Recovery Group Inc. v. Comm'r of Internal Revenue

• Decision Date: 26 July 2011
• Docket Number: No. 10–1886.,10–1886.
• Citation: 108 A.F.T.R.2d 2011,2011 USTC P 50541,652 F.3d 122
• Parties: RECOVERY GROUP, INC., et al., Petitioners, Appellants,v.COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee.
• Court: U.S. Court of Appeals — First Circuit

652 F.3d 122

108 A.F.T.R.2d 2011-5437

2011-2 USTC P 50,541

RECOVERY GROUP, INC., et al., Petitioners, Appellants,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee.

No. 10–1886.

United States Court of Appeals, First Circuit.

Heard Feb. 9, 2011.Decided July 26, 2011.

Peter L. Banis, with whom Banis, O'Sullivan & McMahon, LLP, was on brief for petitioners.Damon W. Taaffe, Attorney, Tax Division, Department of Justice, with whom John A. DiCicco, Acting Assistant Attorney General, and Thomas J. Clark, Attorney, were on brief for respondent.Before TORRUELLA, Circuit Judge, SOUTER,^* Associate Justice, and BOUDIN, Circuit Judge.TORRUELLA, Circuit Judge.

The present appeal requires us to determine whether a covenant not to compete, entered into in connection with the acquisition of a portion of the stock of a corporation that is engaged in a trade or business, is considered a “section 197 intangible,” within the meaning of I.R.C. § 197(d)(1)(E), regardless of whether the portion of stock acquired constitutes at least a “substantial portion” of such corporation's total stock. For the reasons stated below, we answer in the affirmative.

Petitioners–Appellants Recovery Group, Inc. (“Recovery Group”) and thirteen individuals who held shares in said corporation appeal the United States Tax Court's decision in Recovery Group, Inc. v. Comm'r of Internal Revenue, T.C. Memo 2010–76, 99 T.C.M. (CCH) 1324 (U.S.Tax Ct. Apr. 15, 2010), which found in favor of respondent Commissioner of Internal Revenue (the “Commissioner”) concerning the correctness of certain income tax deficiencies assessed by the United States Internal Revenue Service (the “IRS”) against the appellants. ¹ These deficiencies resulted from the finding that a certain covenant not to compete—entered into by Recovery Group in connection with the redemption of 23% of the shares of a former shareholder—constituted a “ section 197 intangible,” and, consequently, that Recovery Group had to amortize the payments it made under such covenant not to compete over the fifteen-year period prescribed by I.R.C. § 197(a), and not over the duration of the covenant, as Recovery Group had reported in its corresponding income tax returns. Because we find that the aforementioned covenant not to compete was an “amortizable section 197 intangible,” we affirm.

I. Facts and Procedural History

The relevant facts in this appeal are not in dispute. During the tax years in question, Recovery Group was an “S corporation” ² that engaged in the business of providing consulting and management services to insolvent companies.

In 2002, James Edgerly—one of Recovery Group's founders, employees and minority shareholders—informed its president that he wished to leave the company and to have the company buy out his shares, which represented 23% of Recovery Group's outstanding stock. As a result of the subsequent negotiations, Mr. Edgerly entered into a buyout agreement whereby Recovery Group agreed to redeem all of Mr. Edgerly's shares for a price of $255,908. In addition, Mr. Edgerly entered into a “noncompetition and nonsolicitation agreement” that prohibited Mr. Edgerly from, inter alia, engaging in competitive activities from July 31, 2002 through July 31, 2003. The amount paid by Recovery Group to Mr. Edgerly for this covenant not to compete (the “Covenant”) amounted to $400,000, which was comparable to Mr. Edgerly's annual earnings.

In its corresponding income tax returns, Recovery Group claimed deductions for its payments under the Covenant by amortizing such payments over the twelve-month duration of the Covenant. Thus, because that twelve-month term straddled the two tax years 2002 and 2003, Recovery Group allocated the $400,000 over those two years.

After a subsequent investigation, the IRS determined that the Covenant was an amortizable section 197 intangible, amortizable by Recovery Group over fifteen years (beginning with the month of acquisition) and not over the duration of the Covenant, as had been reported by Recovery Group in its corresponding income tax returns. Consequently, the IRS partially disallowed Recovery Group's deductions for the cost of the Covenant, allowing amortization deductions of only $11,111 for 2002 and $26,667 for 2003, and disallowing $155,552 for 2002 and $206,667 for 2003. This disallowance increased Recovery Group's net income for each year, and thus each shareholder's share of Recovery Group's income. Accordingly, the IRS issued notices of deficiency to both Recovery Group and its shareholders.³

Recovery Group and its shareholders filed timely petitions in the tax court, alleging that the Covenant was not considered a “section 197 intangible,” and, consequently, that it was not subject to I.R.C. § 197's fifteen-year amortization period, but rather that it was amortizable over its one-year duration. Specifically, Recovery Group alleged that, in order for a covenant not to compete to be considered a “section 197 intangible” under I.R.C. § 197(d)(1)(E), the covenant must be entered into in connection with the acquisition of either the totality of such corporation's stock or a substantial portion of such corporation's total stock. The tax court rejected Recovery Group's interpretation of I.R.C. § 197 and found in favor of the Commissioner, concluding that § 197(d)(1)(E)'s substantiality requirement only applied to asset acquisitions and not to stock acquisitions, and, consequently, that a covenant not to compete entered into in connection with the acquisition of any corporate stock, even if not “substantial,” was considered a “section 197 intangible” amortizable over fifteen years. The tax court also opined, in the alternative, that even if the aforementioned conclusion was incorrect and I.R.C. § 197(d)(1)(E)'s substantiality requirement indeed applied to stock acquisitions, Recovery Group's claim nonetheless failed because the court found the stock redemption in question (23% of Recovery Group's total stock) to be a “substantial portion” of the company's stock. This appeal ensued.⁴

II. Standard of Review

We review de novo the tax court's legal conclusions, including its interpretation of the Internal Revenue Code. Drake v. Comm'r, 511 F.3d 65, 68 (1st Cir.2007).

III. Discussion

On appeal, Recovery Group contests the tax court's decision on the tax deficiencies by challenging the court's interpretation of I.R.C. § 197. ⁵ Specifically, Recovery Group avers that the tax court erred by concluding that the Covenant is a “ section 197 intangible” within the meaning of I.R.C. § 197(d)(1)(E).

In interpreting the meaning of I.R.C. § 197(d)(1)(E), we begin our analysis with the statutory text and determine whether the same is plain and unambiguous. See Carcieri v. Salazar, 555 U.S. 379, 129 S.Ct. 1058, 1063, 172 L.Ed.2d 791 (2009). In so doing, we accord the statutory text “its ordinary meaning by reference to the ‘specific context in which that language is used, and the broader context of the statute as a whole.’ ” Mullane v. Chambers, 333 F.3d 322, 330 (1st Cir.2003) (quoting Robinson v. Shell Oil Co., 519 U.S. 337, 341, 117 S.Ct. 843, 136 L.Ed.2d 808 (1997)). If the statutory language is plain and unambiguous, we “must apply the statute according to its terms,” Carcieri, 129 S.Ct. at 1063–64, except in unusual cases where, for example, doing so would bring about absurd results. See In re Hill, 562 F.3d 29, 32 (1st Cir.2009). “If the statute is ambiguous, we look beyond the text to the legislative history in order to determine congressional intent.” United States v. Vidal–Reyes, 562 F.3d 43, 50–51 (1st Cir.2009) (internal quotation marks omitted). “A statute is ambiguous only if it admits of more than one reasonable interpretation.” Id. at 51 (internal quotation marks omitted).

We begin our discussion by providing a brief background of I.R.C. § 197 and then turn to sketching both the Commissioner's construction of I.R.C. § 197, which was adopted by the tax court as its primary holding, and Recovery Group's interpretation.

A. Background

Section 197 entitles taxpayers to claim “an amortization deduction with respect to any amortizable section 197 intangible.” 26 U.S.C. § 197(a). The cost of an “amortizable section 197 intangible” must be amortized “ratably over the 15–year period beginning with the month in which such intangible was acquired.” Id. No other depreciation or amortization deduction is allowed with respect to any “amortizable section 197 intangible.” Id. at § 197(b). On the other hand, intangible assets not classified as “amortizable section 197 intangible[s]” are not within the purview of I.R.C. § 197 and are not subject to this section's mandatory fifteen-year amortization period. Rather, depreciation and amortization for such non-section 197 intangible assets may be allowed under the rules of other code provisions, such as I.R.C. § 167, provided the asset complies with the requirements set forth therein.

B. Relevant Statutory Language

Section 197(d)(1)(E) defines the term “section 197 intangible” as including, among other things, “any covenant not to compete ... entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof.” Recovery Group does not contest that, under I.R.C. § 197(d)(1)(E), a redemption of stock is considered an indirect acquisition of an interest in a trade or business. See Frontier Chevrolet Co. v. Comm'r, 329 F.3d 1131, 1132 (9th Cir.2003). Rather, the parties' dispute over the construction of this section deals primarily with the antecedent of the word “thereof” and the definition of “an interest.”

The tax court held and the Commissioner asserts that the phrase “an interest in a trade or business” refers to a portion—all or a part—of an ownership interest in a trade or business, and that the phrase “trade or business” is the antecedent of the word “thereof.” Thus, the tax court essentially read I.R.C. § 197(d)(1)(E) as follows: ...