A recent opinion by the 8th Circuit makes it clear that taxpayers cannot necessarily control the tax treatment of a transaction even if both sides to the transaction concur. In Langdon v. Commissioner, the appeals court rejected the allocation of a substantial portion of the purchase price paid for a business to a covenant not to compete by the owner.
The business was operated in corporate form. There would have apparently been a benefit to the seller to have a substantial portion of the purchase price allocated to the covenant, since such an allocation would not have been subject to double tax, once at the corporate level and then again when distributed to the sole shareholder. About 50% of the sale price was allocated in the contract of sale to the covenant not to compete. None of the purchase price was allocated to corporate intangibles, such as good will or going concern value.
The appeals court affirmed the Tax Court’s re-valuation of the allocation, reducing the amount allocated to the covenant by about 70%. The court noted that the buyer and the seller both had an interest in allocating a large portion of the purchase price to the restrictive covenant. More significantly, the court, using a nine factor test, determined that the covenant lacked economic reality. The nine factors used by the court were: (i) The seller’s (i.e., the covenantor’s) ability to compete; (ii) the seller’s intent to compete; (iii) the seller’s economic resources; (iv) the potential damage to the buyer posed by the seller’s competition; (v) the seller’s business expertise in the industry; (vi) the seller’s contacts and relationships with customers, suppliers, and others in the business; (vii) the buyer’s interest in eliminating competition; (viii) the duration and geographic scope of the covenant, (ix) and the seller’s intention to remain in the same geographic area. The court noted that the corporation that was sold was the premier beer distributor in the area and it was unlikely that the buyer could have been harmed to the tune of $1M (the amount allocated to the covenant) if the former owner of the company had determined to become a competitor. Moreover, the former owner also had a fairly lucrative consulting contract with the buyer.