Noncompete agreement entered into contemporaneously with stock redemption.

• Author: Luchs, Lorin D.

This article is an update of a Tax Clinic item with the same title that appeared in The Tax Adviser (May 1997, p. 267), reflecting Sec. 197 final regulations issued by the IRS on Jan. 25, 2000. Consistent with the proposed regulations, Regs. Sec. 1.197-2 provides that a covenant not to compete entered into between a corporation and a shareholder on a corporation's redemption of a shareholder's stock is a Sec. 197 intangible. Unlike the proposed regulations, however, Regs. Sec. 1.197-2 makes no reference to Sec. 162(k), which disallows a deduction "for any amount paid or incurred by a corporation in connection with the reacquisition of its stock...."

Background

Sec. 197, enacted as part of the Revenue Reconciliation Act of 1993 (RRA), includes in the definition of a "Sec. 197 intangible" amortizable over 15 years," any covenant not to compete (or other arrangement to the extent such arrangement has substantially the same effect as a covenant not to compete) entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof." The RRA Conference Report provided that, in the case of a covenant not to compete, "an interest in a trade or business includes not only the assets of a trade or business, but also stock in a corporation that is engaged in a trade or business or an interest in a partnership that is engaged in a trade or business." There was no indication in the Sec. 197 legislative history as to whether a covenant not to compete entered into in connection with a stock redemption was intended to constitute a Sec. 197 intangible. Nor was there any indication of whether Sec. 162(k) was intended to apply to an amount paid or incurred under a covenant not to compete entered into in connection with a stock redemption.

Proposed Regulations

Prop. Regs. Sec. 1.197-2(b)(9) provided that, with respect to covenants not to compete and other similar arrangements, an acquisition of an interest in a trade or business "may be made in the form of ... a stock acquisition or redemption.... "Accordingly, under the proposed regulations, a noncompete agreement entered into in connection with a stock redemption is a Sec. 197 intangible. However, the proposed regulations disallowed amortization of the covenant not to compete by the inclusion of Regs. Sec. 1.197-2(a)(4), which stated that "section 197 does not apply to any amount paid or incurred for a section 197...