Annabelle Candy Co. v. CIR

• Decision Date: 11 December 1962
• Docket Number: No. 17576.,17576.
• Citation: 314 F.2d 1
• Parties: ANNABELLE CANDY CO., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Ninth Circuit

314 F.2d 1 (1962)

ANNABELLE CANDY CO., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 17576.

United States Court of Appeals Ninth Circuit.

August 22, 1962.

Rehearing Denied December 11, 1962.

Dinkelspiel & Dinkelspiel, John F. Taylor, San Francisco, Cal., for petitioner.

Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Melva M. Graney, Charles B. E. Freeman, Attys., Dept. of Justice, Tax Division, Washington, D. C., Crane C. Hauser, Chicago, Ill., Chief Counsel, Bruce Terris, Washington, D. C., Attys., Internal Revenue Service, for respondent.

Before BARNES, HAMLEY and JERTBERG, Circuit Judges.

BARNES, Circuit Judge.

This is another tax case involving solely the allocation of the purchase price of certain corporation stock between asset value, good will, if any, and a covenant not to compete.

It involves the assessment of a deficiency in federal income tax for the years 1956 and 1957. The Commissioner mailed the notice of deficiency for the calendar years 1956 and 1957 in the amounts of $5,236.06 and $3,035.12, respectively, on July 14, 1959. Within ninety days, and on October 5, 1959, a petition for redetermination was filed with the Tax Court under the provisions of Section 6213 of the Internal Revenue Code of 1954, 26 U.S.C.A. § 6213. On June 12, 1961, the Tax Court entered its decision¹ affirming the deficiencies assessed by the Commissioner. A timely petition for review was filed; this court has jurisdiction under Section 7482 of the Internal Revenue Code of 1954.

Though other issues were before the Tax Court, the only question here presented is whether the Tax Court correctly held that petitioner-appellant² was not entitled to deduct from its federal income taxes amounts represented as the amortized cost of a restrictive covenant.

The facts as found by the Tax Court (many of which were stipulated) which are here pertinent may be summarized as follows:

For several years prior to 1955, Sam Altshuler and Fred Sommers engaged in the business, as equal partners, of manufacturing and selling candy. They incorporated taxpayer under the laws of California in November 1954 and began doing business in corporate form on January 1, 1955. Each owned fifty per cent of taxpayer's outstanding common stock. Altshuler became president and Sommers became vice president, and both were directors and actively conducted taxpayer's business.

Virtually the entire volume of taxpayer's sales was dependent on one ten-cent candy bar marketed under the name of "Rocky Road." This name was taken from the type of marshmallow and chocolate candy which was well known in the candy industry and for years had been sold in bulk form in candy stores. The recipe or formula for manufacturing rocky road candy and the name "Rocky Road" are not subject to protection from competitors by registration in any manner, whether by patent, trade-mark, or trade name. There are, however, different methods of making rocky road candy which are not generally known or applied throughout the candy industry. Taxpayer employed unique production methods in manufacturing its candy bar which were valuable to taxpayer, and it marketed its candy bar in a distinctive red wrapper. Both Altshuler and Sommers had full knowledge of taxpayer's unique production methods.

Differences arose between Altshuler and Sommers and they finally decided, in the latter part of 1955, that they no longer could work together. Court action to dissolve taxpayer was a possibility. However, in December of 1955, attorneys for Altshuler and Sommers began negotiations for a method of eliminating one of the clients from participation in the business, but at the same time preserving the business. The attorneys mutually agreed that it would be best for their principals and for the business if a purchase and sale arrangement could be agreed upon without court action.

Altshuler and Sommers were each interested in buying the other's fifty per cent interest in taxpayer's common stock. During the early months of 1956, lengthy negotiations centered on the question of (1) who would be the buyer, (2) who would be the seller, and (3) the purchase price. These questions were finally resolved by an agreement dated May 15, 1956, between taxpayer and Sommers. The agreement provided for a total consideration of $115,000 to be paid in installments to Sommers by taxpayer. Sommers agreed, inter alia, to deliver his fifty percent stock interest, to retire from active participation as an officer and director, and not to compete nor engage in any activities which might be prejudicial to taxpayer's business for a period of five years.³

The restrictive covenants were first discussed by the parties and their counsel after the purchase price of $115,000 for the stock interest had been preliminarily agreed upon and when safeguards for the buyer and security for the seller were then considered. The agreement of May 15, 1956 made no allocation of any portion of the total consideration of $115,000 to the restrictive covenants. Prior to May 15, 1956, there were no discussions between Altshuler and Sommers or their respective attorneys concerning the subject of an allocation of the purchase price to be made to the covenants. Taxpayer's dollar allocation to the covenant not to compete was made subsequent to May 15, 1956, without the knowledge or consent of Sommers.

No separate or severable consideration was bargained for, or paid, for the covenant not to compete contained in the agreement of May 15, 1956.

Taxpayer's earned surplus amounted to $40,082.05 on May 15, 1956. By statute in California, a corporation may redeem its stock only out of earned surplus. (Calif.Corp.Code §§ 1705-1708.) Neither taxpayer's representatives nor Sommers and his counsel were aware of the possible applicability of these sections of the law of the State of California when they negotiated and signed their agreement of May 15, 1956.

In its 1956 income tax return, taxpayer allocated $80,554.67 of the $115,000 purchase price to the covenant not to compete and began amortization of the $80,554.67 over the covenant's five-year term at a rate of $16,110.93 per year, claiming $10,069.93 for the remainder of 1956, and the full $16,110.93 for 1957. The Commissioner disallowed these claimed deductions, determining that the entire $115,000 was paid for Sommers' stock interest, that no portion was allocable to the covenant not to compete, and that, accordingly, taxpayer was not entitled to amortization deductions for the taxable years.⁴

The Tax Court sustained the Commissioner's deficiency determinations on the basis of its finding that no separate or severable consideration was bargained for or paid for the covenant not to compete.

Taxpayer contends there were four errors:

(1) The evidence is clear — and the Tax Court recognized — that the covenants here in question had substantial value; therefore the denial of taxpayer's deductions on the grounds that the parties had not agreed on a separate value for the covenants and that the covenants were "nonseverable" from the transfer of stock is erroneous and contrary to the principles applicable to this case.

(2) It is not a prerequisite to a deduction based upon the amortization of a covenant not to compete that the conditions imposed by the court below be met; if the covenants have value, contends taxpayer, an allocation must be made to it, and the purchaser given the benefit of a deduction equal to its value.

(3) Its allocation to the covenant not to compete is realistic and, being required by law, should be upheld; but even if its allocation is too large the correct allocation should be determined by the courts; the deduction cannot be ignored merely because the parties failed to agree to an allocation.

(4) And, lastly, taxpayer contends the test of "severability" here applied by the Tax Court is artificial and unrealistic, and has recently been criticized by this court; and an assignment of value based upon the impact of California law is required, even though the parties did not negotiate the contract with actual knowledge of the possible application of the law.

The Commissioner concedes that the depreciation deduction authorized by § 167(a) (1) of the Internal Revenue Code of 1954 for property used in trade or business applies to a covenant not to compete for a definite term. But, contends the Commissioner, the deduction, amortized over the term of the covenant, is "of the amount paid (or other basis) for the covenant. * * * And, if a contract contains such a covenant but nothing has been paid for it, there is nothing to be deducted." It is, therefore, the Commissioner's position that:

"A covenant not to compete contained in a contract has no tax effect as to either the vendor or the vendee unless (1) the parties treat the covenant as an item for which a separate amount is paid the vendee and (2) such treatment is in fact realistic. The first requirement — in effect, a showing that the parties intended separate payment for the covenant — will generally be satisfied if the contract allocates a part of the consideration to the covenant."⁵

And, according to the Commissioner, "we are here primarily concerned with the first requirement, i. e., that the parties treat the covenant as an item for which a separate amount is paid by the vendee."

The Commissioner's position, otherwise stated, is

"We do not contend that the presence or absence of an express dollar allocation to the covenant not to compete is a controlling test per se. What we contend is that the evidence must show that the parties treated the covenant as a separate item for which consideration was paid. * * *" (Emphasis the Commissioner\'s.)

The Tax Court's findings indicate that Sommers' covenant not to compete was contained in the contract dated May 15, 1956. But, according to the findings of the Tax Court, the parties had not discussed the covenant until after the purchase price had been preliminar...