Buyers and sellers of businesses or business assets have divergent objectives in structuring purchase and sale transactions. Sellers want to allocate as much as possible to non-taxable return of capital or items to which capital gain, as opposed to ordinary income, tax rates apply. Buyers want to allocate as much as possible to items that provide a current deduction against income, as opposed to those that require costs to be depreciated or amortized over time or capitalized. The IRS generally will respect an allocation agreed upon by the parties. Trouble results when the parties fail to specify an allocation, as illustrated in the recent decision in R. William Becker and Mary Ann Becker v. Commissioner of Internal Revenue.
Richard E. Becker and his family conducted Florida citrus operations since at least the 1950s. In 1983, he formed Becker Holding Corporation (“BHC”) for estate planning purposes and to ensure continuation of the family business. He served as BHC’s chairman of the board and his son, William, served as CEO. Family disputes resulted in William’s termination and the redemption of his shares in BHC. The redemption was made pursuant to an agreement that provided for a $5 million down payment and installments totaling $18,953,934, payable pursuant to a note. The agreement contained a covenant not to compete and the note provided for offsets against the purchase price if William violated the covenant. The redemption agreement did not contain a provision allocating the price between the shares and the covenant not to compete.
Following closing, William’s accountant told him that BHC missed a tax advantage by not allocating a portion of the price to the covenant not to compete and suggested that William negotiate an allocation of a portion of the price to the covenant in exchange for additional consideration or a shorter non-compete period. Negotiations concluded without agreement.
On his tax returns, William reported amounts received as payments for shares taxable as capital gains and subject to non-deductible capitalization by BHC. On its tax returns, BHC claimed all amounts paid were subject to the covenant not to compete and deductible as an amortized expense. The IRS issued a protective deficiency against both parties. Ultimately, William’s treatment prevailed.
The Tax Court noted that the parties’ intent determines price allocations in the absence of mistake, fraud, undue influence or duress. A clear expression of intent in an agreement will be respected by the courts and IRS and will be binding upon the parties. Although the redemption documents included a covenant not to compete and a provision for payment offsets for any breach of the covenant, thereby establishing the parties’ recognition of economic value in the covenant, the Court noted there was no mutual assignment of value in the absence of an agreed upon allocation. On the other hand, the documents clearly stated that the price was being paid in redemption of the shares. Consequently, all amounts received by William were properly reportable as capital gain for the redemption, and none were allowable deductions as amortization of the covenant by BHC, resulting in deficiency assessments for BHC of approximately $1,900,000.
BHC could have avoided this liability by negotiating an allocation to covenant not to compete during the redemption negotiation process. Please call us if you would like to discuss tax issues when planning a purchase, sale or other business transaction.