the application of certain accuracy-
related penalties. The Commissioner did not appeal this ruling.

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the payments it made under such covenant not to compete over the

fifteen-year period prescribed by I.R.C. § 197(a), and not over the

duration of the covenant, as Recovery Group had reported in its

corresponding income tax returns. Because we find that the

aforementioned covenant not to compete was an "amortizable section

197 intangible," we affirm.

I. Facts and Procedural History

The relevant facts in this appeal are not in dispute.

During the tax years in question, Recovery Group was an

"S corporation"2 that engaged in the business of providing

consulting and management services to insolvent companies.

In 2002, James Edgerly -- one of Recovery Group's

founders, employees and minority shareholders -- informed its

president that he wished to leave the company and to have the

company buy out his shares, which represented 23% of Recovery

Group's outstanding stock. As a result of the subsequent

negotiations, Mr. Edgerly entered into a buyout agreement whereby

Recovery Group agreed to redeem all of Mr. Edgerly's shares for a

price of $255,908. In addition, Mr. Edgerly entered into a

"noncompetition and nonsolicitation agreement" that prohibited Mr.

Edgerly from, inter alia, engaging in competitive activities from

2
Subchapter S of the Internal Revenue Code, I.R.C. §§ 1361 et
seq., permits small business corporations meeting the criteria set
forth in the statute to elect to be taxed as "pass through"
entities in a manner similar to partnerships, rather than
corporations. 26 U.S.C. § 1362(a).

-3-
July 31, 2002 through July 31, 2003. The amount paid by Recovery

Group to Mr. Edgerly for this covenant not to compete (the

"Covenant") amounted to $400,000, which was comparable to Mr.

Edgerly's annual earnings.

In its corresponding income tax returns, Recovery Group

claimed deductions for its payments under the Covenant by

amortizing such payments over the twelve-month duration of the

Covenant. Thus, because that twelve-month term straddled the two

tax years 2002 and 2003, Recovery Group allocated the $400,000 over

those two years.

After a subsequent investigation, the IRS determined that

the Covenant was an amortizable section 197 intangible, amortizable

by Recovery Group over fifteen years (beginning with the month of

acquisition) and not over the duration of the Covenant, as had been

reported by Recovery Group in its corresponding income tax returns.

Consequently, the IRS partially disallowed Recovery Group's

deductions for the cost of the Covenant, allowing amortization

deductions of only $11,111 for 2002 and $26,667 for 2003, and

disallowing $155,552 for 2002 and $206,667 for 2003. This

disallowance increased Recovery Group's net income for each year,

and thus each shareholder's share of Recovery Group's income.

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Accordingly, the IRS issued notices of deficiency to both Recovery

Group and its shareholders.3

Recovery Group and its shareholders filed timely

petitions in the tax court, alleging that the Covenant was not

considered a "section 197 intangible," and, consequently, that it

was not subject to I.R.C. § 197's fifteen-year amortization period,

but rather that it was amortizable over its one-year duration.

Specifically, Recovery Group alleged that, in order for a covenant

not to compete to be considered a "section 197 intangible" under

I.R.C. § 197(d)(1)(E), the covenant must be entered into in

connection with the acquisition of either the totality of such

corporation's stock or a substantial portion of such corporation's

total stock. The tax court rejected Recovery Group's

interpretation of I.R.C. § 197 and found in favor of the

Commissioner, concluding that § 197(d)(1)(E)'s substantiality

requirement only applied to asset acquisitions and not to stock

acquisitions, and, consequently, that a covenant not to compete

entered into in connection with the acquisition of any corporate

3
If an eligible corporation makes an election under I.R.C.
§ 1362(a) to be treated as an "S corporation" for income tax
purposes, as Recovery Group did for the tax years here in question,
the corporation's income is generally not taxed at the corporate
level, but rather is passed through (and taxed) to its
shareholders. As an exception to this rule, however, an
S corporation itself is liable for tax under I.R.C. § 1374(a) on
its "net recognized built-in gain," if any. In the instant case,
the IRS's disallowance of the deductions claimed by Recovery Group
gave rise to such a gain. Thus, the IRS also issued a notice of
deficiency to Recovery Group.

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stock, even if not "substantial," was considered a "section 197

intangible" amortizable over fifteen years. The tax court also

opined, in the alternative, that even if the aforementioned

conclusion was incorrect and I.R.C. § 197(d)(1)(E)'s substantiality

requirement indeed applied to stock acquisitions, Recovery Group's

claim nonetheless failed because the court found the stock

redemption in question (23% of Recovery Group's total stock) to be

a "substantial portion" of the company's stock. This appeal

ensued.4

II. Standard of Review

We review de novo the tax court's legal conclusions,

including its interpretation of the Internal Revenue Code. Drake

v. Comm'r, 511 F.3d 65, 68 (1st Cir. 2007).

III. Discussion

On appeal, Recovery Group contests the tax court's

decision on the tax deficiencies by challenging the court's

interpretation of I.R.C. § 197.5 Specifically, Recovery Group

avers that the tax court erred by concluding that the Covenant is

a "section 197 intangible" within the meaning of I.R.C.

§ 197(d)(1)(E).

4
We have jurisdiction to hear this appeal, pursuant to
I.R.C. § 7482.
5
All appellants, including Recovery Group, join in raising the
same arguments on appeal.

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 In interpreting the meaning of I.R.C. § 197(d)(1)(E), we

begin our analysis with the statutory text and determine whether

the same is plain and unambiguous. See Carcieri v. Salazar, 555

U.S. 379, 129 S.Ct. 1058, 1063 (2009). In so doing, we accord the

statutory text "its ordinary meaning by reference to the 'specific

context in which that language is used, and the broader context of

the statute as a whole.'" Mullane v. Chambers, 333 F.3d 322, 330

(1st Cir. 2003) (quoting Robinson v. Shell Oil Co., 519 U.S. 337,

341 (1997)). If the statutory language is plain and unambiguous,

we "must apply the statute according to its terms," Carcieri, 129

S.Ct. at 1063-64, except in unusual cases where, for example, doing

so would bring about absurd results. See In re Hill, 562 F.3d 29,

32 (1st Cir. 2009). "If the statute is ambiguous, we look beyond

the text to the legislative history in order to determine

congressional intent." United States v. Vidal-Reyes, 562 F.3d 43,

50-51 (1st Cir. 2009) (internal quotation marks omitted). "A

statute is ambiguous only if it admits of more than one reasonable

interpretation." Id. at 51 (internal quotation marks omitted).

We begin our discussion by providing a brief background

of I.R.C. § 197 and then turn to sketching both the Commissioner's

construction of I.R.C. § 197, which was adopted by the tax court as

its primary holding, and Recovery Group's interpretation.

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A. Background

Section 197 entitles taxpayers to claim "an amortization

deduction with respect to any amortizable section 197 intangible."

26 U.S.C. § 197(a). The cost of an "amortizable section 197

intangible" must be amortized "ratably over the 15-year period

beginning with the month in which such intangible was acquired."

Id. No other depreciation or amortization deduction is allowed

with respect to any "amortizable section 197 intangible." Id. at

§ 197(b). On the other hand, intangible assets not classified as

"amortizable section 197 intangible[s]" are not within the purview

of I.R.C. § 197 and are not subject to this section's mandatory

fifteen-year amortization period. Rather, depreciation and

amortization for such non-section 197 intangible assets may be

allowed under the rules of other code provisions, such as I.R.C.

§ 167, provided the asset complies with the requirements set forth

therein.

B. Relevant Statutory Language

Section 197(d)(1)(E) defines the term "section 197

intangible" as including, among other things, "any covenant not to

compete . . . entered into in connection with an acquisition

(directly or indirectly) of an interest in a trade or business or

substantial portion thereof." Recovery Group does not contest

that, under I.R.C. § 197(d)(1)(E), a redemption of stock is

considered an indirect acquisition of an interest in a trade or

-8-
business. See Frontier Chevrolet Co. v. Comm'r, 329 F.3d 1131,

1132 (9th Cir. 2003). Rather, the parties' dispute over the

construction of this section deals primarily with the antecedent of

the word "thereof" and the definition of "an interest."

The tax court held and the Commissioner asserts that the

phrase "an interest in a trade or business" refers to a portion --

all or a part -- of an ownership interest in a trade or business,

and that the phrase "trade or business" is the antecedent of the

word "thereof." Thus, the tax court essentially read

I.R.C. § 197(d)(1)(E) as follows: "the term 'section 197

intangible' means . . . any covenant not to compete . . . entered

into in connection with an acquisition . . . of [(1)] an interest

in a trade or business or [(2)] [a] substantial portion [of a trade

or business]." It is noteworthy that, under this interpretation,

the question of whether an acquisition is "substantial" arises only

where the acquisition is "of a trade or business" (i.e., of assets

constituting a trade or business), and not where the acquisition is

of "an interest" (i.e., a stock or partnership ownership interest)

in a trade or business. In other words, under this reading, a

covenant not to compete executed in connection with a stock

acquisition of any size -- substantial or not -- would be

considered a "section 197 intangible." Meanwhile, in the context

of asset acquisitions, a covenant not to compete would only be

considered a "section 197 intangible" insofar as it is entered into

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in connection with the acquisition of all or a substantial portion

of assets constituting a trade or business. Accordingly, the tax

court held that "15-year amortization is required when a covenant

is entered into in connection with an acquisition of either an

interest (i.e., an entire or fractional stock interest) in a trade

or business or assets constituting a substantial portion of a trade

or business." Recovery Group, Inc., T.C. Memo 2010-76.

Recovery Group, on the other hand, argues that the words

"an interest in a trade or business" refer to "the entire interest

in a trade or business," and that the phrase "an interest in a

trade or business" is the antecedent of the word "thereof."

Accordingly, Recovery Group maintains that I.R.C. § 197(d)(1)(E)

should be construed as follows: "the term 'section 197 intangible'

means . . . any covenant not to compete . . . entered into in

connection with an acquisition . . . of [(1)] [the entire] interest

in a trade or business or [(2)] [a] substantial portion [of an

interest in a trade or business]." Recovery Group further alleges

that the phrase "an interest in a trade or business" should be read

to include both assets constituting a trade or business and stock

in a corporation that is engaged in a trade or business.6 Thus,

6
Recovery Group supports its interpretation -- that "interest in
a trade or business" is the operative phrase working as the
antecedent of the word "thereof" -- by citing a sentence in the
legislative history that states as follows: "For [purposes of
I.R.C. § 197], an interest in a trade or business includes not only
the assets of a trade or business, but also stock in a corporation
that is engaged in a trade or business or an interest in a

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under this interpretation, section 197's fifteen-year amortization

would apply to covenants issued in connection with a stock

acquisition only insofar as the covenantee7 acquires at least a

"substantial portion" of stock in a corporation that is engaged in

a trade or business. In other words, under this reading of I.R.C.

§ 197(d)(1)(E), the question of whether an acquisition is

"substantial" would arise both in stock and asset acquisitions.

As an initial matter, we note that Recovery Group's

construction of I.R.C. § 197(d)(1)(E) makes a portion of the

statutory language seem redundant, and thus fails to give effect to

the entire statute. See In re Baylis, 313 F.3d 9, 20 (1st Cir.

2002) ("In construing a statute we are obliged to give effect, if

possible, to every word Congress used." (quoting Reiter v. Sonotone

Corp., 442 U.S. 330, 339 (1979))). Specifically, if, as Recovery

Group alleges, the textual definition of a section 197 intangible

includes a covenant not to compete entered into in connection with,

(1) the entire interest in a trade or business or (2) a substantial

portion of an interest in a trade or business, then the first

partnership that is engaged in a trade or business." H.R. Rep. No.
103-111, at 764 (1993). However, as discussed in the following
section, a comprehensive analysis of the congressional concerns and
purposes manifested in the legislative history of I.R.C. § 197
makes clear that Recovery Group's reading of the statute is
incorrect.
7
A "covenantee" is the "person to whom a promise by covenant is
made; one entitled to the benefit of a covenant." Black's Law
Dictionary 421 (9th ed. 2009). In the present case, Recovery Group
was the covenantee under the Covenant.

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category may be considered redundant because any acquisition

falling under "(1)" would presumably also satisfy the second

category. Nevertheless, this weakness, by itself, is not

sufficient in the present case to discard Recovery Group's

interpretation as unreasonable or to dispel the ambiguity that

otherwise arises from the statutory language. See Lamie v. United

States Tr., 540 U.S. 526, 536 (2004) (noting that "[a court's]

preference for avoiding surplusage constructions is not absolute").

Rather, we find that the relevant statutory language is ambiguous,

as both the Commissioner's and Recovery Group's interpretations of

the same are reasonable within the context of the statute.8

Accordingly, we proceed to analyze the statute's legislative

history in order to determine congressional intent. See

Vidal-Reyes, 562 F.3d at 50-51.

C. Purpose and Legislative History

Prior to the enactment of I.R.C. § 197, as part of the

Revenue Reconciliation Act of 1993 (Pub. L. No. 103-66, 107 Stat.

312), taxpayers were not allowed an amortization deduction with

respect to goodwill, but were allowed an amortization deduction for

intangible assets that had limited useful lives that could be

determined with reasonable accuracy. See Newark Morning Ledger Co.

v. United States, 507 U.S. 546, 548 n.1 (1993) (citing 26 C.F.R.

8
As counsel for the respondent-appellee understatedly conceded
during oral arguments for this appeal, the statutory language here
in question "is not a model of clarity."

-12-
§ 1.167(a)–3 (1992)). As a result, taxpayers and the IRS engaged

in voluminous litigation concerning the identification of

amortizable intangible assets and their useful lives.9

The legislative history of I.R.C. § 197 identified the

following three types of disputes arising between taxpayers and the

IRS: "(1) whether an amortizable intangible asset exists; (2) in

the case of an acquisition of a trade or business, the portion of

the purchase price that is allocable to an amortizable intangible

asset; and (3) the proper method and period for recovering the cost

of an amortizable intangible asset." H.R. Rep. No. 103-111, at 760

(1993).

The legislative history referred to the "severe backlog

of cases in audit and litigation [as] a matter of great concern,"

and made explicitly clear that "[t]he purpose of [I.R.C. § 197]

[was] to simplify the law regarding the amortization of

intangibles." Id. at 777.10 The Committee "believed that much of

the controversy that [arose] under [pre-section-197] law with

9
In 1993, the IRS estimated that $14.4 billion in proposed
adjustments relating to intangible amortization cases were in
various levels of the audit and litigation process. Sheppard, IRS
Official Discusses Settlement of Intangible Cases, Tax Analysts,
Tax Notes Today, 93 TNT 204-1, October 4, 1993.
10
In the American Jobs Creation Act of 2004, Pub. L. No. 108-357,
118 Stat. 1418, which extended the rules of I.R.C. § 197 to
acquisitions of sports franchises, Congress had an opportunity to
reiterate the purposes served by I.R.C. § 197. Notably, the
legislative history of this act referred to disputes over the
amortizable life of intangible assets as "an unproductive use of
economic resources." H.R. Rep. No. 108-548, pt. 1 (2004).

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respect to acquired intangible assets could be eliminated by

specifying a single method and period for recovering the cost of

most acquired intangible assets and by treating acquired goodwill

and going concern value as amortizable intangible assets." Id. at

760. Accordingly, the bill required the cost of most acquired

intangible assets, including goodwill and going concern value, to

be amortized ratably over a fixed fifteen-year period. Id.11 In

reaching this simplified approach, the Committee recognized that

certain acquired intangible assets -- to which I.R.C. § 197 applied

-- would have useful lives that would not coincide with the

fifteen-year amortization period prescribed by the statute. Id.

In the particular case of a covenant not to compete,

Congress made I.R.C. § 197 applicable only where the covenant was

entered into in connection with an acquisition of an interest in a

trade or business or substantial portion thereof.12 26 U.S.C.

§ 197(d)(1)(E). This category was included in I.R.C. § 197 because

of the immense volume of litigation regarding the value properly

assignable to covenants not to compete. See generally Annette

11
Although this portion of the legislative history provided for
a fourteen-year amortization period, the bill was later modified to
reflect a fifteen-year amortization period. See
H.R. Rep. No. 103-213 (1993).
12
Other covenants not to compete are not governed by I.R.C. § 197
and may be amortized over their useful lives, provided they satisfy
the requirements of I.R.C. § 167 and its regulations. See
generally David L. Cameron & Thomas Kittle-kamp, Federal Income
Taxation of Intellectual Properties & Intangible Assets
¶ 8.03[2][b], at 8 (RIA 2011).

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Nellen, BNA Tax Management Portfolio 533-3rd: Amortization of

Intangibles § III.B.10.

In the context of asset acquisitions, if

I.R.C. § 197(d)(1)(E) had not been included, a buyer of assets

constituting a trade or business would have had a significant tax-

motivated incentive to allocate as covenant cost -- and amortize

over the covenant's useful life -- what was in fact purchase price

attributable to section 197 intangibles (such as goodwill and going

concern), which are amortizable over a fifteen-year period pursuant

to I.R.C. § 197.13 This incentive would have inevitably given rise

to much litigation, since the value of goodwill and going concern

is notoriously difficult to determine, see Sanders v. Jackson, 209

F.3d 998, 1003 (7th Cir. 2000) (noting that "due to its transitory

nature, goodwill is extremely difficult to quantify and value with

any certainty"), thus allowing for much latitude and uncertainty in

the allocation of amounts between the covenant and these

intangibles. Section 197 attempts to eliminate this incentive and

avoid litigation by applying to the covenant not to compete the

same fifteen-year amortization period and rules applicable to

13
This incentive would have been balanced only by the stock
seller-covenantor's preference for allocating purchase price to the
assets sold (instead of the covenant), because he presumably would
receive capital gain treatment (generally taxed at preferential
rates) for his gain on the sale of the assets and would receive
ordinary gain treatment for the consideration received under the
covenant. See Muskat v. United States, 554 F.3d 183, 188 (1st Cir.
2009).

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section 197 intangibles (such as goodwill and going concern)

transferred under the sale of the business, thereby making it less

relevant for a buyer of a business whether a payment to the seller

is classified as covenant consideration or goodwill purchase price.

However, because goodwill and going concern are presumably only

transferred where at least a substantial portion of assets

constituting a trade or business is sold, the opportunity to

classify as covenant consideration what is in fact goodwill

purchase price is generally not present where a covenant is entered

into in connection with the acquisition of less than a substantial

portion of assets constituting a trade or business. This explains

why, in the context of asset acquisitions, Congress made

I.R.C. § 197(d)(1)(E) applicable only where the covenant not to

compete was entered into in connection with the acquisition of at

least a substantial portion of assets constituting a trade or

business.

In the context of stock acquisitions, however, the

uncertainty -- and consequently the possibility for much litigation

between taxpayers and the IRS -- caused by the inherent difficulty

in valuing goodwill and going concern is generally present even

where the purchased stock does not constitute a substantial portion

of the corporation's total stock. This is due to the fact that

goodwill and going concern generally constitute an essential

component of the value of each share of corporate stock, as each

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share of stock reflects a proportionate allotment of the value of

the corporation's goodwill and going concern. See, e.g., Home Sav.

Bank v. City of Des Moines, 205 U.S. 503, 512 (1907) (noting that

goodwill was an essential component of the value of the shares of

a bank); Charter Wire, Inc. v. United States, 309 F.2d 878, 879

(7th Cir. 1962) ("The stock included the good will value of the

enterprise."); Young v. Seaboard Corp., 360 F. Supp. 490, 497

(D. Utah 1973) (noting that the market value of the shares of a

corporation "included the going concern and good will value of the

corporation"). Accordingly, especially in the case of non-publicly

held corporations,14 the valuation of shares of corporate stock can

become quite complex and uncertain. See Dugan v. Dugan, 457 A.2d

1, 6 (N.J. 1983) ("There are probably few assets whose valuation

imposes as difficult, intricate and sophisticated a task as

interests in close corporations. They cannot be realistically

evaluated by a simplistic approach which is based solely on book

value, which fails to deal with the realities of the good will

concept . . . ."). As discussed below, concerns over the

voluminous amount of litigation between taxpayers and the IRS,

brought in part by this uncertainty in the valuation of corporate

14
The valuation of shares in publicly traded corporations is not
as complex as in non-publicly traded corporations, because, in the
case of the former, one can determine their value based on the
market price of the stock. See Dugan v. Dugan, 457 A.2d 1, 5 (N.J.
1983) (citing G. Catlett & N. Olson, Accounting for Goodwill 14
(1968)).

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stock, directly influenced the solution crafted by Congress in

I.R.C. § 197(d)(1)(E).

If I.R.C. § 197(d)(1)(E) had not applied to a covenant

not to compete entered into in connection with the acquisition of

a corporation's stock, a buyer of such stock would have had a very

significant incentive to allocate to the cost of the covenant what

was in fact stock purchase price, because the ostensible cost of

the covenant would presumably be amortized and deducted over its

usually short useful life, while amounts allocated to the stock's

purchase price would not be deductible and would simply form part

of the buyer's basis in the stock, presumably to be recovered only

after the buyer subsequently disposed of such stock and a capital

gain/loss was computed on such disposition. See generally, Boris

I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates

and Gifts ¶ 46.1 (RIA 2011). This powerful incentive for the stock

buyer-covenantee to overstate the cost of the covenant and to

understate the price of the stock, combined with the opportunity

for massaging the numbers provided by the aforementioned

uncertainty inherent in determining the value of the stock, would

create fertile ground for substantial litigation between taxpayers

and the IRS. Section 197 addresses this situation by decreasing

the stock buyer-covenantee's tax-motivated incentive to overstate

the cost of the covenant. Specifically, I.R.C. § 197 imposes a

fifteen-year amortization period to covenants not to compete

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entered into in connection with the acquisition of stock in a

corporation that is engaged in a trade or business. H.R. Rep. No.

103-111, at 764 (1993). This rule reduces the tax benefit that a

stock buyer-covenantee would presumably have otherwise derived from

an overstatement of the covenant's cost (i.e., it precludes the

taxpayer from amortizing and deducting the covenant over its

usually short useful life).

In light of the foregoing, we now analyze the crux of

this case: whether Congress intended I.R.C. § 197(d)(1)(E) to apply

to any stock acquisition or only those stock acquisitions

considered "substantial."

D. Analysis

We disagree with Recovery Group's contention that, in the

context of stock acquisitions, I.R.C. § 197(d)(1)(E) only applies

to acquisitions considered at least "substantial."

As previously mentioned, I.R.C. § 197(d)(1)(E)

illustrates Congress' recognition that the difficulty and

uncertainty in the valuation of corporate stock, combined with the

rule allowing taxpayers to deduct and amortize covenants not to

compete over their usually short useful lives, provided too much of

an incentive for stock buyers, who entered into a covenant not to

compete in connection with the acquisition of such stock, to

overstate the cost of the covenant and understate the price of the

stock. Congress thus attempted, under I.R.C. § 197, to reduce this

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incentive and simplify the law regarding amortization of

intangibles, by decreasing the tax benefit related to such

covenants; more specifically, it required that they all be

amortized over a fifteen-year period, instead of their usually

short useful lives.

Furthermore, it is important to note that these concerns

-- influencing Congress to include stock acquisitions in

I.R.C. § 197(d)(1)(E) -- are present both where the taxpayer

acquires a substantial and a less than substantial portion of a

corporation's stock. That is, the fact that a taxpayer acquires a

non-substantial portion of corporate stock -- as opposed to a

substantial portion -- does not make the value of such stock any

less difficult to quantify, because the goodwill and going concern

components are still present even where a non-substantial portion

of stock is transferred. Accordingly, a taxpayer who enters into

and pays for a covenant not to compete (as the covenantee) -- in

connection with the acquisition of a non-substantial portion of

corporate stock -- generally has the same opportunity, for purposes

of overstating the cost of the covenant and understating the value

of the stock, as compared to a taxpayer who instead acquires a

substantial portion of stock. Thus, Congress' concerns and

purposes behind the enactment of I.R.C. § 197(d)(1)(E) strongly

suggest that Congress intended that the section be made applicable

to covenants entered into in connection with the acquisition of any

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shares of corporate stock, regardless of whether they constitute a

substantial portion of the corporation's total stock.

The situation is different, however, in the case of asset

acquisitions, because a transfer of assets, which do not constitute

a substantial portion of a trade or business, presumably does not

encompass the transfer of goodwill or going concern, and,

consequently, does not pose the same difficult valuation issues as

a transfer of assets constituting a substantial portion of a trade

or business, the value of which presumably includes goodwill and

going concern. This difference explains why Congress chose

different tax treatments for (1) covenants executed in connection

with the acquisition of at least a substantial portion of assets

constituting a trade or business, as opposed to (2) covenants

executed in connection with the acquisition of less than a

substantial portion of assets constituting a trade or business.

Specifically, as both parties assert, in this context, Congress

made I.R.C. § 197(d)(1)(E) applicable only to covenants not to

compete entered into in connection with the acquisition of at least

a substantial portion of assets constituting a trade or business.

As previously explained, however, the reason for this difference in

tax treatment is not present in the context of stock acquisitions.

Based on the above, we agree with the tax court and the

IRS in that I.R.C. § 197(d)(1)(E) should be construed as follows:

"the term 'section 197 intangible' means . . . any covenant not to

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compete . . . entered into in connection with an

acquisition . . . of [(1)] an interest in a trade or business or

[(2)] [a] substantial portion [of assets constituting a trade or

business]." Accordingly, we hold that, pursuant to this section,

a "section 197 intangible" includes any covenant not to compete

entered into in connection with the acquisition of any shares --

substantial or not -- of stock in a corporation that is engaged in

a trade or business.

We find that this interpretation comports better with the

purposes of I.R.C. § 197 and responds to Congress' reiterated

intentions of simplifying the law regarding the amortization of

intangibles and reducing the voluminous amount of litigation that

has characterized this area. Based on the legislative history, we

doubt Congress chose to spur a new wave of litigation in this area

by unnecessarily requiring taxpayers and the IRS to litigate what

may constitute a "substantial portion" of corporate stock.

Having found that I.R.C. § 197(d)(1)(E) applies to

covenants not to compete entered into in connection with the

acquisition of any shares of corporate stock, we conclude in the

instant case that the Covenant, which was entered into by Recovery

Group in connection with the redemption (i.e., indirect

acquisition) of 23% of its stock, was a "section 197 intangible."

Moreover, because Recovery Group does not allege that any exception

applies, we conclude that the Covenant was an "amortizable section

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197 intangible" subject to the fifteen-year amortization period

prescribed under I.R.C. § 197(a). We therefore affirm the tax

court's decision as to the tax deficiencies in question.

IV. Conclusion

For the reasons stated, we conclude that the Covenant was

an "amortizable section 197 intangible" subject to the fifteen-year

amortization period set forth under I.R.C. § 197(a). Accordingly,

we affirm the tax court's determination regarding the tax

deficiencies disputed in this appeal.

Affirmed.

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