Portion of payment to former shareholder characterized as consulting expense had to be amortized.

• Author: Fiore, Nicholas J.
• Position: IRS advisory

A began operating a cardroom and entertainment business as a partnership. Eventually, he incorporated the business, operating a restaurant and cardroom business through T, a wholly owned corporation; In Year 1, the building in which T operated its business was demolished and its business operations ceased.

In Year 1, a group of investors purchased 90% of the stock in T. In Year 2, T opened a restaurant, bar and deli. To continue with the cardroom business, T was required to obtain a gaming license. Because of difficulties encountered in obtaining the license, many investors eventually sold their stock in T.

By Year 3, B owned 90% of T. In February of Year 3, A agreed to sell his 10% stock ownership in T to B. Subsequent to the sale, B would own 100% of the T stock. The sale of the Stock was to occur when T opened for business to the general public as a licensed gaming or cardroom business.

Also in February of Year 3, A and T entered into an agreement entitled "Agreement of sale of goodwill and covenant not to compete" (Agreement). Pursuant to the Agreement, T acquired A's goodwill and A entered into a covenant not to compete in connection with the sale of goodwill in exchange for a monthly payment. The Agreement would become effective when T acquired all gaming or cardroom licenses necessary to open the business and actually opened for business as a gaming establishment. The payments would continue until the earliest of A's death, A's purchase of T stock that A had a conditional right to repurchase, or A's violation of the noncompetition agreement.

In Year 3, to ensure the continued patronage of T's customers, A and T orally agreed that A would greet players in the game rooms. In each of October, November and December of Year 3, T paid A; from each payment, a portion was characterized as "wages" and a portion as "consulting expenses." T deducted the entire payment, and A reported it as ordinary income.

Analysis

It appears that, subsequent to entering into the Agreement, T and A entered into an oral agreement that modified the Agreement. Under the oral modification, T would pay A a set amount each month to greet players in the game room, and the amount paid under the Agreement would be reduced by that amount. To the extent this payment was reasonable for the service provided, T may deduct the payment. To the extent it does not represent a modification or payment for services, the payment would be included as an amount paid under the...