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:: New Vehicle Dealership Audit Technique Guide 2004 - Chapter 9
- Sales of Dealerships (12-2004)
Chapter 10 -
Table of Contents
This
chapter discusses the applicable
law and potential audit issues
involving goodwill, covenants
not to compete and consulting
agreements when a dealership is
sold or transferred.
When a dealership is sold, as a
general rule, the assets are
sold and the stock is
liquidated. For most sales of
profitable dealerships, goodwill
is a material asset. As a
condition of the sale, it is
common for the parties to enter
into covenant not to compete and
a consulting agreement. A
portion of the sales price is
allocated goodwill, commonly
referred to as "blue sky" in the
auto industry, and to each
agreement. In most cases, these
agreements are valid and serve a
useful business purpose for the
both the buyer and seller. In
the financial statements,
goodwill may be broken down into
specific elements such as
customer lists and workforce in
place which has no impact on the
tax result.
In
a covenant not to compete, the
buyer wishes to protect the
market for which he has paid a
significant sum of money. The
seller in turn receives
compensation for agreeing not to
open the same franchise within a
specified geographical area or
to compete directly with the
buyer. Self employment tax is
not applicable to a pure
covenant not to compete.
In
a consulting agreement, the
seller agrees to provide the
buyer with assistance after the
sale and to perform specific
duties for a specified period in
return for compensation. The
seller is generally an
independent contractor.
The tax treatment of goodwill, a
covenant not to compete and a
consulting agreement can be
summarized as follows:
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Buyer
|
Seller
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Goodwill
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Amortize 15 years
|
Sec. 1231 asset
|
Covenant not to
compete
|
Amortize 15 years
|
Ordinary income
|
Consulting agreement
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Deduct as incurred
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Ordinary income
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Documents to Request
-
Complete sales agreement,
including all exhibits and
addendums.
-
Complete covenant not to
compete agreement
-
Complete consulting
agreement
-
Documentation to determine
how the value of Goodwill
was calculated
Interview Questions
-
Has there been a recent sale
or purchase of a dealership?
-
Is the taxpayer currently a
party in a covenant not to
compete and/or consulting
agreement?
Audit
Techniques
Goodwill and covenant not to
compete agreements
On the buyer's books, the
covenant not to compete should
be capitalized and a deduction
taken for amortization. This is
true regardless of whether any
expenses associated with the
agreement are deductible
pursuant to IRC 162.
The judicial tests found in
Forward Communications
Corporation v. United States,
608 F.2d 485 (Ct. Cl., 1979),
can be applied to determine the
validity of a covenant not to
compete. The following tests can
help determine whether any part
of the purchase price may be
separately allocated to these
agreements:
-
Whether the amount paid for
the covenant is severable
from the price paid for the
goodwill.
The sales contract should
specify a specific price
paid for the covenant not to
compete. The other terms
listed in the covenant not
to compete agreement should
be specific enough to
distinguish the covenant not
to compete from the sale of
goodwill. For example, the
covenant not to compete
should include a provision
for breach of contract if
the seller fails to comply
with the terms of the
covenant. If there is no
provision, the covenant may
be disguised goodwill.
The buyer amortizes both the
covenant not to compete and
goodwill over a 15 year
period. However, the seller
recognizes the amount
received for the covenant
not to compete as ordinary
income. The amount received
from the sale of goodwill is
taxed as capital gain
income, except that to the
extent that amortization has
been taken, it is recaptured
as ordinary income under
Section 197(f)(7).
Consequently, it is
advantageous to the seller
for the covenant not to
compete to be disguised as
goodwill.
If there is no allocation,
the buyer and seller must be
able to demonstrate that
they intended that some
portion of the sales price
be assigned to the covenant
not to compete when they
executed the sales contract.
-
Whether the covenant had
some independent basis in
fact or a valid business
purpose.
-
Rev. Rul. 77-403 expands
this analysis:
-
In the absence of
the covenant,
determine if the
seller desires to
compete with the
purchaser.
-
Is the seller
retiring or
retired?
-
Is the seller
moving out of
the area?
-
Is the seller
involved in
another line of
business?
-
The ability of the
seller to compete
effectively with the
buyer.
-
Determine if the
seller is in a
financial
position to
compete with the
buyer.
-
The feasibility of
the seller
effectively
competing with the
buyer, considering
the business and
market within the
time and area
specified in the
covenant not to
compete.
Is the geographical area
covered in the covenant not
to compete reasonable?
Common sense applies. A
manufacturer will not allow
a new dealership to open if
it jeopardizes an existing
one. The covenant not to
compete should cover an area
large enough to prevent the
seller from operating a
franchise that would compete
with the buyer.
If
the covenant not to compete does
not comply with the provisions
of IRC 197 and the regulations
there under, IRC 1060 requires a
reallocation be made to the
assets other than the covenant
not to compete that were sold as
part of the sale of the
dealership.
Since the enactment of IRC 197,
there is no effect on the
seller's tax treatment
regardless of the allocation of
the sales price between the IRC
197 assets and the remaining
assets. However, the allocation
of the purchase price may have a
significant tax effect on the
buyer because the buyer is able
to amortize IRC 197 assets over
a 15-year period but must
capitalize and depreciate the
purchase price allocated to the
remaining assets for periods of
up to 40 years. The potential
exists for an excessive amount
to be allocated to IRC 197
assets for the benefit of the
buyer.
Tax effects of indirect
acquisitions
If a taxpayer acquires an
indirect interest in a
business in connection with a
covenant not to compete
agreement, the covenant must be
amortized over a 15 year period.
This is true even if no assets
were sold or exchanged.
In
Frontier Chevrolet Co. v.
Commissioner; 116 T.C. 289
(2001) affirmed, 329 F3rd 1131,
(9th Cir. 2003), the Tax Court
determined that if a shareholder
redeems its stock, the covenant
not to compete, entered into in
connection with the stock
redemption, must be amortized
over 15 years under IRC 197.
Two shareholders controlled
Frontier Chevrolet. Menholt, an
individual, owned 25%, and
Roundtree Automotive Group, a
management company, owned 75%.
Roundtree actively managed
Frontier Chevrolet. Menholt was
an employee of Roundtree. In
1994, Frontier Chevrolet
redeemed 100% of its stock.
After the redemption, Menholt
became 100% shareholder of
Frontier Chevrolet. In
connection with the redemption,
Roundtree entered into a
covenant not to compete
agreement with Frontier.
The court ruled that because
Frontier's redemption caused
Menholt to own 100% of its
stock, the noncompetition
agreement was entered into
connection with the stock sale
agreement and it must be
amortized over 15 years.
Frontier argued that it did not
acquire an interest in a trade
or business pursuant to the
stock transaction because it
acquired no other new assets.
The court cited the legislative
history of IRC 197, which states
that an interest in a trade or
business includes not only the
direct acquisition of the assets
of the trade or business but
also the acquisition of stock in
a corporation that is engaged in
a trade or business.
Pre
IRC 197 sales agreements
As stated earlier, covenants not
to compete are amortized over 15
years regardless of the life of
the covenant if the related
assets were acquired after
August 10, 1993. If the taxpayer
enters into a binding contract
prior to August 10, 1993, the
covenant is amortized over the
life of the covenant.
In
Burien Nissan, Inc., et al.
v. Commissioner; T.C. Memo.
2001-116 (May, 2001), appellate
decision, 92 AFTR 2nd 6199,
9/16/2003, the Court held that
when the parties to a stock
purchase agreement make
substantial changes to that
agreement, a new agreement is
executed and the prior agreement
is disregarded for purposes of
IRC 197. The court determined
that the prior agreement was not
a binding contract.
Two individuals, Johnston and
McLaughlin, owned 100% of Burien
Nissan's stock. In 1990, prior
to the enactment of IRC 197,
Johnston and McLaughlin entered
into an agreement to sell their
stock to three individuals. A
noncompete agreement was
required. The 1990 agreement was
breached because Johnston and
McLaughlin did not receive any
payments for their stock. In
1993, Johnston and McLaughlin
amended the 1990 agreement
substantially changing both
terms of the sale and the
noncompete agreement. This
agreement included a termination
clause of the 1990 contracts.
The Court held that the1993
agreement was a separate and
distinct contract that was not
merely an amendment of the1990
contract. The court concluded
that Burien Nissan didn't
acquire a noncompetition
agreement until 1993 and that
Burien Nissan must amortize the
payments over 15 years under IRC
197.
Other issues
A covenant not to compete must
be amortized over a 15 year
period regardless of the terms
of the agreement. The only
exception is if all the assets
associated with the covenant are
sold or become worthless, the
balance of the amortization may
be written off at that time.
Regulation 1.197-2(g)(1)(iii).
Sales between related parties
merit careful consideration. It
is common for dealerships to be
sold or exchanged among family
members. Often this occurs as
the original owner retires or is
otherwise unable to operate the
dealership. Consider the
application of IRC 267 and 318
in these situations.
Consulting agreements
It is common for the buyer to
retain the services of the
seller for a specified period of
time and enter into a consulting
agreement. These agreements
typically cover a period of up
to 5 years. The seller generally
agrees to provide the buyer with
technical assistance, advice and
consulting with respect to the
management and operation of the
dealership, business principles
employed, analysis of market
conditions and other matters
pertaining to the profitable
operation of the business.
Tax effect
If the agreement is reasonable
and there is evidence that the
seller has performed services,
the buyer's cost is treated as
compensation and is deductible
according to the buyer's method
of accounting. Regulation
1.197-2(b)(9) states that a
consulting agreement does not
have the same effect as a
covenant not to compete to the
extent that the amount paid
under the agreement represents
reasonable compensation for
services actually rendered.
The same common sense principles
that apply to the covenant not
to compete agreement should be
employed in determining the
reasonableness of a consulting
agreement.
Supporting Law
IRC 197 and its regulations
govern the definition of
goodwill and covenant not to
compete agreements. IRC 197
generally became effective for
assets acquired after August 10,
1993. IRC 197 allows both
goodwill and covenants not to
compete to be amortized over a
period of 15 years, using the
straight-line method.
IRC 197(a) states that a
taxpayer shall be entitled to an
amortization deduction with
respect to any amortizable IRC
197 intangible asset.
IRC 197(c) defines the term
"amortizable section 197
intangible" as intangible
property that is acquired by the
taxpayer and held in connection
with the conduct of a trade or
business or an investment
activity.
IRC 197(d)(1) includes goodwill
and covenants not to compete as
IRC 197 intangible assets.
IRC 197(f)(3) requires amounts
paid by the buyer pursuant to a
covenant not to compete to be
capitalized.
Regulation 1.197-2(b)(9) states
IRC 197 intangibles include any
covenant not to compete entered
into in connection with the
direct or indirect acquisition
of an interest in a trade or
business. This includes an
acquisition in the form of an
asset acquisition, a stock
acquisition, a redemption and
the acquisition or redemption of
a partnership interest.
Regulation 1.197-2(f) states IRC
197 intangible assets are
amortized using the
straight-line method over a
period of 15 years.
Rev. Rul. 77-403 lists factors
to determine if a covenant not
to compete has a valid business
purpose.
Forward Communications
Corporation v. United States,
608 F.2d 485 (Ct. Cl., 1979) .
defines judicial tests in
covenant not to compete
agreements.
In
Frontier Chevrolet Co. v.
Commissioner; 116 T.C.289 (
2001), the Tax Court determined
that if a shareholder redeems
its stock, the covenant not to
compete, entered into in
connection with the stock
redemption, must be amortized
over 15 years under IRC 197.
In
Burien Nissan, Inc., et al.
v. Commissioner; T.C. Memo.
2001-116 (May, 2001), the Court
held that when the parties to a
stock purchase agreement make
substantial changes to that
agreement, a new agreement is
executed and the prior agreement
is disregarded for purposes of
IRC 197. The court determined
that the prior agreement was not
a binding contract.
In
Howard Pontiac-GMC, Inc v.
Commissioner, T.C. Memo
1997-313, the Court reduced the
value of the taxpayer's covenant
not to compete agreement. The
taxpayer argued that the seller
was a significant competitive
threat to his business;
therefore the value of the
covenant was proper. The Court
determined that the taxpayer did
not take into account the low
probability of the seller being
able to obtain another identical
franchise in the same
geographical area as the buyer.
In
Heritage Auto Center, Inc v.
Commissioner, T.C. Memo
1996-21, the Court reduced the
value of the taxpayer's covenant
not to compete and consulting
agreements. In determining the
value of the covenant, the Court
determined that the seller was
not a major competitive threat
because he had a tarnished
reputation in the auto
community. In determining the
value of the consulting
agreement, the Court determined
that no meaningful and
significant negotiations took
place.
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