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.
-4-
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.
-6-
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.
-7-
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).
-14-
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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