Lucas v. Comm'r of Internal Revenue

Citation58 T.C. 1022
Decision Date26 September 1972
Docket NumberDocket No. 6691-70.
CourtUnited States Tax Court

58 T.C. 1022


Docket No. 6691-70.

United States Tax Court

Filed September 26, 1972.

[58 T.C. 1023]

James G. Leathers, Jr., for the petitioners.

Harry M. Asch and William E. Saul, for the respondent.

T purchased an accounting practice from X at a stated purchase price of $40,000. The contract of sale contained no covenant against competition by X; and although T was interested in preventing competition by X until T had sufficient opportunity to establish himself with X's clients, the parties deliberately decided not to include any such covenant in the contract. X treated the proceeds of the sale as capital gain, but T attempted to treat $20,000 of the purchase price as a consideration for a covenant against competition, and proceeded to amortize that amount over a period of 4 years. Held: In the circumstances of this case, T has failed to show under the required standard of ‘strong proof’ that a covenant against competition should be implied. He is therefore not entitled to any deduction in respect of any portion of the purchase price allegedly allocable to such a covenant.

The Commissioner determined deficiencies in petitioners' income tax as follows:

                ¦Year ¦Deficiency ¦
                ¦ ¦ ¦
                ¦1965 ¦$1,249.89 ¦
                ¦1966 ¦1,551.00 ¦
                ¦1967 ¦1,646.00 ¦

The sole issue for decision is whether part of the purchase price paid by petitioner Glenn W. Lucas, in connection with the acquisition of an accounting practice, was attributable to a covenant not to compete in respect of which petitioners are entitled to depreciation deductions in the years in issue under section 167, I.R.C. 1954.


The parties have filed a stipulation of facts which, together with the accompanying exhibits, is incorporated herein by this reference.

Petitioners Glenn W. Lucas, Jr., and Carlene Lucas are husband and wife. They filed joint Federal income tax returns for the calendar years 1965, 1966, and 1967 with the district director of internal revenue at San Francisco, Calif., and resided in Woodland, Calif., at the time of the filing of their petition herein. Petitioners were on the accrual basis of accounting.

During 1964 and at all other times here relevant, Glenn W. Lucas, Jr. (hereinafter referred to as petitioner), was licensed as a certified public accountant by the State of California. For approximately 6 years prior to August 1964, petitioner had practiced in the general area of Woodland, Calif.

Sometime before August 22, 1964, petitioner entered into negotiations with Raymond J. Bell (Bell) for the purchase of Bell's accounting practice also located in Woodland. Bell, who was licensed by the State of California as a public accountant, had been practicing in Woodland for approximately 20 years. His practice consisted primarily

[58 T.C. 1024]

of the preparation of tax returns, the maintenance of bookkeeping records for small retail business, as well as a small amount of business management. The major part of the practice involved performing such accounting services on a continuing basis for clients with whom Bell had become familiar over a period of years. Woodland was a small community with a population of around 20,000 people, and the residents were aware of the accounts practicing in the area. Bell, who had lived there since 1934, was well known in the community both as an accountant and local leader. Most of his clients were located in the general vicinity of Woodland, and through his community activities Bell had become personally acquainted with most of the individual clients who made up the principal part of his practice.

As of August 1964, Bell had in his employ at least four other people, two of whom, Jack Richter (Richter), an accountant, and Mrs. Diva Anderson, a bookkeeper, had been associated with him for 10 and 14 years, respectively, and both of whom also had direct personal contact with Bell's clients.

During the 5 years preceding August 1964, Bell's accounting practice averaged about $60,000 per year in gross billings; and in the last of those years gross billings amounted to approximately $75,000. Bell's average personal net income from the accounting practice in these years was approximately $20,000 per year. Petitioner's own accounting practice in Woodland was similar to Bell's, but the gross billing revenues arising therefrom were only about half those of Bell's practice, or approximately $30,000 per year.

Petitioner became aware of the availability of Bell's accounting practice through a third party. Bell had decided to sell the practice because he was tired and wished to lessen his workload. Initially, negotiations were conducted directly between petitioner and Bell. After two such meetings between them, Bell arrived at an overall figure of $40,000 for his accounting practice, and petitioner accepted this offer of sale without otherwise negotiating the price.

Sometime thereafter, petitioner met with Bell and Bell's attorney in the attorney's office to discuss the terms of a formal agreement for the sale of the accounting practice. Petitioner did not obtain legal counsel to represent him at the meeting because he thought the matters involved simple enough not to require representation.

Bell considered that part of the assets involved in the sale consisted of goodwill associated with his familiarity with the individual clients of his practice. He therefore felt a responsibility in connection with the proposed sale, to work with petitioner and to assist in the actual transfer of the clientele itself. Petitioner also hoped that after his

[58 T.C. 1025]

purchase of Bell's practice it would be possible to retain Bell's clients as his own, and in this respect anticipated that for several months after the sale of the accounting practice Bell would perform substantial services in connection with the transfer of the practice to petitioner. And petitioner thought that after this transition period Bell would perform more limited services consistent with Bell's desire to reduce his professional commitments.

Petitioner also considered that it was otherwise important to be protected in some manner from possible future competition by Bell after the proposed sale and purchase of the accounting practice, and had decided that he would not purchase the practice without such protection. Accordingly, during the course of the meeting, petitioner stated that he wanted a covenant not to compete on Bell's part written into the proposed contract of sale. Bell's attorney advised both parties that a person could not be legally deprived of his right to make a living, and that therefore such a covenant should not be made part of the contract of sale. It was pointed out to petitioner that he And bell might not get along during the period of transition in which Bell was to assist in the transfer of the accounting practice and its clients, and that Bell should otherwise still retain the right to earn a livelihood. Petitioner accepted the position taken by Bell and his attorney in this respect, and the parties agreed that the contract of sale would not include such a covenant not to compete.

Petitioner then suggested that the matter of his protection against possible competition from Bell be handled in another way, and requested that, in lieu of the covenant not to compete, a separate employment contract be entered into between Bell and himself at the same time as the contract of sale. Petitioner stated at the meeting that if he could deal directly with Bell's former clients over a period of 3 years without competition from Bell, such clients would become his own.

Although petitioner also understood from information given to him by attorneys in the past that such an employment contract could not run for more than 1 year or the courts would not enforce the contract as against public policy, petitioner nonetheless considered that he would be protected, by such an employment agreement in conjunction with the purchase price payment features of the sale, against possible competition from Bell during a period longer than the 3 years petitioner thought necessary to acquire the allegiance of Bell's clients. In this respect, the payment schedule agreed to by petitioner and Bell for the $40,000 purchase price called for a downpayment of $3,500, a promissory note of $16,500 at 6-percent interest with payments to begin on a set date, and another promissory note of $20,000 with

[58 T.C. 1026]

no interest until the first payment was made thereon by petitioner which was not to occur until 5 years after the termination of Bell's employment with petitioner. Petitioner and Bell also agreed that should the gross billing fees of the accounting practice fall below an average of $75,000 per year for 1965 and 1966, there would be a credit against the principal due on the $20,000 note of one-half the deficit below $75,000. Petitioner considered that the provisions taken together effectively protected him against competition from Bell, and that if Bell entered into competition with him, petitioner could tie the matter up in litigation and still not be liable for interest on the $20,000 note for 5 years. In addition, petitioner thought that after the expiration of the 5 years and at the time payments on the second note began, Bell, who was 51 years old in 1964, would be too old to compete.

Bell for his part did not consider these provisions to constitute a covenant not to compete which he and petitioner had agreed would not be part of the agreement of sale. Rather, Bell thought the provisions relating to the projected $75,000 gross billing revenues for 1965 and 1966, and the credit aspect of the $20,000 note in connection therewith, merely created a guarantee of income. As indicated hereinabove, Bell did not have any intention of...

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