Recovery Group, Inc. v. Commissioner of Internal Revenue, T.C. Memo. 2010-76 (U.S.T.C. 4/15/2010)

Decision Date15 April 2010
Docket NumberNo. 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.
PartiesRECOVERY GROUP, INC., ET AL.,<SMALL><SUP>1</SUP></SMALL> Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
CourtU.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

GUSTAFSON, Judge.

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.

FINDINGS OF FACT

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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