New Vehicle Dealership Audit Technique Guide 2004 - Chapter 10 - Sales of Dealerships (12-2004)
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Chapter 10 - Table of Contents
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:
|Goodwill||Amortize 15 years||Sec. 1231 asset|
|Covenant not to compete||Amortize 15 years||Ordinary income|
|Consulting agreement||Deduct as incurred||Ordinary income|
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
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?
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.
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.
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.
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.
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.