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USTC Cases, Recovery Group, Inc., et al., Petitioners, Appellants v.
Commissioner of Internal Revenue, Respondent, Appellee., U.S. Court of
Appeals, First Circuit, 2011-2 U.S.T.C. ¶50,541, (Jul. 26, 2011)
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Recovery Group, Inc., et al., Petitioners, Appellants v. Commissioner of Internal Revenue, Respondent,
Appellee.
U.S. Court of Appeals, First Circuit; 10-1886, July 26, 2011.
Affirming the Tax Court, 99 TCM 1324, Dec. 58,184(M), TC Memo. 2010-76.
[ Code Sec. 197]
Business deductions: Amortization: Covenant not to compete: Intangible property.–
The Tax Court properly determined that a minority shareholder’s covenant not to compete with a corporation,
entered into upon the complete redemption of the shareholder’s 23-percent interest in the company, was a
Code Sec. 197 intangible subject to a 15-year amortization period. The corporation was not entitled to deduct
its payment to the shareholder under the covenant by amortizing the payments over the covenant’s 12-month
duration. The court rejected the corporation’s argument that in order for a covenant not to compete to be
considered a Code Sec. 197 intangible under Code Sec. 197(d)(1)(E), the covenant must be entered into in
connection with the acquisition of either all or a substantial portion of such corporation’s total stock. Congress
intended Code Sec. 197(d)(1)(E) to apply to covenants entered into in connection with the acquisition of any
shares of corporate stock, regardless of whether they constituted a substantial portion of the corporation’s total
stock. Moreover, the corporation failed to provide exception to show that the covenant was not an amortizable
Code Sec. 197 intangible. Back reference: ¶12,455.31.
Peter L. Banis, Banis, O’Sullivan & McMahon, for petitioners; John A. DiCicco, Acting Assistant Attorney
General, Damon W. Taaffe, Department of Justice, Thomas J. Clark, respondent.
*
Before: Torruella, Circuit Judge, Souter, Associate Justice, and Boudin, Circuit Judge.
TORRUELLA, Circuit Judge: The present appeal requires us to determine whether a covenant not to compete,
entered into in connection with the acquisition of a portion of the stock of a corporation that is engaged in a trade
or business, is considered a “ section 197 intangible,” within the meaning of I.R.C. §197(d)(1)(E), regardless of
whether the portion of stock acquired constitutes at least a “substantial portion” of such corporation’s total stock.
For the reasons stated below, we answer in the affirmative.
Petitioners-Appellants Recovery Group, Inc. (“Recovery Group”) and thirteen individuals who held shares in
said corporation appeal the United States Tax Court’s decision in Recovery Group, Inc. v. Comm’r of Internal
Revenue [ CCH Dec. 58,184(M)], T.C. Memo 2010-76, 99 T.C.M. (CCH) 1324 (U.S. Tax Ct. Apr. 15, 2010),
which found in favor of respondent Commissioner of Internal Revenue (the “Commissioner”) concerning the
correctness of certain income tax deficiencies assessed by the United States Internal Revenue Service (the
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“IRS”) against the appellants. These deficiencies resulted from the finding that a certain covenant not to
compete — entered into by Recovery Group in connection with the redemption of 23% of the shares of a former
shareholder — constituted a “ section 197 intangible,” and, consequently, that Recovery Group had to amortize
the payments it made under such covenant not to compete over the fifteen-year period prescribed by I.R.C.
§197(a), and not over the duration of the covenant, as Recovery Group had reported in its corresponding income
tax returns. Because we find that the aforementioned covenant not to compete was an “amortizable section 197
intangible,” we affirm.
I. Facts and Procedural History
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The relevant facts in this appeal are not in dispute. During the tax years in question, Recovery Group was an
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“S corporation” that engaged in the business of providing consulting and management services to insolvent
companies.
In 2002, James Edgerly — one of Recovery Group’s founders, employees and minority shareholders —
informed its president that he wished to leave the company and to have the company buy out his shares, which
represented 23% of Recovery Group’s outstanding stock. As a result of the subsequent negotiations, Mr. Edgerly
entered into a buyout agreement whereby Recovery Group agreed to redeem all of Mr. Edgerly’s shares for a
price of $255,908. In addition, Mr. Edgerly entered into a “noncompetition and nonsolicitation agreement” that
prohibited Mr. Edgerly from, inter alia, engaging in competitive activities from July 31, 2002 through July 31,
2003. The amount paid by Recovery Group to Mr. Edgerly for this covenant not to compete (the “Covenant”)
amounted to $400,000, which was comparable to Mr. Edgerly’s annual earnings.
In its corresponding income tax returns, Recovery Group claimed deductions for its payments under the
Covenant by amortizing such payments over the twelve-month duration of the Covenant. Thus, because that
twelve-month term straddled the two tax years 2002 and 2003, Recovery Group allocated the $400,000 over
those two years.
After a subsequent investigation, the IRS determined that the Covenant was an amortizable section 197
intangible, amortizable by Recovery Group over fifteen years (beginning with the month of acquisition) and not
over the duration of the Covenant, as had been reported by Recovery Group in its corresponding income tax
returns. Consequently, the IRS partially disallowed Recovery Group’s deductions for the cost of the Covenant,
allowing amortization deductions of only $11,111 for 2002 and $26,667 for 2003, and disallowing $155,552 for
2002 and $206,667 for 2003. This disallowance increased Recovery Group’s net income for each year, and thus
each shareholder’s share of Recovery Group’s income. Accordingly, the IRS issued notices of deficiency to both
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Recovery Group and its shareholders.
Recovery Group and its shareholders filed timely petitions in the tax court, alleging that the Covenant was not
considered a “ section 197 intangible,” and, consequently, that it was not subject to I.R.C. §197’s fifteen-year
amortization period, but rather that it was amortizable over its one-year duration. Specifically, Recovery Group
alleged that, in order for a covenant not to compete to be considered a “ section 197 intangible” under I.R.C.
§197(d)(1)(E), the covenant must be entered into in connection with the acquisition of either the totality of such
corporation’s stock or a substantial portion of such corporation’s total stock. The tax court rejected Recovery
Group’s interpretation of I.R.C. §197 and found in favor of the Commissioner, concluding that §197(d)(1)(E)’s
substantiality requirement only applied to asset acquisitions and not to stock acquisitions, and, consequently,
that a covenant not to compete entered into in connection with the acquisition of any corporate stock, even
if not “substantial,” was considered a “ section 197 intangible” amortizable over fifteen years. The tax court
also opined, in the alternative, that even if the aforementioned conclusion was incorrect and I.R.C. §197(d)
(1)(E)’s substantiality requirement indeed applied to stock acquisitions, Recovery Group’s claim nonetheless
failed because the court found the stock redemption in question (23% of Recovery Group’s total stock) to be a
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“substantial portion” of the company’s stock. This appeal ensued.
II. Standard of Review
We review de novo the tax court’s legal conclusions, including its interpretation of the Internal Revenue Code.
Drake v. Comm’r, 511 F.3d 65, 68 (1st Cir. 2007).
III. Discussion
On appeal, Recovery Group contests the tax court’s decision on the tax deficiencies by challenging the court’s
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interpretation of I.R.C. §197. Specifically, Recovery Group avers that the tax court erred by concluding that
the Covenant is a “ section 197 intangible” within the meaning of I.R.C. §197(d)(1)(E).
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In interpreting the meaning of I.R.C. §197(d)(1)(E), we begin our analysis with the statutory text and determine
whether the same is plain and unambiguous. See Carcieri v. Salazar, 555 U.S. 379, 129 S.Ct. 1058, 1063
(2009). In so doing, we accord the statutory text “its ordinary meaning by reference to the ‘specific context in
which that language is used, and the broader context of the statute as a whole.’” Mullane v. Chambers, 333 F.3d
322, 330 (1st Cir. 2003) (quoting Robinson v. Shell Oil Co., 519 U.S. 337, 341 (1997)). If the statutory language
is plain and unambiguous, we “must apply the statute according to its terms,” Carcieri, 129 S.Ct. at 1063-64,
except in unusual cases where, for example, doing so would bring about absurd results. See In re Hill, 562 F.3d
29, 32 (1st Cir. 2009). “If the statute is ambiguous, we look beyond the text to the legislative history in order
to determine congressional intent.” United States v. Vidal-Reyes, 562 F.3d 43, 50-51 (1st Cir. 2009) (internal
quotation marks omitted). “A statute is ambiguous only if it admits of more than one reasonable interpretation.”
Id. at 51 (internal quotation marks omitted).
We begin our discussion by providing a brief background of I.R.C. §197 and then turn to sketching both the
Commissioner’s construction of I.R.C. §197, which was adopted by the tax court as its primary holding, and
Recovery Group’s interpretation.
A. Background
Section 197 entitles taxpayers to claim “an amortization deduction with respect to any amortizable section
197 intangible.” 26 U.S.C. §197(a). The cost of an “amortizable section 197 intangible” must be amortized
“ratably over the 15-year period beginning with the month in which such intangible was acquired.” Id. No other
depreciation or amortization deduction is allowed with respect to any “amortizable section 197 intangible.” Id. at
§197(b). On the other hand, intangible assets not classified as “amortizable section 197 intangible[s]” are not
within the purview of I.R.C. §197 and are not subject to this section’s mandatory fifteen-year amortization period.
Rather, depreciation and amortization for such non- section 197 intangible assets may be allowed under the
rules of other code provisions, such as I.R.C. §167, provided the asset complies with the requirements set forth
therein.
B. Relevant Statutory Language
Section 197(d)(1)(E) defines the term “ section 197 intangible” as including, among other things, “any 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.” Recovery Group does not contest that, under I.R.C. §197(d)(1)(E),
a redemption of stock is considered an indirect acquisition of an interest in a trade or business. See Frontier
Chevrolet Co. v. Comm’r, 329 F.3d 1131, 1132 (9th Cir. 2003). Rather, the parties’ dispute over the construction
of this section deals primarily with the antecedent of the word “thereof” and the definition of “an interest.”
The tax court held and the Commissioner asserts that the phrase “an interest in a trade or business” refers to a
portion — all or a part — of an ownership interest in a trade or business, and that the phrase “trade or business”
is the antecedent of the word “thereof.” Thus, the tax court essentially read I.R.C. §197(d)(1)(E) as follows:
“the term ‘ section 197 intangible’ means … any covenant not to compete … entered into in connection with an
acquisition … of [(1)] an interest in a trade or business or [(2)] [a] substantial portion [ of a trade or business].”
It is noteworthy that, under this interpretation, the question of whether an acquisition is “substantial” arises only
where the acquisition is “of a trade or business” (i.e., of assets constituting a trade or business), and not where
the acquisition is of “an interest” ( i.e., a stock or partnership ownership interest) in a trade or business. In other
words, under this reading, a covenant not to compete executed in connection with a stock acquisition of any
size — substantial or not — would be considered a “ section 197 intangible.” Meanwhile, in the context of asset
acquisitions, a covenant not to compete would only be considered a “ section 197 intangible” insofar as it is
entered into in connection with the acquisition of all or a substantial portion of assets constituting a trade or
business. Accordingly, the tax court held that “15-year amortization is required when a covenant is entered into
in connection with an acquisition of either an interest ( i.e., an entire or fractional stock interest) in a trade or
business or assets constituting a substantial portion of a trade or business.” Recovery Group, Inc. [ CCH Dec.
58,184(M)], T.C. Memo 2010-76.
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Recovery Group, on the other hand, argues that the words “ an interest in a trade or business” refer to “ the
entire interest in a trade or business,” and that the phrase “an interest in a trade or business” is the antecedent
of the word “thereof.” Accordingly, Recovery Group maintains that I.R.C. §197(d)(1)(E) should be construed as
follows: “the term ‘ section 197 intangible’ means … any covenant not to compete … entered into in connection
with an acquisition … of [(1)] [ the entire] interest in a trade or business or [(2)] [a] substantial portion [ of an
interest in a trade or business].” Recovery Group further alleges that the phrase “an interest in a trade or
business” should be read to include both assets constituting a trade or business and stock in a corporation that is
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engaged in a trade or business. Thus, under this interpretation, section 197’s fifteen-year amortization would
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apply to covenants issued in connection with a stock acquisition only insofar as the covenantee acquires at
least a “substantial portion” of stock in a corporation that is engaged in a trade or business. In other words, under
this reading of I.R.C. §197(d)(1)(E), the question of whether an acquisition is “substantial” would arise both in
stock and asset acquisitions.
As an initial matter, we note that Recovery Group’s construction of I.R.C. §197(d)(1)(E) makes a portion of
the statutory language seem redundant, and thus fails to give effect to the entire statute. See In re Baylis,
313 F.3d 9, 20 (1st Cir. 2002) (“In construing a statute we are obliged to give effect, if possible, to every word
Congress used.” (quoting Reiter v. Sonotone Corp., 442 U.S. 330, 339 (1979))). Specifically, if, as Recovery
Group alleges, the textual definition of a section 197 intangible includes a covenant not to compete entered into
in connection with, (1) the entire interest in a trade or business or (2) a substantial portion of an interest in a
trade or business, then the first category may be considered redundant because any acquisition falling under
“(1)” would presumably also satisfy the second category. Nevertheless, this weakness, by itself, is not sufficient
in the present case to discard Recovery Group’s interpretation as unreasonable or to dispel the ambiguity that
otherwise arises from the statutory language. See Lamie v. United States Tr., 540 U.S. 526, 536 (2004) (noting
that “[a court’s] preference for avoiding surplusage constructions is not absolute”). Rather, we find that the
relevant statutory language is ambiguous, as both the Commissioner’s and Recovery Group’s interpretations of
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the same are reasonable within the context of the statute. Accordingly, we proceed to analyze the statute’s
legislative history in order to determine congressional intent. See Vidal-Reyes, 562 F.3d at 50-51.
C. Purpose and Legislative History
Prior to the enactment of I.R.C. §197, as part of the Revenue Reconciliation Act of 1993 (Pub. L. No. 103-66,
107 Stat. 312), taxpayers were not allowed an amortization deduction with respect to goodwill, but were allowed
an amortization deduction for intangible assets that had limited useful lives that could be determined with
reasonable accuracy. See Newark Morning Ledger Co. v. United States [ 93-1 USTC ¶50,228], 507 U.S. 546,
548 n.1 (1993) (citing 26 C.F.R. §1.167(a)-3 (1992)). As a result, taxpayers and the IRS engaged in voluminous
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litigation concerning the identification of amortizable intangible assets and their useful lives.
The legislative history of I.R.C. §197 identified the following three types of disputes arising between taxpayers
and the IRS: “(1) whether an amortizable intangible asset exists; (2) in the case of an acquisition of a trade or
business, the portion of the purchase price that is allocable to an amortizable intangible asset; and (3) the proper
method and period for recovering the cost of an amortizable intangible asset.” H.R. Rep. No. 103-111, at 760
(1993).
The legislative history referred to the “severe backlog of cases in audit and litigation [as] a matter of great
concern,” and made explicitly clear that “[t]he purpose of [ I.R.C. §197] [was] to simplify the law regarding the
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amortization of intangibles.” Id. at 777. The Committee “believed that much of the controversy that [arose]
under [pre-section-197] law with respect to acquired intangible assets could be eliminated by specifying a single
method and period for recovering the cost of most acquired intangible assets and by treating acquired goodwill
and going concern value as amortizable intangible assets.” Id. at 760. Accordingly, the bill required the cost of
most acquired intangible assets, including goodwill and going concern value, to be amortized ratably over a fixed
fifteen-year period. Id.
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In reaching this simplified approach, the Committee recognized that certain acquired
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intangible assets — to which I.R.C. §197 applied — would have useful lives that would not coincide with the
fifteen-year amortization period prescribed by the statute. Id.
In the particular case of a covenant not to compete, Congress made I.R.C. §197 applicable only where the
covenant was entered into in connection with an acquisition of an interest in a trade or business or substantial
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portion thereof. 26 U.S.C. §197(d)(1)(E). This category was included in I.R.C. §197 because of the immense
volume of litigation regarding the value properly assignable to covenants not to compete. See generally Annette
Nellen, BNA Tax Management Portfolio 533-3rd: Amortization of Intangibles §III.B.10.
In the context of asset acquisitions, if I.R.C. §197(d)(1)(E) had not been included, a buyer of assets constituting
a trade or business would have had a significant taxmotivated incentive to allocate as covenant cost — and
amortize over the covenant’s useful life — what was in fact purchase price attributable to section 197 intangibles
(such as goodwill and going concern), which are amortizable over a fifteen-year period pursuant to I.R.C.
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§197. This incentive would have inevitably given rise to much litigation, since the value of goodwill and
going concern is notoriously difficult to determine, see Sanders v. Jackson, 209 F.3d 998, 100 …
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