Lorvic Holdings, Inc. v. Commissioner

Citation76 T.C.M. 220
Decision Date04 August 1998
Docket NumberDocket No. 15611-97.,Docket No. 3408-97.
PartiesLorvic Holdings, Inc. v. Commissioner.
CourtU.S. Tax Court

John P. Barrie, Dana Lasley and Elizabeth Ann Smith, for the petitioner. Robert J. Burbank, for the respondent.



Respondent determined the following deficiencies in petitioner's Federal income tax:

                Taxable Year                             Deficiencies
                1992 .................................     $204,000
                1993 .................................      204,420
                1994 .................................      204,321
                1995 .................................      153,329

The issue for consideration is whether, for purposes of section 167, the aggregate fair market value of the 5-year covenant not to compete and the secrecy agreement is $3 million as claimed by petitioner on its corporate Federal income tax returns.1 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.


Petitioner, Lorvic Holdings, Inc., is the parent of the Lorvic Corp. (New Lorvic), and in turn, New Lorvic is the corporate successor to certain assets of the Lorvic Corp. (Old Lorvic). Petitioner is a Delaware corporation, whose principal offices are located in Earth City, Missouri. Old Lorvic was engaged in the development, design, manufacturing, marketing, distribution, and sale of a variety of health care products for the professional dental market. In general, the company segmented its product offerings into four broad classifications: (a) Preventive, (b) oral evacuation, (c) infection control, and (d) miscellaneous. Old Lorvic offered more than 60 items, including, but not limited to, fluoride gels, solutions, prophylaxis paste, applicator trays, aspirator instruments, sterile tubing, and tofflemire bands. Old Lorvic supplemented each product classification with private label business for several major dental manufacturers. Many of the company's products were relatively simple to fabricate and were disposable in nature. Moreover, most of the foregoing items were not patented. In that regard, the company operated a manufacturing plant in St. Louis, Missouri.

Old Lorvic actively pursued and developed specific niche markets which major dental manufacturers either overlooked or had not emphasized because the overall size of such markets was not of sufficient magnitude to make it profitable for the larger companies to pursue. On the other hand, Old Lorvic's structure enabled it to exploit these niches and command high profit margins. Old Lorvic utilized a complex network of dental product dealers to distribute its products to dental professionals. In that regard, Old Lorvic's primary sales occurred in the United States, while Canada comprised the largest foreign market for the company's products.

In 1954, Charles Nemanick acquired an interest in Old Lorvic, and assumed managerial responsibilities. At some point, Charles Nemanick and family members acquired a controlling interest in the company. In 1979, Old Lorvic acquired Scientific Associates, Inc. (SAI), a contract testing laboratory in St. Louis, Missouri, which had been providing a certain amount of services to Old Lorvic. SAI was thereafter operated as a separate stand-alone business.

In March 1985, R.P. Scherer Corp. (Scherer), an international developer of drug delivery systems and the world's largest producer of softgels for the pharmaceutical and nutritional supplements industries, acquired Old Lorvic. After the acquisition, Old Lorvic continued to operate, in practice, as an autonomous business. At the time of purchase, Scherer was diversifying in order to expand its domestic earnings base. In the foregoing transaction, Scherer paid approximately $5.8 million for the outstanding stock of Old Lorvic. Scherer, however, did not prepare a valuation of the assets it had acquired through Old Lorvic.

The Stock Purchase Agreement (1985 Agreement) incorporated a covenant not to compete from Charles Nemanick and his son, Richard S Nemanick (Richard Nemanick). Specifically, Article XIV of the 1985 Agreement declared:

Section 14.1 Covenant Not to Compete. Each of the Principal Stockholders covenants and agrees that commencing with the Effective Date and continuing for a period of five (5) years or until the expiration of three (3) years following the termination of any Employment Agreement between [Scherer] as the surviving corporation and a Principal Stockholder, whichever is later, such Principal Stockholder shall not anywhere in the United States and Canada, directly or indirectly, by or for themselves or as the agent of another or through others as their agent:

(a) promote, sell, license, distribute or otherwise deal in products or services which are in competition with those of [Scherer] or any of its subsidiaries;

(b) own, manage, operate, be compensated by, participate in, render advice to, have any right to or interest in any business directly or indirectly engaged in the design, production, sale or distribution of products or services directly competitive with [Scherer] or any of its subsidiaries; or

(c) solicit or accept any business from customers of [Scherer] or any of its subsidiaries for products or services directly competitive with those of [Scherer] or any of its subsidiaries, or request, induce or advise customers of [Scherer] or any of its subsidiaries to withdraw, curtail or cancel their business with [Scherer] or any of its subsidiaries.

* * * * * * *

Section 14.4 No Consideration Paid for Covenant. [The parties] each recognize and agree that the entire consideration passing to the Stockholders pursuant to the Merger represents and constitutes the fair market value of the shares of Lorvic Stock, and that no portion thereof represents payment for the covenants not to compete by the Principal Stockholders set forth in Section 14.1 or in the Employment Agreements attached hereto * * * For federal and state income tax purposes neither [of the parties] will treat any portion of such consideration as representing payment for said covenants not to compete.

The 1985 Agreement also incorporated an unsigned, and undated, exclusive Employment Agreement with Charles Nemanick, who, at the date of the 1985 transaction, was the chairman and president of Old Lorvic. Scherer, through its new subsidiary, sought to retain Charles Nemanick "so that the experience and management ability" would continue to be available to Old Lorvic. Subsequent to the 1985 acquisition, several employees of Old Lorvic departed the company and were not, at any point, employed by Scherer.

Charles Nemanick managed and operated Old Lorvic until his death in 1986. Following Charles Nemanick's death, his son Richard Nemanick, and Charles' wife assumed the positions of president and chairman, respectively. Richard Nemanick possessed substantial experience with the company. Specifically, he joined Old Lorvic in 1969, holding various positions throughout the company. In that regard, he was responsible for marketing, manufacturing, acquisitions, and product development.

Old Lorvic was one of Scherer's profitable subsidiaries. In that time frame, Old Lorvic earned, before taxes, annual profit margins of approximately 40 percent. In particular, Old Lorvic's Nyclave product which was a nylon wrap, was one of the principal products in terms of sales volume. Old Lorvic controlled approximately 90 percent of the Nyclave market. Also, Old Lorvic controlled approximately 80 percent of the market for disposable surgical aspirators, and 40 percent of the market for oral evacuators and a somewhat lesser percentage for prophylaxis paste. In that connection, Old Lorvic's major distributors accounted for more than 50 percent of its gross sales.

Throughout the period, Richard Nemanick provided the management of Scherer, on a monthly basis, with reports that detailed Old Lorvic's top 10 products, including the sales percentage change by month and year to date. Such reports included sensitive information which incorporated data on important customers, competitors, and Government regulations affecting the market. In addition, he prepared profit plans which included projections of future sales. He also prepared annual budget reports. which detailed its profit margins by product line and by specific product. Richard Nemanick conducted frequent telephone conversations with representatives from Scherer and participated in company meetings at least twice a year.

In late 1989, Scherer was acquired in a leveraged buyout by Shearson Lehman Hutton Holdings, Inc. (Shearson Lehman). Subsequently, pursuant to directions from Shearson Lehman, Scherer contemplated divesting itself of Old Lorvic because of new strategic objectives and considerations with respect to its business.

In an undated Descriptive Memorandum prepared by Shearson Lehman, it was noted that "Management feels the loyalty of its customer base is Lorvic's most significant competitive advantage in a market dominated by large corporate organizations." Moreover, the Descriptive Memorandum also recognized that "While [Old Lorvic] utilizes a dealer network for the majority of sales, senior management has built strong direct relationships with [Old] Lorvic's old customers." The Descriptive Memorandum reported that the management of Old Lorvic projected that revenues would increase in the short term. In particular, revenue was projected to be $4.1 million for the taxable year ended March 31, 1990. This figure was a 12.8-percent increase from the previous year. For the fiscal year 1992, revenues were projected to reach $5 million with $2.1 million in operating income.

Scherer offered to sell Old Lorvic to Richard Nemanick for approximately $7.5 million. At the same time, Chemical Ventures Capital Associates (Chemical...

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