SCOTUS Reports

Tag: purchase price allocation

  • Peterson Machine Tool, Inc. v. Commissioner, 79 T.C. 72 (1982): Allocating Purchase Price to Covenants Not to Compete

    Peterson Machine Tool, Inc. v. Commissioner, 79 T. C. 72 (1982)

    When a stock purchase agreement includes covenants not to compete, a portion of the purchase price can be allocated to those covenants if they are intended as part of the contract and have independent economic significance.

    Summary

    In Peterson Machine Tool, Inc. v. Commissioner, the Tax Court ruled on the allocation of a $280,000 purchase price for the stock of Kansas Instruments, Inc. , between the stock itself and covenants not to compete signed by the sellers. The contract explicitly stated that the covenants were a ‘material portion’ of the purchase price. The court found that the covenants were intended to be part of the agreement and had real economic value, given the sellers’ ability to compete. While the buyer allocated $100,000 to the covenants, the court determined $70,000 was a more appropriate allocation, allowing the buyer to amortize this amount over 5 years and treating it as ordinary income for the sellers.

    Facts

    Peterson Machine Tool, Inc. purchased all the stock of Kansas Instruments, Inc. from Carl U. Hansen, Robert W. Moses, and M. V. Welch for $280,000. The purchase agreement included covenants not to compete, which the sellers signed. The contract specified that the covenants were ‘materially significant and essential to the closing’ and ‘a material portion of the purchase price. ‘ The sellers were aware of these terms and did not object. Peterson allocated $100,000 of the purchase price to the covenants, intending to amortize this amount over 5 years. The sellers did not allocate any portion of the price to the covenants and were unaware of the tax implications until later.

    Procedural History

    The Commissioner of Internal Revenue assessed deficiencies against both Peterson and the sellers based on inconsistent treatment of the covenant allocation. Peterson filed a petition in the U. S. Tax Court to challenge the disallowance of its amortization deductions, while the sellers contested the treatment of the covenant proceeds as ordinary income. The cases were consolidated for trial.

    Issue(s)

    1. Whether the parties intended to allocate a portion of the purchase price to the covenants not to compete?
    2. Whether the covenants not to compete had independent economic significance?
    3. What amount, if any, should be allocated to the covenants not to compete?

    Holding

    1. Yes, because the contract explicitly stated the covenants were a ‘material portion’ of the purchase price and the sellers were aware of this term.
    2. Yes, because the sellers had the knowledge, resources, and ability to compete with Peterson, making the covenants economically significant.
    3. $70,000, because while the covenants had real value, the $100,000 allocation by Peterson was too high based on the evidence presented.

    Court’s Reasoning

    The court applied general contract interpretation principles, focusing on the plain meaning of the contract terms. The phrase ‘material portion’ in the contract clearly indicated an intent to allocate some of the purchase price to the covenants. The court rejected the sellers’ argument that the ‘strong proof’ doctrine applied, as neither party was attempting to vary the contract terms but rather to construe them. The court found the covenants had independent economic significance because the sellers had the ability to compete effectively with Peterson. Hansen had turned Kansas Instruments around financially, Welch had the manufacturing capability, and Moses had intimate knowledge of the business. The court used its discretion under the Cohan rule to allocate $70,000 to the covenants, finding this amount reflected their economic reality within the overall purchase price.

    Practical Implications

    This decision clarifies that when a stock purchase agreement includes covenants not to compete, a portion of the purchase price can be allocated to those covenants if the contract language supports it and the covenants have real economic value. Attorneys drafting such agreements should carefully consider the language used to describe the covenants and their relationship to the purchase price. Buyers should assess the competitive threat posed by sellers when determining an appropriate allocation amount. The ruling also demonstrates the court’s willingness to adjust allocations it deems unreasonable, even when the parties agree on a specific figure. This case has been cited in subsequent decisions involving the allocation of purchase price to covenants not to compete, such as Schulz v. Commissioner and Leavell v. Commissioner.

  • Silberman v. Commissioner, 12 T.C.M. (CCH) 1254 (1953): Allocating Purchase Price Between Covenant Not to Compete and Goodwill

    <strong><em>Silberman v. Commissioner</em></strong>, 12 T.C.M. (CCH) 1254 (1953)

    When a business is sold, the allocation of the purchase price between a covenant not to compete and goodwill is determined by the intent of the parties, supported by the economic realities of the transaction, and the allocation made in the agreement is not determinative but is evidence of intent.

    <strong>Summary</strong>

    The Tax Court addressed whether a portion of a business sale’s purchase price should be allocated to a covenant not to compete or to goodwill. The court found that $14,375 of the total price paid by Silberman to Rothman was for Rothman’s agreement not to compete. This determination was based on the parties’ intent, the business’s nature, and the economic realities, including the lack of substantial goodwill value. The court emphasized that the allocation in the agreement, and the accounting entries, were not decisive, but provided evidence of the parties’ intentions.

    <strong>Facts</strong>

    Joseph Silberman purchased Harry Rothman’s interest in Tissue Products Company. The parties entered into an agreement, and a “Good Will” account was opened on the books for $14,375, which matched the claimed amount for a non-compete covenant. The business, which packed and converted private imprint tissues, did not have significant goodwill because its main selling point was printing the customer’s name, with sales dependent on personal contacts. Rothman agreed not to compete with Silberman and his assigns for three years.

    <strong>Procedural History</strong>

    The case appeared before the Tax Court to determine the proper allocation of the purchase price for tax purposes, specifically addressing whether the amount paid for the covenant not to compete could be amortized. The court considered the facts and arguments presented by both the taxpayers and the Commissioner of Internal Revenue.

    <strong>Issue(s)</strong>

    1. Whether the purchase price paid by Silberman included a payment for Rothman’s covenant not to compete.

    2. If so, what amount of the purchase price should be allocated to the covenant not to compete.

    3. Whether the amount allocated to the covenant not to compete could be amortized for tax purposes.

    <strong>Holding</strong>

    1. Yes, because the court found the $14,375 was, in fact, paid solely for the agreement not to compete, supported by the testimony and circumstances.

    2. $14,375 of the purchase price was allocated to the covenant not to compete because the business had no goodwill value, and the covenant was essential to protect Silberman’s business.

    3. Yes, the court found that the amount of consideration allocated to the covenant not to compete could be amortized ratably over the term of the covenant because there was a severable consideration.

    <strong>Court’s Reasoning</strong>

    The court analyzed the economic realities to determine the true nature of the transaction. They found the business lacked goodwill due to its dependence on personal services and customer relationships, not a brand name. The court emphasized the significance of the non-compete covenant in protecting Silberman’s business from Rothman’s potential actions, especially during tissue shortages. The court also found that the accounting treatment did not accurately reflect the true nature of the transaction. The court stated, “We find no goodwill value attributable to Rothman’s interest.” The court held that “the naming or misnaming of the account is not determinative to the contrary.” The fact that the agreement required Rothman to return part of the price if he competed before a certain date further corroborated the intention.

    <strong>Practical Implications</strong>

    This case highlights the importance of properly documenting and structuring agreements for business sales. It emphasizes that the allocation of the purchase price should be based on the economic realities of the transaction. This decision informs how tax professionals should advise clients on allocating purchase prices in business sales, focusing on the intent of the parties as reflected in the agreement and the underlying circumstances. The lack of goodwill and the importance of the non-compete agreement were crucial. It means practitioners must carefully examine the nature of the business, the parties’ intentions, and any potential for competition to properly structure and allocate the transaction.