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Lessons from the Tax Court: Covenants not to compete

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Under Section 197 of the tax code, the cost of acquiring an intangible business asset generally must be amortized over a period of 15 years. In a new Tax Court case, deductions for payments made under a “covenant not to compete” were required to be spread over this 15-year period—even though the term of the agreement was much shorter.

Facts: A shareholder owned 23% of a “crisis management” business. The company agreed to buy out the shareholder for $805,364. The buyout included a $400,000 payment for a covenant not to compete. This agreement covered a 12-month period: Aug. 1, 2002, through July 31, 2003.

The company’s accountants allocated the $400,000 payment for the covenant over just two years (2002 and 2003). But the IRS challenged the fast write-off. It said that the write-off period should be 15 years. Eventually, the case went to the Tax Court.

The company argued that the 15-year write-off period applies to a covenant not to compete only if it was obtained in the acquisition of a substantial interest in a business. And it said that the 23% interest was not “substantial.” But the Tax Court disagreed with this reasoning. The percentage is immaterial because the “covenant not to compete” arose from the acquisition of the business interest.

Tax result: Because Section 197 is clearly applicable, the payment must be amortized over 15 years. (Recovery Group, Inc., TC Memo 2010-76)

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