Don't overlook the credit for tax on prior transfers.

• Author: Castillo, Carlos H.

However, what is surprising is that the proposed regulations take the unprecedented view that a covenant not to compete entered into contemporaneously with a stock redemption is entered into "in connection with" the redemption for purposes of Sec. 162(k), which disallows a deduction "for any amount paid or incurred by a corporation in connection with the reacquisition of its stock...." In addition, Prop. Regs. Sec. 1.197-2(a)(4) states that "Section 197 does not apply to any amount paid or incurred for a section 197 intangible if a deduction for the amount would be disallowed under any provision of the Internal Revenue Code other than section 263. (See, for example, section 162(k).)"

Therefore, although the covenant not to compete would constitute a Sec. 197 intangible, any amount paid or incurred under the covenant would not be deductible under Sec. 162(k). Thus, the proposed regulations apply the "in connection with" language of Sec. 197(d)(1)(E) to Sec. 162(k).

This position is illustrated in Prop. Regs. Sec. 1.197-2 (k), Example (4). However, this example suggests that amounts paid or incurred pursuant to a covenant not to compete, entered into at the time of a stock redemption, may not always be nondeductible under Sec. 162(k). In the example, the corporation and the shareholder have no business relationship with each other except for the corporate-shareholder relationship. This appears to indicate that, if the shareholder was also an employee or had some other active involvement in the corporation's business (factors often present in many closely held or family-owned corporations), perhaps the noncompete agreement would not be viewed as being entered into in connection with a stock redemption (and, therefore, not subject to Sec. 162(k)).

If the proposed regulations are finalized, amounts paid or incurred under a covenant not to compete entered into contemporaneously with a stock redemption will be scrutinized as being:

--additional consideration for the redeemed stock, nondeductible to the corporation and generally capital gain to the shareholder;

--in connection with the stock redemption, nondeductible to the corporation and ordinary income to the shareholder under the covenant's terms; or

--not in connection with the stock redemption, amortizable by the corporation over 15 years and ordinary income to the shareholder under the covenant's terms.

Consequently, under these proposed regulations, factual controversies can be anticipated...