The sale of assets of an ongoing business often involves the payment of a purchase price in excess of the fair market value of the tangible assets. This excess represents the “goodwill” or the additional element of value which attaches to property by reason of being part of a going concern.
Prior to 1993, the allocation of a portion of the purchase price of a business to goodwill was generally disadvantageous to a buyer, for tax purposes. This was because goodwill was an intangible asset that could not be deducted or amortized. In response, creative tax advisers allocated such excess payments to non-competition agreements also known as “covenants not to compete” or to “consulting agreements.” Under a non-competition agreement, sellers would agree not to be involved with a competitor of the buyer within a designated geographical area for a certain period of time. Under a typical consulting agreement, the seller would agree to be available to work with the buyer to maintain customer relationships or work with suppliers. Under such arrangements, buyers could deduct payments to sellers over the life of the agreements, typically three to five years. From the seller’s perspective, an allocation to goodwill was treated as capital gain, while income from a non-competition agreement or consulting contract was treated as ordinary income.
The response of the Internal Revenue Service was to give deference to such allocations if it perceived that the parties had adverse tax interests. Prior to 1987 adverse tax interests were generally the rule. Buyers would prefer allocations of the purchase price to a non-competition agreement which could be deducted over the life of contract. On the other hand sellers preferred allocations to goodwill since this would result in capital gain, rather than the ordinary income treatment from a covenant. The differential in tax rates, i.e. maximum-capital gain rate of 20% versus an ordinary rate of 50% generally insured that the buyers and sellers had adverse tax interests. Thus there was a tension between the tax interests of the buyer and seller which was perceived by the IRS to lead to arm’s length agreements.
With the Tax Reform Act of 1986, the ordinary income rate was reduced from 50% to 28% and the capital gain rate was raised to 28%. [The maximum ordinary income rate has been adjusted upward several times since 1986. It currently stands at 39.6%]. As a result, the rate differential disappeared along with much of the incentive on the part of the seller to prefer an allocation to goodwill. Buyers and sellers no longer had adverse tax interests. Non-competition agreements and consulting agreements thus became attractive in an attempt to convert what was otherwise a non-deductible payment for goodwill into a tax deduction.
The Tax Court recently dealt with a contractual allocation involving the sale of automobile dealerships in Seattle, Washington where the parties aggressively utilized both a covenant not to compete and a consulting agreement. [Heritage Auto Center, Inc. v. Commissioner T.C. Memo 1996-21].
W owned Ford, Toyota and Suzuki dealerships in Seattle. W’s dealerships had been subject to adverse publicity due to lawsuits brought by the state attorney general for alleged fraudulent sales, advertising and repair practices by W. Prior to the adverse publicity, W’s dealerships had been quite profitable. However, afterwards the dealerships suffered losses. Ford Motor Company wanted the dealerships to be sold to experienced auto professionals who could turn the dealerships around and make them profitable.
H entered into negotiations with W to acquire W’s dealerships. After a number of meetings H agreed to acquire the assets of W’s dealerships for a price of $1,350,000 over and above the fair market value of the tangible assets. The initial allocation of the excess purchase price was $200,000 to goodwill and $1,150,000 to a 3-year non-competition agreement. After further negotiations the allocations were changed with H agreeing to pay W $675,000 for the covenant not to compete and $675,000 to be paid in three annual installments of $225,000 per year to provide consulting services for 3 years. At closing, H paid the $675,000 non-competition fee and prepaid the $675,000 consulting fee. H took prorata deductions in 1988 for both amounts and a full deduction of $225,000 each for the consulting fee and the non-competition fee in 1989.
The IRS claimed that the payments were for nonamortizable goodwill or going-concern value and disallowed the deductions
H argued that the consulting agreement had significant value since W was needed to deal with Toyota with whom he had significant contracts. The Court however found that W was in fact, used minimally in the periods following the sale. In addition the Court found that the owners of H had significant experience of their own which minimized the need to use W. As a result, the Court allowed a value of only $1,200 for the consulting agreement, a 99.82% reduction.
With respect to the covenant not to compete, the Court found that although W’s reputation had suffered damage as a result of the adverse publicity, he still posed a competitive threat to H, in that he could recruit employees away or he could work for a competing dealership. The Court discounted the $675,000 allocation by 50%, allowing $337.500 to be amortized for the covenant.
Comment: The case illustrates that attempts to aggressively allocate payments for business goodwill to something more attractive from a tax perspective will be carefully scrutinized by the IRS and the courts. Congress has dealt somewhat with this problem under legislation passed in 1993. Under Code Section 197, for contracts effective after August 1993, amounts paid for goodwill or covenants are to be amortized over a 15-year term. Amounts allocated to a covenant not to compete should be supported by reasonable evidence. Consulting agreements continue to be available and amounts paid for consulting services, including insuring the availability of the consulting, are still deductible over the term. However, because of the tax advantages they offer to the buyer, such consulting agreements are likely to be subject to even greater IRS scrutiny, and must therefore have a realistic relationship to the value of the consulting services to be performed.
This article was written in 1996.