Recovery Group, Inc. v. Commissioner
108 A.F.T.R.2d (RIA) 5437, 2011 U.S. App. LEXIS 15364, 652 F.3d 122 (2011)
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Rule of Law:
A covenant not to compete entered into in connection with an acquisition of any interest in a trade or business, including a non-substantial portion of corporate stock, is a 'section 197 intangible' under I.R.C. § 197(d)(1)(E) and must be amortized over a 15-year period. The 'substantial portion' requirement in the statute applies only to acquisitions of assets, not to acquisitions of stock.
Facts:
- Recovery Group, Inc. was an S corporation providing consulting services to insolvent companies.
- James Edgerly, a founder and minority shareholder, owned 23% of Recovery Group's outstanding stock.
- In 2002, Edgerly informed the company president that he wished to leave and have his shares bought out.
- Recovery Group agreed to redeem all of Edgerly's shares for $255,908.
- In a separate but related agreement, Recovery Group paid Edgerly $400,000 for a covenant not to compete that was effective for a one-year period from July 31, 2002, to July 31, 2003.
Procedural Posture:
- Recovery Group filed its income tax returns for 2002 and 2003, amortizing the $400,000 covenant payment over its one-year term.
- The Internal Revenue Service (IRS) audited Recovery Group and determined the covenant was a 'section 197 intangible' requiring a 15-year amortization period.
- The IRS disallowed a portion of Recovery Group's deductions and issued notices of deficiency to the corporation and its shareholders.
- Recovery Group and its shareholders, as petitioners, filed petitions in the United States Tax Court challenging the deficiencies asserted by the Commissioner of Internal Revenue.
- The Tax Court ruled in favor of the Commissioner, holding that the covenant was a section 197 intangible subject to 15-year amortization.
- Recovery Group, Inc. and its shareholders, as petitioners-appellants, appealed the Tax Court's decision to the United States Court of Appeals for the First Circuit.
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Issue:
Does a covenant not to compete, entered into in connection with the acquisition of a corporation's stock, qualify as a 'section 197 intangible' requiring 15-year amortization, regardless of whether the amount of stock acquired constitutes a 'substantial portion' of the corporation's total stock?
Opinions:
Majority - Torruella, Circuit Judge
Yes. A covenant not to compete entered into in connection with the acquisition of any shares of stock in a corporation that is engaged in a trade or business is a 'section 197 intangible' subject to a 15-year amortization period. The court found the text of I.R.C. § 197(d)(1)(E)—'an interest in a trade or business or substantial portion thereof'—to be ambiguous. Turning to the legislative history, the court determined that the purpose of § 197 was to simplify the law and reduce litigation over the amortization of intangibles. The court reasoned that in stock acquisitions, the value of the stock includes a component of goodwill, which is difficult to value. This difficulty creates a tax-motivated incentive for buyers to over-allocate the purchase price to a short-term, rapidly deductible non-compete agreement rather than to the stock basis. This incentive exists regardless of whether the stock portion is 'substantial.' Therefore, to fulfill Congress's purpose, the 15-year amortization period must apply to non-competes connected to any stock acquisition, thereby reducing the incentive for such over-allocation and preventing litigation. The 'substantial portion' language, by contrast, applies only to asset acquisitions, as goodwill is generally not transferred with a non-substantial portion of a business's assets.
Analysis:
This decision provides a clear, bright-line rule that resolves a significant ambiguity in I.R.C. § 197, confirming that the 'substantial portion' test does not apply to stock acquisitions. By doing so, the ruling promotes the statute's primary goal of simplifying tax law and reducing litigation between taxpayers and the IRS over the classification and amortization of intangible assets. It prevents taxpayers from structuring stock redemptions to accelerate deductions for non-compete agreements, strengthening the IRS's ability to enforce the 15-year amortization period in a wide range of corporate transactions. This holding creates a sharp and predictable distinction between the tax treatment of non-competes in stock acquisitions versus asset acquisitions.
