Question

Juan owns 40% and Mario owns 60% of Crispy Donuts, Inc. (CDI). Juan wants to buy out Mario's interest in CDI, so he arranges a stock sale agreement under which CDI will redeem (purchase) all of Mario's shares for $900,000. This will then make Juan the sole shareholder of CDI. Juan wants to ensure that Mario does not open a competing donut business nearby so he also has a covenant-not-to-compete drawn up at the same time as the stock sale agreement.

Under the terms of the covenant-not-to-compete, Mario cannot open another donut business within a 10 mile radius for a period of five years. During this 60 month period, CDI will pay Mario $9,000 per month in return for his agreement not to compete. CDI wants to know over what time period it should amortize the covenant-not-to-compete.

Consider any ethical issues that may arise. Cite proper IRS regulation(s) to support your point of view.

Answer 1

Issue: Over what time period should CDI amortize the covenant-not-to-compete?

Conclusion: CDI should amortize the covenant-not-to-compete over 15 years.

Discussion of Reasoning and Authorities: As a general rule, Section 197(a) states that a taxpayer shall be entitled to an amortization deduction with respect to any amortizable section 197 intangible.  The amount of such deduction shall be determined by amortizing the adjusted basis of such intangible ratably over the 15-year period beginning with the month in which such intangible was acquired.  A covenant-not-to-compete is considered a “section 197 intangible” pursuant to Section 197(d)(1)(E).  Even though the covenant only covers a five-year time period, it still must be amortized over 15 years.  The amount of CDI's yearly amortization is $36,000 [($9,000 x 60 months) / 15 years].