Case — NonCompete Agreement

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TL Case Summ

THE QUESTION

Can the cost of a noncompete agreement be amortized over its life instead of the 15-year statutory period?

THE DISPUTE

Taxpayer Says: The agreement does not fall within the definition in the Internal Revenue Code, and can be deducted over its one-year life.

Internal Revenue Service Says: The agreement is an intangible asset as defined in the Internal Revenue Code and must be amortized over 15 years.

THE LAW

From Internal Revenue Code Section 197(a): General Rule. A taxpayer shall be entitled to an amortization deduction with respect to any amortizable section 197 intangible. The amount of such deduction shall be determined by amortizing the adjusted basis (for purposes of determining gain) of such intangible ratably over the 15-year period beginning with the month in which such intangible was acquired.

From Internal Revenue Code Section 197(d)(1)(E): Section 197 Intangible. For purposes of this section– (1) In general. Except as otherwise provided in this section, the term “section 197 intangible” means– (E) any covenant not to compete (or other arrangement to the extent such arrangement has substantially the same effect as a 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 * * *.

THE CAUSE OF THE DISPUTE

If, as part of the purchase of a business, you agree to pay the former owner to refrain from competing with you, this “noncompete agreement” is considered an intangible asset – basically something of value that has no “real” physical substance. You can amortize, or expense, the cost of the agreement over time, in a manner similar to depreciation.

Disputes arise over whether certain agreements meet the definition of an intangible asset as described in section 197 of the Internal Revenue Code.

In this case, an S corporation purchased the 23% interest of a founding shareholder. In addition to the stock buy-out, the company also paid $400,000 for a one-year noncompete agreement with the shareholder, and deducted that cost over the life of the agreement (12 months) on its corporate tax return.

The corporation contends the agreement is not a section 197 intangible asset because the shareholder’s 23% was not a “substantial portion” of the business.

The IRS takes the position that “interest” means an ownership interest of any percentage, large or small, and therefore the cost of the agreement has to be deducted over the 15-year period required by section 197.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 58KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. The legislative history is unmistakable on the point that the “substantial portion” in section 197(d)(1)(E) is a substantial portion of a trade or business. A covenant gets 15-year amortization if it was obtained either in an acquisition of any “interest in a trade or business” (such as the taxpayer’s stock) or in an acquisition of a substantial portion of a trade or business–i.e., a substantial portion of its assets (not at issue here). It is therefore immaterial whether the taxpayer’s 23% stock interest would be characterized as “substantial”. The cost of the covenant not to compete may not be amortized over its one-year term; the covenant is an amortizable IRC section 197 intangible and must be amortized over 15 years.
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