T.C. Memo. 1997-313
UNITED STATES TAX COURT
HOWARD PONTIAC-GMC, INC.,
D.B.A. BOB HOWARD AUTOMALL, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4972-95. Filed July 7, 1997.
Randall K. Calvert, for petitioner.
David G. Hendricks and Michael J. O'Brien, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: Respondent determined deficiencies in
petitioner's Federal income tax of $4,689 and $24,367 for the
1990 and 1991 tax years, respectively. Petitioner purchased the
inventories (parts, accessories, new and used cars) of Dave
Markley Jeep-Eagle, Inc. (seller). Pursuant to a sales
- 2 -
agreement, John David Markley (Mr. Markley), the sole shareholder
and president of seller, terminated his Jeep-Eagle franchise with
Chrysler Corp. (Chrysler) and granted petitioner a covenant not
to compete. Petitioner acquired the relinquished franchise from
Chrysler. The sole issue for decision is whether the fair market
value of the covenant not to compete (sometimes referred to as
the covenant) is $490,000, as petitioner contends, $125,000, as
respondent contends, or some other amount. All section
references are to the Internal Revenue Code in effect for the
years in issue, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference. Petitioner (sometimes
referred to as buyer) is a corporation whose home office and
principal place of business was in Oklahoma City, Oklahoma, at
the time it filed the petition in this case. Petitioner filed
Forms 1120, U.S. Corporation Income Tax Return, for the taxable
years 1990 and 19911 with the Internal Revenue Service Center,
Austin, Texas. Petitioner had a calender yearend.
Mr. Markley's Ability to Compete
Mr. Markley entered the automobile dealership business in
the mid-1960's. He purchased a Ford dealership in Yukon,
1
Unless otherwise indicated, all descriptions pertain to
the years in issue.
- 3 -
Oklahoma, in 1968 and a Ford dealership in Dallas, Texas, in
1975. He was the sole shareholder and dealer of the Yukon and
Dallas dealerships. Both of these dealerships were successful,
and Mr. Markley enjoyed a good reputation within the industry
with his customers. As a suburban Oklahoma Ford dealer, Mr.
Markley was a competitor of Oklahoma City dealerships, and was
consistently ranked among the top two or three truck dealers in
the Oklahoma City metro area (out of seven dealerships). In 1980
and 1981, Mr. Markley sold the Dallas and Yukon dealerships.
In May 1988, Mr. Markley reentered the automobile dealership
business when Chrysler awarded him a Jeep-Eagle franchise in
Oklahoma City. He acquired the Jeep-Eagle franchise directly
from Chrysler. The seller's sales and service agreement with
Chrysler (the franchise) was not transferable and was conditioned
upon the continued performance of day-to-day management duties by
Mr. Markley.
Mr. Markley was a successful Jeep-Eagle dealer in the
Oklahoma City market. His overall vehicle sales averages
exceeded his market share responsibility as determined by
Chrysler. Mr. Markley's name was known in the Oklahoma City
market as a result of his 14 years of advertising as a Ford
dealer in Yukon, Oklahoma (a suburb of Oklahoma City).
At the time of the sale to petitioner, Mr. Markley intended
to stay in the Oklahoma City area. He was 49 years old, in good
health, and intended to expand an existing used car and finance
company business in Oklahoma City.
- 4 -
Mr. Howard
At the time of the agreement, Robert E. Howard II, was the
sole shareholder and CEO of petitioner. He was 43 years old.
Mr. Howard has been in the automobile business all his life. He
began working in his father's car dealership as a teenager. In
1971, at age 24, Mr. Howard began working for Bob Moore Cadillac.
Bob Moore is a "mega dealer"2 who has assisted a number of other
individuals in acquiring dealerships, all of whom have been
successful and some of whom have become mega dealers in their own
right. Mr. Howard worked his way up to the position of sales
manager for Bob Moore Cadillac and in 1973, at the age of 26, was
the youngest metropolitan Cadillac sales manager in the United
States. In 1973, Mr. Howard was promoted to general manager of a
Chevrolet dealership owned by Mr. Moore.
In 1978, at age 31, Mr. Howard purchased an interest in a
Pontiac-GMC dealership (petitioner) in Edmond, Oklahoma. By
1980, Mr. Howard had become the sole shareholder of petitioner.
Bob Howard Automall
By 1982, petitioner had obtained the rights to represent
Subaru, Mazda, and Yugo. In 1986, Mr. Howard acquired 10-1/2
acres of land in Oklahoma City (the site). Mr. Howard
constructed three automobile sales facilities and a parts and
service facility on the site which became known as the Bob Howard
Automall (the automall). Mr. Howard devoted all of his time to
2
The term was used, but not defined, by the parties. We
use the term to mean a very large automobile dealership.
- 5 -
the operations of petitioner from 1978 through 1991. Mr. Howard
has been president and general manager of petitioner since 1978.
By 1988, petitioner, primarily through the efforts of Mr. Howard,
had become the number 2 volume sales leader for Pontiac and GMC
trucks in the State of Oklahoma. By 1988, petitioner had also
become the number 1 volume retail sales leader in the State of
Oklahoma for Mazda, Subaru, and Yugo.
The facilities at the automall were approximately twice as
big as were needed for petitioner's operations. Petitioner was
very successful with the vehicle lines represented; however, the
overhead expense from the oversized facilities made the
acquisition of other vehicle lines very important to petitioner.
In 1988 and 1989, Mr. Howard was actively seeking additional
automobile lines from other manufacturers for his automall. Mr.
Howard talked to manufacturers about new dealerships that might
be awarded in the Oklahoma City area.
Mr. Howard was also looking for dealerships whose assets
could be acquired without the necessity of having to enter into
an agreement to lease or purchase the real estate where the
dealership was located. In approximately 1988 or 1989,
petitioner became very interested in the possibility of
representing Dodge, Chrysler-Plymouth, or Jeep-Eagle. Petitioner
could not operate a Jeep-Eagle distributorship without a Jeep-
Eagle franchise.
- 6 -
The Sale and the Agreement
Petitioner wanted to acquire the Jeep-Eagle franchise held
by seller. Seller's business premises were located approximately
2 miles from petitioner's automall. In late 1989, Mr. Howard (on
behalf of petitioner) and Mr. Markley (on behalf of seller) began
discussions regarding the possibility of petitioner acquiring
certain assets of seller. By November 1989, Mr. Howard and Mr.
Markley agreed that petitioner would acquire the inventories (the
new cars, used cars, and parts inventory) of seller. Petitioner
did not purchase or utilize seller's location in any way.
Petitioner was prohibited from using the Markley name.
Mr. Howard and Mr. Markley contacted their attorneys, who
had not been involved in the negotiations up to that point, and
asked them to draft an agreement (the agreement) which embodied
the terms on which they had agreed. At the time they were
memorializing the agreement, the attorneys suggested to the
parties that they should allocate $10,000 to goodwill.
Accordingly, the parties allocated $490,000 to the covenant and
$10,000 to goodwill.
The final draft of the agreement provided for the purchase
of parts and new vehicle inventories based upon manufacturer's
price lists and invoices and the purchase of used car inventories
based upon the agreed value of each vehicle at date of closing.
Petitioner would not agree to purchase the fixed assets of
seller. The total consideration paid was approximately $2.5
million, allocated by buyer and seller as follows:
- 7 -
Inventories $2,000,000
Covenant not to compete 490,000
Goodwill 10,000
Total sales price 2,500,000
Petitioner and seller signed the agreement on November 15,
1989. The form of the covenant not to compete was attached as
schedule 1 to the agreement. Section 10 of the agreement
provided:
The Buyer [petitioner] agrees that Buyer will not use
Seller's name or location in Buyer's operation. The
parties acknowledge that any goodwill to be acquired by
Buyer is nominal and have therefore agreed that the
Buyer will pay Seller Ten Thousand Dollars ($10,000)
for Seller's goodwill on the closing date.
For payment of $500,000 (over and above the agreed upon sale
price of the tangible inventories of seller's Jeep-Eagle
distributorship), petitioner received a number of benefits,
including seller's agreement to terminate its Jeep-Eagle
franchise, and seller's agreement to provide to petitioner all
sales and service records, customer lists, and other information
which might be useful to petitioner.
Seller's termination of its sales and service agreement with
Chrysler was a condition to the closing of the agreement.
Approval of petitioner's application for a Jeep-Eagle franchise
from Chrysler was also a condition to the closing of the
agreement. Petitioner could only acquire seller's Jeep-Eagle
franchise if seller would agree to terminate the franchise.
Chrysler's Franchise Policies
Standard Jeep-Eagle franchises are issued for an indefinite
term. A Jeep-Eagle franchisee can expect to retain its franchise
- 8 -
rights under standard franchise for as long as it meets the terms
of the franchise agreement. Chrysler reserves the right to
independently evaluate all dealer candidates and accept or reject
candidates based upon its sole discretion. Success in obtaining
a Jeep-Eagle franchise is not assured, even for an individual
with Mr. Howard's demonstrated abilities.
Mr. Howard's Application for a Chrysler Franchise
In obtaining approval by Chrysler of Mr. Howard and
petitioner as a dealer candidate, petitioner and Mr. Howard's
credentials and plans were considered on their own merit.
The procedure for obtaining Chrysler's approval as a new
dealer candidate is a lengthy and detailed one. When applying as
a dealer candidate, petitioner and Mr. Howard were required to
provide detailed information about their respective backgrounds
in the automobile sales industry, financing information, detailed
dealership plans, and numerous other documents. Mr. Howard and
the employees and agents of petitioner spent several weeks
preparing the necessary documentation and meeting with Chrysler
representatives.
Ultimately, Mr. Howard's demonstrated abilities as an
automobile dealership manager and petitioner's demonstrated
performance in representing other manufacturers resulted in
petitioner's approval by Chrysler.
Petitioner's Jeep-Eagle franchise would terminate by its
nonperformance of the franchise terms, by voluntary termination
- 9 -
by the franchisee, by Mr. Howard's death, or by his failure to
materially participate.
Covenant Not to Compete
The amount paid for the covenant not to compete and the term
of the covenant were negotiated separately from the price of the
other assets. Prior to negotiating with Mr. Markley, Mr. Howard
intuitively calculated the value of Mr. Markley's agreeing not to
compete with petitioner. Mr. Howard projected annual gross
profits less variable costs for the Jeep-Eagle dealership at
approximately $1,996,000, as follows:
New vehicle sales $810,000
Finance and insurance income 351,000
Used vehicle sales 222,750
Parts and service 612,000
1,995,750
Mr. Howard believed that Mr. Markley could take 25 percent
of his business if Mr. Markley competed with him.
At the time of the transaction, petitioner believed that Mr.
Markley was a significant competitive threat because: (1)
Mr. Markley had very good connections with the Jeep-Eagle factory
personnel; (2) Mr. Markley's name was well known in the Oklahoma
City metropolitan area; (3) Mr. Markley was from Oklahoma City
and was continuing in the automobile business in Oklahoma City
after the sale; (4) Mr. Markley's demonstrated sales ability was
very good; (5) Mr. Markley's age and background made him a
competitive threat; (6) Mr. Markley had good customer relations
in the Oklahoma City metropolitan area; and (7) Mr. Markley had
superior knowledge of Chrysler and Jeep-Eagle product lines.
- 10 -
Petitioner was fearful that Mr. Markley would be a
competitive threat by (1) acquiring a new Jeep-Eagle
franchise in a suburb of Oklahoma City (as he had done when he
was a Ford dealer in Yukon) (2) acquiring an existing Jeep-Eagle
dealership or (3) going to work for an existing competitor.
The covenant not to compete is for a 3-year term and covers
Oklahoma, Canadian, Logan, Pottawatomie, Lincoln, and Cleveland
Counties. The covenant not to compete does not preclude seller
and/or Mr. Markley from competing with petitioner in Kingfisher
County, which county is adjacent to Oklahoma County and is less
than 15 miles from petitioner's automall, from competing with
petitioner by working for or with any dealership, including Jeep-
Eagle, for compensation of less than $100,000 per year, or from
competing with petitioner by obtaining any franchise other than
Jeep-Eagle.
Deductions for Amortization
For the taxable years 1990, 1991, and 1992, petitioner
deducted $163,000, $163,500, and $163,500, respectively, as
amortization of the covenant not to compete.
Respondent's Notice of Deficiency
In the notice of deficiency dated February 2, 1995, upon
which this case is based, respondent disallowed petitioner's
deduction for amortization of the covenant not to compete for the
taxable years 1990 and 1991 to the extent of $121,330 for each
year.
- 11 -
OPINION
Respondent determined that the fair market value of the
covenant not to compete was $125,000. Petitioner bears the
burden of proof. Rule 142(a).
A taxpayer generally may amortize intangible assets over
their useful lives. Sec. 167(a); Citizens & S. Corp. v.
Commissioner, 91 T.C. 463, 479 (1988), affd. 919 F.2d 1492 (11th
Cir. 1990). To be amortizable, an intangible asset must have an
ascertainable value and a limited useful life, the duration of
which can be ascertained with reasonable accuracy. Newark
Morning Ledger Co. v. United States, 507 U.S. 546, 556 n.9
(1993). A covenant not to compete is an intangible asset that
has a limited useful life and, therefore, may be amortized over
its useful life. Warsaw Photographic Associates v. Commissioner,
84 T.C. 21, 48 (1985); O'Dell & Co. v. Commissioner, 61 T.C. 461,
467 (1974).
The amount a taxpayer pays or allocates to a covenant not to
compete is not always controlling for tax purposes. Lemery v.
Commissioner, 52 T.C. 367, 375 (1969), affd. per curiam 451 F.2d
173 (9th Cir. 1971). We strictly scrutinize an allocation if the
parties do not have adverse tax interests because adverse tax
interests deter allocations which lack economic reality. Wilkof
v. Commissioner, 636 F.2d 1139 (6th Cir. 1981), affg. per curiam
T.C. Memo. 1978-496; Haber v. Commissioner, 52 T.C. 255, 266
(1969), affd. per curiam 422 F.2d 198 (5th Cir. 1970); Roschuni
- 12 -
v. Commissioner, 29 T.C. 1193, 1202 (1958), affd. 271 F.2d 267
(5th Cir. 1959). A covenant not to compete must have
"economic reality"; i.e., some independent basis in fact or some
relationship with business reality so that reasonable persons
might bargain for such an agreement. Patterson v. Commissioner,
810 F.2d 562, 571 (6th Cir. 1987), affg. T.C. Memo. 1985-53;
Schulz v. Commissioner, 294 F.2d 52, 55 (9th Cir. 1961), affg. 34
T.C. 235 (1960); O'Dell & Co. v. Commissioner, supra at 467-468.
Respondent, in the notice of deficiency, determined that the
covenant not to compete had a fair market value of $125,000.
Petitioner argues that by placing a value on the covenant not to
compete respondent has, in effect, conceded the existence of
economic reality. In fact, respondent formally concedes, in the
reply brief, that the covenant was amortizable and had economic
reality; thus the only issue for us to decide is the fair market
value of the covenant not to compete.
Value of the Covenant Not to Compete
Neither party called an expert witness to opine on the value
of the covenant not to compete.
a. Petitioner's Arguments
Petitioner argues that the covenant was worth well in excess
of the $490,000 paid to Mr. Markley. Petitioner calculates the
value of the covenant as follows:
The total amount of gross profit less variable costs as
projected by Mr. Howard was approximately $1,996,000
per year. * * * Any reduction in this amount will
result in a dollar for dollar reduction in the
- 13 -
dealership's income (or increase in the dealership's
loss).
* * * * * * *
Mr. Howard projected that the effect of competition by
David Markley would be reduction in sales of at least
twenty-five percent (25 percent). A twenty-five
percent (25 percent) reduction in sales would equate to
a loss of $1,497,000 over the term of the covenant
[$1,996,000 x .25 x 3].
Petitioner cites the testimony of Stuart Ray,3 who was
allowed to testify under Rule 143(f)(2) as an expert on the
automobile dealership industry's practice of using covenants not
to compete:
Mr. Ray indicated that based upon his experience,
practice and industry custom he would estimate lost
profit [lost sales] due to competition from a seller
[not petitioner specifically] in an Oklahoma City
metropolitan dealership such as this one, in the range
of twenty percent (20 percent) to twenty-five percent
(25 percent).
b. Respondent's Arguments
Respondent, while admitting that the covenant has some value
($125,000), argues that petitioner has overstated the magnitude
of potential lost sales from Mr. Markley competing with
petitioner, citing petitioner's strong background in auto sales
and established presence in the Oklahoma City market.
3
Mr. Ray is a C.P.A. and was a partner in an accounting
and consulting firm whose clientele consisted of about 400
automobile dealers in 30 States. Mr. Ray has negotiated over 40
buy-sell agreements; prepared tax returns and financial
statements for at least 60 automobile dealerships; and has 17
years of experience working exclusively with automobile
dealerships. Mr. Ray, however, had no personal knowledge of
petitioner's transactions and did not opine on the value of the
seller's covenant not to compete.
- 14 -
Respondent also argues that the likelihood of competition
from Mr. Markley is low, citing the "limited market entry" into
the Jeep-Eagle market in Oklahoma City area due to the limited
number of Jeep-Eagle franchises allowed by Chrysler in the
Oklahoma City market; that Mr. Markley showed no intention of
competing and, in fact, left Oklahoma shortly after the sale to
pursue a business opportunity in Houston, Texas; and that the
covenant allows for significant competition since it only covers
the sale of new Jeep-Eagle automobiles and does not cover an
adjacent county.
Respondent further argues that petitioner's method of
valuing the covenant, in addition to the shortcomings mentioned
above, also fails to: discount the stream of payments required
under the covenant to reflect the time value of money; and to
factor in the effect that amortizing the covenant would have on
after tax cash flow--the payments under the covenant being
deductible and thus reducing petitioner's income tax liability.
Finally, respondent argues that any amount paid by
petitioner in excess of $125,000 (of the disputed $490,000
payment) was for Mr. Markley's agreement to terminate his Jeep-
Eagle franchise. Respondent correctly points out that the sale
was contingent upon Chrysler's awarding petitioner Mr. Markley's
franchise, and petitioner could not obtain Mr. Markley's Jeep-
Eagle franchise unless he informed Chrysler that he wished to
terminate his franchise.
- 15 -
Conclusions as to Value
It is undisputed that petitioner acquired a covenant not to
compete from Mr. Markley that had economic reality. As to
whether petitioner acquired something else of value, Mr. Markley
testified as follows at trial:
Q. And would you have given up this business for
nothing?
A. No. Would I have given up the business?
Q. Would you have given up the business, if someone
had said, I would like to just take it over, but I am
sorry, I can't pay you anything for it. Would that
have been attractive to you?
A. No.
Q. What would it have taken for you to agree to that
proposition?
A. To sell the business?
Q. To turn it over--to sell the business.
A. Well, it took $500,000 is what it took.
Apart from the $500,000, Mr. Markley received payment from
petitioner based on the cost of the new vehicles, the fair market
value of the used cars, and the return value for the spare parts.
Essentially, payment to Mr. Markley for terminating a profitable
business (Markley testified that he personally made a minimum of
$120,000 a year) was included in the $500,000, of which $490,000
was allocated to the noncompetition covenant. We find that a
part of the $490,000 was to compensate Mr. Markley for
terminating his franchise with Chrysler.
- 16 -
In order to value the covenant, using the methodology
adopted by petitioner, we would need to calculate the potential
lost business from competition by Mr. Markley and then, as
respondent correctly points out, lower that number to reflect the
probability of Mr. Markley competing. Mr. Howard testified to
the potential for lost sales. Mr. Howard's testimony was
consistent with Mr. Ray's testimony on this issue. We realize
that Mr. Ray was not testifying specifically about Mr. Markley's
covenant; however, it adds to Mr. Howard's credibility that his
response was in line with industry norms in the Oklahoma City
area. We note, however, that lost sales in the first year would
have to reflect the business reality that whatever form of
competition Mr. Markley might engage in, it would take some time
to implement. Using the lower end of the range, 20 percent, and
factoring a time lag in the first year, the potential for lost
business is approximately $300,000 the first year and $400,000
for each of the following 2 years.
The analysis does not stop at this point. The potential
annual lost business needs to be reduced to reflect the
probability of competition taking place during each of the 3
years of the covenant. See International Multifoods Corp. v.
Commissioner, 108 T.C. 25, 47-48 (1997). In evaluating the
probability of competition, we take into account that the
covenant was restricted to the sale of new Jeep-Eagle
automobiles, which required a franchise from Chrysler. The value
ascribed to the covenant must be further reduced to reflect its
- 17 -
present value. See International Multifoods Corp. v.
Commissioner, supra.
Petitioner has failed to take these factors into account;
therefore we find that the covenant not to compete was worth less
than the $490,000 claimed by petitioners. Respondent
underestimated the probability that Mr. Markley would compete as
well as the damage that would be caused by such competition.
Consequently, we find that respondent has underestimated the
value of the covenant not to compete. Based on the record as a
whole, considering all of the facts and circumstances, we hold
that the covenant not to compete had a value of $300,000.
To reflect the foregoing,
Decision will be entered
under Rule 155.