## Facts

- Several taxpayers, all shareholders of Butler County Loan Company, sold their shares to Thrift Investment Corporation in 1959.
- Thrift’s written offer contemplated a stock purchase plus a “usual” covenant not to compete in the Butler, Pennsylvania area.
- The final written agreements expressly allocated $152 per share as consideration for each seller’s covenant not to compete, with the balance allocated to the stock.
- The shareholders signed individual noncompete covenants reciting the allocated amount as the consideration for the covenants.
- On their returns, the taxpayers reported all proceeds as capital gain from a stock sale, disregarding the contractual allocation to the covenants.
- The Commissioner treated the allocated covenant amounts as ordinary income and assessed deficiencies.
- The Tax Court held the covenant allocations should be disregarded for tax purposes, concluding the amounts were not, in substance, paid for covenants not to compete.

## Issues

1. Whether taxpayers who sign a written agreement expressly allocating consideration to covenants not to compete may later recharacterize that consideration for tax purposes without proving grounds that would alter or invalidate the agreement under applicable state contract law.
2. Whether the Tax Court erred by disregarding the express allocation based on the taxpayers’ claim that the allocation was not separately bargained for or did not reflect the transaction’s substance.

## Decision

- The Third Circuit (en banc) reversed and remanded.
- The court held the taxpayers were bound by the written allocation of $152 per share to the covenants not to compete.
- The taxpayers could challenge the allocation only by producing proof that would be admissible in an action between the contracting parties to alter or invalidate the agreement under state law.
- Because the taxpayers did not prove fraud, duress, mutual mistake, or similar grounds for reformation or invalidation, the allocation controlled for federal tax purposes.

## Legal Principles

- A party to a written agreement with an express allocation of consideration is generally bound by that allocation for federal tax purposes.
- A taxpayer may challenge the tax consequences of an express allocation only by adducing proof that would be admissible, under applicable state contract law, to alter, reform, or invalidate the agreement (e.g., fraud, duress, mutual mistake).
- Evidence that the allocation was tax-motivated, drafted by the buyer, or not specifically negotiated is insufficient, standing alone, to disregard the written allocation.
- The rule promotes certainty and prevents parties from accepting contractual terms for deal purposes and later disavowing them to obtain different tax treatment.

## Conclusion

The Third Circuit held that taxpayers who sign agreements expressly allocating part of the sale price to covenants not to compete must accept the resulting tax treatment unless they can prove contract-law grounds that would permit changing or nullifying the allocation between the parties.


Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967)