Reference no: EM133190802

Facts

1. The name of the US client is George's Software, Inc. ("George's")

2. The business, George's, is an S corporation

3. The corporation is a calendar year end, cash basis taxpayer

4. George's recently redeemed 23% of the shares from a shareholder Robyn Harley ("Harley")

5. As part of the transaction George's and Harley entered into a Covenant Not to Compete ("CNC")

6. The CNC is for a period of one year and is in relation to customer contracts and relationships

Issues

1. Which code section of the Internal Revenue Code covers the deductibility of a CNC for George's?

2. What is the normal period for deducting the costs of a CNC for federal income tax purposes?

3. Is it possible to deduct the costs in accordance with the term (one year in this case) of the CNC?

Conclusions

1. §197 of the Internal Revenue Code covers the deductibility of a CNC. The CNC is considered a Code Sec. 197 intangible.

2. A taxpayer can deduct the cost of a CNC over a 15-year period, beginning in the month the asset is acquired.

3. Since the CNC is a section 197 intangible that is amortizable over fifteen years, it is not possible to deduct the costs of the CNC over its duration of one year.

A nalysis

Which code section of the Internal Revenue Code covers the deductibility of a CNC for George's?

As a general rule, under §197, of the Internal Revenue Code, a taxpayer is entitled to an
amortization deduction of any section 197 intangible asset. A CNC 1 is considered to be an intangible asset that is deductible over a 15-year period, beginning with the month of the asset's acquisition.2 George's is also holding the asset in connection with a trade for the production of income, another requirement for an asset to be considered a section 197 intangible.

Furthermore, when dealing with any corporate stock acquisition, it does not matter whether the corporate stock is substantial or not because it will still be considered a "section 197 intangible" nonetheless.3

Certainly, there are exceptions to these assets which include: financial interests4, land5, computer software6, certain interests or rights acquired separately7, and some more discussed further throughout §197(e). §197(f)(1)(B) also discusses the special rule regarding covenants not to
compete, which is that no event shall be treated as disposable before the disposition of the entire interest.

What is the normal period for deducting the costs of a CNC for federal income tax purposes?

As discussed before, Internal Revenue Code §197 covers the normal period for deducting the
costs of a CNC for federal income tax purposes. §197(a) states that the deductions are "...ratably over [a] 15-year period..." The deductions also begin within the month the intangible asset is obtained by the taxpayer.

In the case, Recovery Group, Inc., et al., Petitioners, Appellants v. Commissioner of Internal Revenue, Respondent, Appellee8, the Internal Revenue Service (IRS) changed the amount of
allowed amortization deductions that Recovery Group had reported in their income tax returns since they allocated the income from their CNC over a two-year period instead of the correct 15-year period. As a result, the change in the allowed amortization deductions increased Recovery Group's income for each year, and thus the amount of each shareholder's share.

Is it possible to deduct the costs in accordance with the term (one year in this case) of the CNC?

In Recovery Group, Inc. v. Commissioner of Internal Revenue9, the court found in favor of the Commissioner regarding the length of the amortization period for a CNC. They analyzed the requirements and rules regarding an intangible asset under section 197.

The court concluded that Recovery Group's interpretation of §197(d)(1)(E) was incorrect and that any CNC "...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 taxpayer must use the correct IRC §197 rules for its intangible asset and it cannot claim any other type of depreciation or amortization to align with those rules contradicting the possibility of the costs to be deductible in accordance with the term of the CNC.

Attachment:- Internal Revenue Code.rar