Theophelis v. U.S.

Decision Date27 December 1984
Docket NumberNo. 83-1828,83-1828
Citation751 F.2d 165
Parties-521, 85-1 USTC P 9105 George L. THEOPHELIS and Arlene Theophelis, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
CourtU.S. Court of Appeals — Sixth Circuit

Fred Gordon, Mark A. Goldsmith (argued), Richard J. Briski, Troy, Mich., for plaintiffs-appellants.

Leonard R. Gilman, U.S. Atty., Detroit, Mich., Glenn L. Archer, Jr., Michael L. Paup--Chief Appel. Sec., Richard Perkins, John P. Griffin (argued), Tax Div., Dept. of Justice, Washington, D.C., for defendant-appellee.

Before EDWARDS and KEITH, Circuit Judges, and JOHNSTONE, District Judge. *

KEITH, Circuit Judge.

This is an appeal by the plaintiffs, George L. Theophelis and Arlene Theophelis, from a reported decision of the United States District Court for the Eastern District of Michigan granting summary judgment in favor of the United States. Theophelis v. United States, 571 F.Supp. 516 (E.D.Mich.1983). The Theophelises initiated this action under 28 U.S.C. Sec. 1346(a)(1) seeking a refund of income taxes for the years 1976 through 1978. The taxpayers claim that the Internal Revenue Service incorrectly disallowed a depreciation deduction for a covenant not to compete acquired in the purchase of a retail store, the "Party Center," in 1976. Following discovery, the government filed a motion for summary judgment. After briefing and argument, the district court granted summary judgment. For the reasons set forth below, we affirm the judgment of the district court.

The material facts in this case are essentially undisputed. In the summer of 1975, the taxpayers became interested in purchasing a party store (a retail store selling beer, wine and incidental refreshments) from Matthew A. Lumetta. After inspecting the store and arranging to borrow the funds necessary for the purchase, the taxpayers and Lumetta agreed upon a purchase price of $145,000. Subsequently, the attorneys and accountants of the parties became involved in finalizing the additional terms and conditions of an agreement of sale. One such additional condition requested by the taxpayers was the inclusion in the agreement of a covenant not to compete on the part of the seller.

On November 28, 1975, the taxpayers executed an agreement to purchase the Party Center. Under paragraph 1 of the agreement, the taxpayers purchased:

the lease to such premises, the keys and all other indicia of possession, the goodwill of the business as a going concern, the Seller's interest in the liquor licenses, stock-in-trade, furniture, fixtures, equipment, transferable insurance policies, all contracts which have been made by or granted to the Seller in connection with the business, and all other property (except cash and accounts receivable) owned and used by the Seller in the business.

Joint Appendix at 43a. Under paragraph 2, the purchase price for "all of the assets referred to in Paragraph 1, other than the stock-in-trade," was set at $145,000. Id. The purchase price for the stock in trade was set forth separately in paragraph 3. Paragraphs 17 and 18 of the agreement contained provisions which served the function of covenants not to compete (hereinafter collectively referred to as the covenant) whereby the seller agreed that for a period of two years after the date of closing, he would neither (1) engage in any similar business within a ten mile radius of the Party Center, nor (2) solicit any sales from the industrial accounts on a list which was to be furnished to taxpayers. Joint Appendix at 52a. 1

Aside from the attribution of the entire $145,000 purchase price to the assets set forth in paragraph 1 of the agreement, and the separate purchase price for the stock-in-trade set forth in paragraph 3 of the agreement, the parties did not further allocate the purchase price among the specific items included in paragraph 1. Most importantly, no part of the purchase price was allocated to the covenant. In fact, the district court noted that the parties never even discussed the subject of an allocation to the covenant until their final meeting during which they executed the agreement. 571 F.Supp. at 517. At that time, the parties, in effect, agreed that they would not allocate any specific part of the purchase price to the covenant, but rather they would allow the Internal Revenue Service to determine its value when the first of the parties to the sale was audited. Id. 2

On their 1976 federal income tax return, the taxpayers claimed that the tangible depreciable property purchased with the Party Center had a value of $100,000, and claimed an investment credit of $10,000. The return was audited and the Commissioner determined that the property's value was only $45,000. Subsequent to that audit, in 1980, the taxpayers filed amended returns for 1976, 1977 and 1978, and for the first time claimed that $75,000 was paid for the covenant. The taxpayers sought to amortize the cost of the covenant over its two year life span, pursuant to Section 167 of the Internal Revenue Code. 26 U.S.C. Sec. 167. The deduction was disallowed and after the claim for refund was denied, the taxpayers filed the instant refund suit in the district court.

It is well settled that the depreciation deduction authorized by Section 167(a)(1) of the Internal Revenue Code for property used in a trade or business applies to intangibles such as a covenant not to compete for a definite term, but it does not apply to good will. See Tres.Reg. Secs. 1.167(a)-1, 1.167(a)-3. The deduction, amortized over the term of the covenant, is limited to the amount paid (or other tax basis) for the covenant. See 26 U.S.C. Secs. 167(g), 1011, 1012. Thus, if a contract contains a covenant not to compete, but nothing has been paid for it, there is nothing to deduct.

Courts have frequently been called on to determine the amount properly allocable to a seller's covenant not to compete when a business is sold. Generally, the amount allocated by the parties' agreement is controlling, because they have competing and conflicting tax interests. Balthrope v. Commissioner, 356 F.2d 28, 31 (5th Cir.1966). The seller benefits with respect to his taxes by allocating little or nothing to the covenant, because whatever is allocated to it must be recognized as ordinary income, whereas the remainder of the sales price is normally recognized as capital gains and taxed at lower rates. The buyer, on the other hand, prefers allocating as much as possible to the covenant, because that amount is amortizable over the term of the covenant, allowing an ordinary income tax deduction, whereas the alternative--an allocation to good will--is nondepreciable and provides no such deduction. Better Beverages, Inc. v. United States, 619 F.2d 424, 425 n. 2, explained and reh'g. denied, 625 F.2d 1160 (5th Cir.1980).

The question presented by this appeal is what amount, if any, is deductible for a covenant not to compete when the parties' agreement of sale allocates the entire purchase price to assets other than the covenant? It appears that while our Court has not directly addressed this precise issue, there is substantial authority which supports the decision reached by the district court in this case.

For example, in Major v. Commissioner, 76 T.C. 239 (1981), the Tax Court addressed a similar situation in which a purchaser of a trucking business belatedly attempted to allocate a portion of the purchase price to the seller's covenant not to compete. In analyzing that case the Tax Court adopted an approach which placed "heavy emphasis upon the intention of the parties at the time the contract was entered into." 76 T.C. at 246. While the Tax Court also recognized that whether the covenant had independent economic significance or reality was another relevant factor. The Tax Court stressed that "[t]he economic reality test, however, is applied with a view to the parties' intention, e.g., whether the covenant was separately bargained for." Id.; see also Peterson Machine Tools, Inc. v. Commissioner, 79 T.C. 72, 81 (1982).

From our review of the record, it is clear that at the time the contract was entered into, the parties did not intend to allocate a portion of the purchase price to the covenant not to compete. In this respect, we note that the agreement between the parties contains no specific allocation of the purchase price to the covenant. This failure to allocate a portion of the purchase price to the covenant appears to be "good evidence that none was intended." Major v. Commissioner, 76 T.C. at 250. Also, we note the district court's uncontroverted finding that an allocation was never even discussed until the final meeting of the parties when they executed the agreement. Theophelis v. United States, 571 F.Supp. at 517. Further, when the parties did discuss this issue, they agreed not to allocate a portion of the purchase price to the covenant. See supra note 2. Finally, we note that on their tax returns, the taxpayers themselves did not even attempt to allocate anything to the covenant until almost four years after the transaction.

On appeal the taxpayers contend, in essence, that since the covenant not to compete was of some economic value to them, it was, therefore, improper for the district court to grant summary judgment and not resolve the proffered question of fact by determining the value of the covenant. With respect to its tax law consequences, this argument is misguided. In Better Beverages, Inc. v. United States, 619 F.2d 424 (5th Cir.1980), the purchaser of a going concern soft drink bottling and distribution business similarly sought to avoid summary judgment by inviting the court to examine the "real economic value" of a covenant not to compete to which no part of the purchase price had been allocated. In declining this invitation, the Fifth Circuit noted:

[S]ince [the buyer] seeks to prove its basis in the covenant by allocating to it a portion of...

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    ...that the covenant possessed value typically is insufficient to establish the purchaser's basis therein. See, e.g., Theophelis v. United States, 751 F.2d 165 (6th Cir. 1984); Markham & Brown, Inc. v. United States, 648 F.2d 1043 (5th Cir. 1981); Peterson Machine Tool, Inc. v. Commissioner, 7......
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    ...allocated no portion of the contract price to the covenant. Patterson, 810 F.2d at 571-72 & 571 n. 6 (citing Theophelis v. United States, 751 F.2d 165, 168 (6th Cir.1984)). However, under the Danielson rule, the court does not reach the mutual intent inquiry where the parties seek to vary t......
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    • February 2, 1987
    ...in Theophelis, "if a contract contains a covenant not to compete, but nothing has been paid for it, there is nothing to deduct." 751 F.2d at 167. We find this test appropriate in the instant case despite the fact that the buyer, Jerrico, is not technically a party herein. As we have explain......
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