July 2003 > Tax Matters
Taxing the Sale of a Business
Cortland Langdon owned Bemidji Distributing Co. (BDC), the largest wholesale beer distributor in northern Minnesota. He decided to sell BDC and hired an appraiser to value the business. The appraiser determined the companys tangible assets were worth $765,000 and the intangible assets $1,200,000. In 1992 Langdon sold BDC to Bravo Beverage for $2,017,461, allocating $200,000 to a two-year consulting contract, $1,000,000 to a five-year noncompete agreement and $817,461 for the tangible assets. The IRS determined the amount allocated to the noncompete agreement was overstated. The Tax Court agreed with the IRS and set the amount at $334,000. This increased the gain BDC reported and caused Langdon to report the difference in valuations as a dividend. The taxpayer appealed the decision.
Result. For the IRS. The Eighth Circuit started by saying the IRS was not bound by the allocation the parties agreed to. The courts generally defer to the stated allocation if the parties are adverse. If not, they carefully scrutinize the allocation and agreements to determine the correct allocation. These varying standards are needed because the agreement may or may not reflect economic reality.
In this case the Eighth Circuit held that the Tax Court was correct in concluding the parties were not adverse. By shifting the purchase price from the assets to the covenant not to compete, the taxpayer paid less tax and the acquirer was entitled to greater early tax deductions. Thus the parties were not adverse.
In determining the correct value of the covenant not to compete, the court used the standard nine-factor test:
Applying these factors to the case indicated minimal need for the covenant. As the court asked: Why would the taxpayer sell the largest business in the area just to start a smaller one and try to compete with the business he had sold? In addition the consulting contract nullified any reasonable intent to compete. The final proof the value assigned the covenant was overstated was the parties failure to allocate anything to the intangible assets, which the appraiser had given such a high value. Therefore, the Eighth Circuit affirmed the Tax Courts revaluation of the covenant at a significantly lower amount.
Taxpayers selling businesses today should be careful to substantiate the value of the individual items allocated in the sales proceeds and avoid including conflicting items such as covenants and consulting contracts. Taxpayers also need to recognize that IRC section 197 includes covenants as an amortizable intangible with a 15-year useful life if purchased in connection with a business acquisition. Today, the acquirer may prefer a large amount be allocated to tangible assets with shorter useful lives rather than a covenant not to compete, thereby making the buyer and seller adverse and the courts more likely to honor the stated allocations.
Cortland Langdon v. Commissioner, CA-8, February 2003.
Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.