Recovery Group, Inc. v. Commissioner of Internal Revenue, T.C. Memo. 2010-76 (U.S.T.C. 4/15/2010)
| Decision Date | 15 April 2010 |
| Docket Number | No. 29336-07.,No. 29321-07.,No. 29385-07.,No. 12430-08.,No. 29314-07.,No. 29326-07.,No. 29335-07.,No. 29333-07.,12430-08.,29314-07.,29321-07.,29326-07.,29333-07.,29335-07.,29336-07.,29385-07. |
| Parties | RECOVERY GROUP, INC., ET AL.,<SMALL><SUP>1</SUP></SMALL> Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. |
| Court | U.S. Tax Court |
Recovery Group, Inc. (RG), an S corporation, redeemed all of the stock held by E, a minority shareholder and employee. In addition to paying E for his 23-percent interest in the company, RG also paid E $400,000 to enter into a 1-year covenant not to compete. RG deducted the cost of the covenant not to compete over its 12-month term. The IRS determined that RG could not immediately deduct the covenant not to compete and determined built-in gains taxes under I.R.C. sec. 1374 and accuracy-related penalties for RG under I.R.C. sec. 6662. The disallowed deductions increased the taxable income flowing through RG to its shareholders, and the IRS also determined deficiencies in the shareholders' tax.
Held: The cost of the covenant not to compete may not be amortized over its 1-year term; the covenant is an amortizable I.R.C. sec. 197 intangible and must be amortized over 15 years.
Held, further, RG reasonably relied on competent, fully informed professionals to prepare its tax returns and thereby satisfies the reasonable cause and good faith exception of I.R.C. sec. 6664(c) and avoids liability for the accuracy-related penalty.
Peter L. Banis and D. Sean McMahon, for petitioners.
Paul V. Colleran, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
These cases are before the Court pursuant to section 6213(a)2 for redetermination of deficiencies in tax and penalties for 2002 and 2003, which the Internal Revenue Service (IRS) determined against Recovery Group, Inc. (Recovery Group), and its shareholders. The determination against Recovery Group, an S corporation, was made pursuant to section 1374 (see infra note 5) and was as follows:
Accuracy-Related
Penalties
Docket Deficiencies Sec. 6662
Petitioner No. 2002 2003 2002 2003
Recovery Group, Inc. 12430-08 $46,138 $70,011 $9,288 $14,002
The IRS determined the following deficiencies in the Federal income taxes of Recovery Group's shareholders:
Petitioner(s) Docket No. 2002 2003
Robert J. & Yvonne M. Glendon 29314-07 $2,599 $2,825
John S. & Mary V. Sumner 29321-07 2,824 3,071
Stephen S. Gray & Linda Baron 29326-07 20,790 22,603
Michael & Barbara Epstein 29333-07 1,970 -0-
Anthony J. Walker & Pamela S. Mayer 29335-07 1,695 1,431
Andre & Helen Laus 29336-07 5,197 4,494
Parham Pouladdej 29385-07 10,395 11,301
______ ______
Total 45,470 45,725
All of the disputed deficiencies result from the IRS's determination that the cost of a covenant not to compete must be amortized over 15 years. The IRS determined accuracy-related penalties against Recovery Group only; it determined no penalties against the subchapter S shareholders.
The issues for decision are:
1. Whether Recovery Group may amortize the cost of a covenant not to compete over its 12-month term or whether it must amortize that cost over 15 years pursuant to section 197(a). We find that the covenant is an amortizable section 197 intangible and we sustain respondent's determination that it must be amortized over 15 years.
2. Whether Recovery Group is liable under section 6662 for accuracy-related penalties on the underpayments that result from disallowance of the excess deductions it took by amortizing the covenant not to compete over its 12-month term. We find that because Recovery Group reasonably relied on its accountants to prepare its returns, it had reasonable cause and acted in good faith in filing its returns and is not liable for the penalties.
The parties do not dispute the facts in these cases that relate to the amortization of the covenant not to compete, but they do dispute the facts related to the accuracy-related penalty. We incorporate by this reference the stipulation of facts filed June 24, 2009, and the attached exhibits.
Recovery Group is a "turn-around, crisis-management business" providing consulting and management services to insolvent companies, together with services as bankruptcy trustee, examiner in bankruptcy cases, and receiver in Federal and State courts. Recovery Group had its principal place of business in Massachusetts when it filed its petition in this Court.3
Employee/Shareholder's departure
In 2002 James Edgerly, one of Recovery Group's founders, employees, and minority shareholders, informed its president, Stephen Gray, that he wished to leave the company and to have his shares bought out and settle various debts between himself and the company. Mr. Gray, who is also a founder and shareholder, discussed the departure with the remaining shareholders and developed a framework for the buyout. He then asked the company's accountant, Ron Orleans, to calculate the buyout numbers and tell Mr. Gray how the transaction should work. Mr. Gray explained to Mr. Edgerly the structure and the financial details of the proposed buyout agreement. Mr. Edgerly considered the offer and then accepted it.
Mr. Edgerly held 18,625 shares of Recovery Group stock, which represented 23 percent of the outstanding stock of the company. The agreement between Mr. Edgerly and Recovery Group called for the company to pay him a total of $805,363.33, in payment of which the company gave him a $205,363.33 check and a $600,000 promissory note payable over three years. The company and Mr. Edgerly itemized the buyout payment as follows:
Description Amount
Stock purchase price $255,908
Noncompetition payment 400,000
Company's debt to stockholder (principal) 25,000
Company's debt to stockholder (interest) 2,553
Company's note payable to stockholder (principal) 122,177
Company's note payable to stockholder (interest) 11,976
Shareholder's debt to company (12,250)
__________
Total due from company to stockholder 805,364
The "Noncompetition payment" was for a "noncompetition and nonsolicitation agreement" that prohibited Mr. Edgerly from, inter alia, engaging in competitive activities from July 31, 2002, through July 31, 2003; and the $400,000 that Recovery Group paid for the covenant was comparable to Mr. Edgerly's annual earnings.
Mr. Orleans, Recovery Group's accountant, was involved with the buyout throughout. As is noted above, he calculated the buyout amounts. Mr. Gray, Recovery Group's president, did not discuss the tax implications of the buyout with Mr. Orleans when he asked him to compute the numbers. When Recovery Group executed the buyout, Mr. Gray did not consider the tax ramifications of the deal; but he understood that some portion of the buyout payment was tax deductible while the remainder was not. Deductibility was not a consideration in his structuring the deal; rather, he assumed that the tax results would be what the accountants determined.
Recovery Group's accountants
Mr. Orleans began practicing as an accountant in 1973 and has been a certified public accountant (C.P.A.) since 1976. At his accounting firm—Kanter, Troy, Orleans & Wexler, LLP— Mr. Orleans was the relationship partner assigned to Recovery Group. He was responsible for overseeing Recovery Group's accounting operations and managing the preparation of Recovery Group's financial statements and tax returns. Mr. Orleans worked with Donald Troy, a tax specialist at his firm. Mr. Troy was licensed as a C.P.A. in 1986, and he held a bachelor's degree in accountancy and a master's degree in taxation. During the years in issue, Mr. Troy was the accounting firm's tax director.
Preparing Recovery Group's returns
Mr. Orleans relied upon Mr. Troy to make the technical decisions on how Recovery Group's tax returns should be prepared, and Recovery Group relied upon the accountants to make these decisions correctly.
When considering how to report Recovery Group's expense for the covenant not to compete on its tax returns, Mr. Troy consulted case law, together with the statutory language, regulations, and legislative history of section 197. He concluded that the covenant not to compete was not a section 197 intangible and thus was exempt from that section's 15-year amortization period. Accordingly, he prepared Recovery Group's returns to amortize the covenant not to compete ratably over its 12-month term. Since that 12-month term straddled the two years 2002 and 2003, he allocated the $400,000 between those two years (rather than over the 15 years 2002 through 2016)—i.e., roughly five-twelfths of the total ($166,663) in 2002 and the remainder, approximately seven-twelfths ($233,337), in 2003. Those amounts constituted less than 2 percent of Recovery Group's deductions reported on the returns for those years.4
Approving Recovery Group's returns
Each year, Mr. Orleans presented the tax return for Recovery Group to Mr. Gray. Mr. Gray held brief discussions with Mr. Orleans during those meetings, but he did not ask specific questions or closely review the returns prepared by the company's accountants. Rather, he asked Mr. Orleans whether the returns represented what the company had to file, and he accepted Mr. Orleans's representations that they did. Mr. Gray did not discuss tax issues with Mr. Troy or specifically approve tax decisions he made,...
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