Numa Co., Ltd. v. Commissioner

Decision Date18 February 1981
Docket NumberDocket No. 4856-78.
PartiesNuma Co., Ltd. and Subsidiaries (an Ohio corporation) v. Commissioner.
CourtU.S. Tax Court

Thomas J. Scanlon, 1525 Leader Bldg., Cleveland, Ohio and Jeffrey Terbeek, for the petitioner. John P. Graham, for the respondent.

Memorandum Findings of Fact and Opinion


Respondent determined differences in petitioners' income tax of $18,540 for the taxable year ended June 30, 1972 and $16,481.34 for the taxable period ended February 28, 1973. After concessions by petitioners, the sole issue for decision is whether petitioners are entitled to an amortization deduction in respect of a covenant not to compete.

Findings of Fact

Some of the facts have been stipulated and are found accordingly. The stipulation of facts, with accompanying exhibits, is incorporated herein.

Petitioners, Numa Co., Ltd., and subsidiaries, including Halbert's, Inc. (hereinafter collectively referred to as petitioner), are corporations incorporated under the laws of the State of Ohio, with their principal places of business in Akron, Ohio, at the time of the filing of the petition herein. Consolidated income tax returns were filed for each of the taxable periods involved with the Cincinnati Service Center, Cincinnati, Ohio.

Halbert's, Inc. (hereinafter sometimes the corporation) was organized under the laws of the State of Ohio on January 2, 1970. The original shareholders of Halbert's were Gary C. Halbert (Halbert) and Dennis B. Haslinger (Haslinger).

Halbert and Haslinger had originally formed a partnership, H & H Sales, in the late fall of 1968, for the purpose of developing a direct mail sales catalog. During 1969, Halbert developed various ideas for the catalog, and the partnership determined to go into business selling genealogical and heraldic products by mail. The partners thereupon formed the corporation Halbert's, Inc., for the purpose of engaging in that business. Halbert and Haslinger each received 10 shares of the corporation's common stock, which constituted 50 percent of the corporation's issued and outstanding stock. Haslinger became president and treasurer of the corporation. Halbert became vice-president and secretary.

The primary product developed by the corporation was the surname research report which was a one or two page account of the origin and history of a particular surname, accompanied by a reproduction of the earliest or the most prominent coat of arms (if any) associated with that name. The corporation marketed its surname research reports in the following manner. First, it contracted with the Reuben H. Donnelley Corporation (Donnelley), which possessed a list of more than 70 million names of American motorists arranged by zip code (Donnelley list), to rearrange that list by alphabetical order of surnames. Then, it selected individual surnames and mailed solicitation letters to persons on the list with those surnames. The solicitation letter offered to sell the surname research report for the recipient's surname at a price which was originally set at $1 and later at $2.

On the basis of response to the original (or follow-up) letters, the corporation compiled a new list of people who had purchased surname research reports, and that list was used to solicit orders for more expensive genealogical or heraldic products, particularly $20 plaques decorated with coats of arms. The lists of names of persons who had purchased surname research reports came to be known as the Nancy L. Halbert File (Halbert file). The Halbert file eventually grew to include approximately 6 million names; in the process of developing it, the corporation mailed approximately 140 million pieces of mail to names on the original Donnelley list. As of October, 1971, the Halbert file was approximately 10 percent developed, and was the result of about 7 million solicitation letters mailed to names on the Donnelley list.

Sales during the corporation's first full fiscal year, ended June 30, 1971, exceeded $3 million; net income in that year was $331,650 and retained earnings as of June 30, 1971, were $338,583, up from $6,933 as of July 1, 1970. Paid-in capital reflected on Halbert's, Inc., balance sheet amounted to only $3,603. Sometime after June 30, 1972, and before October 6, 1972, the audit firm of Haskins & Sells succeeded J.K. Lasser and Co., which previously had done the auditing for the taxable year ended June 30, 1971. Haskins & Sells restated the income for Halbert's, Inc., for the taxable year ended June 30, 1971, as $165,650, on management's recommendation, by setting up a reserve for income taxes otherwise due in the amount of $166,000, but not payable by reason of a net loss of a subsidiary, G.O.A., Inc., through its oil and gas well operations. The restated taxable income of Halbert's, Inc., from its operations before that loss of G.O.A., Inc., and before provisions for income tax was $416,739 for its taxable year ended June 30, 1971. For the year ended June 30, 1972, the restated taxable income of Halbert's, Inc., from its operations before provision for a net loss of G.O.A., Inc., and before provision for income tax attributable to the covenant not to compete (here in issue) amounted to $903,667.1 The restated balance sheet showed a stockholders equity in Halbert's, Inc., of $176,186 as of June 20, 1971, and $158,482 as of June 30, 1972, but the statement of assets and liabilities of Halbert's, Inc., attached to the consolidated return for the period ended June 30, 1972, showed such equity at $427,275 as of June 30, 1971, and $413,240 as of June 30, 1972.

Shortly after the formation of Halbert's, Inc., in January, 1970, that corporation and its two shareholders (Halbert and Haslinger) entered into a stock purchase agreement dated February 1, 1970.

Under the terms of the agreement, neither shareholder could sell any of his shares in the corporation without first offering to sell them to the corporation at an agreed price per share; similarly, provisions were made for repurchase of a deceased shareholder's stock from his estate. The agreed repurchase price per share was to be set by collateral agreement, and revised periodically. By addendum to the agreement of February 1, 1970, the agreed valuation for each of the corporation's issued 20 shares was set at $20,000. The agreement did not contain a covenant not to compete.

Halbert's, Inc., in January, 1971, brought in William L. Miller (Miller), a corporate executive from another corporation, to be vice-president and general manager.

On April 26, 1971, Halbert's, Inc., declared a stock dividend of 9 shares of its authorized and unissued stock for each share then outstanding so that Haslinger and Halbert each wound up with a total of 100 shares of the corporation's stock.

On April 27, 1971, Halbert, Haslinger, and Miller entered into an agreement of sale whereby Halbert and Haslinger each sold Miller two shares of his stock in Halbert's, Inc., for $2,000 per share so that upon consumation of such sale to Miller the outstanding capital stock of the corporation was owned as follows:

                  Shareholder         No. of Shares  Percent
                  Haslinger .............  98          49
                  Halbert ...............  98          49
                  Miller ................   4           2

The agreement of sale contained a waiver of the restrictions imposed by the stock purchase agreement, dated February 1, 1970, to which the corporation agreed.

The price of $2,000 per share for such sale to Miller was set by adjusting the agreed valuation per share under the February 1970 stock purchase agreement adjusted for the 9 for 1 stock dividend.

Also, on April 27, 1971, Halbert, Haslinger, Miller, and Halbert's, Inc., entered into a modification of the stock purchase agreement of February 1970, whereby Miller agreed to be bound by its terms. Again, there was no provision for a covenant not to compete.

On June 21, 1971, the shareholders of the corporation (Halbert, Haslinger, and Miller) and the corporation entered into a Statement of Stock Valuation and Purchase Price, which placed a value of $4,500 per share on the 200 outstanding shares of the corporation's stock.

Miller, by a letter dated June 22, 1971, to Halbert, offered to purchase all of Halbert's stock in the corporation for $750,000 cash, contingent upon arranging financing. Miller's offer did not contain or refer to any covenant not to compete by Halbert. The amount of his offer was the least amount that Halbert would take for his stock ownership. The parties to the stock purchase agreement executed an appropriate waiver of its restrictions for the purposes of the prospective purchase and sale.

Miller did not purchase Halbert's stock in the corporation because he was unable to obtain the financing, and the sales agreement, therefore, lapsed in accordance with its terms.

On or about October 8, 1971, the shareholders and the corporation resolved inter alia to enter into a written agreement whereby the corporation would purchase all of the shares of the corporation's stock owned by Halbert. Said resolution was made and adopted in corporate minutes and, pursuant to such resolution, a written contract for the sale and purchase of Halbert's stock in the corporation was entered into by and between the corporation and Halbert on or about October 8, 1971. Concurrently with the execution and the delivery of the contract, Halbert, Haslinger, and Miller, as shareholders of the corporation, and the corporation executed a written consent to said stock sale by Halbert.

The aforesaid resolution specifically provided in part —

that the Corporation purchase from Gary C. Halbert the 98 shares of without par value, common stock owned by him of the Corporation for the total purchase price of $750,000.00, the sum of $150,000.00 to be paid in cash and the balance by the issuance and delivery of the Corporation's Subordinated Debenture in the sum of

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