## Facts

- Recovery Group, Inc. provided consulting and management services to financially distressed companies and was taxed as an S corporation, with items flowing through to shareholders.
- A minority shareholder, employee, and director (James Edgerly) decided to leave the company in 2002 and sought redemption of his shares, representing about 23% of outstanding stock.
- Recovery Group entered a buyout agreement to redeem Edgerly’s shares for $255,908 and separately obtained a covenant not to compete from Edgerly for a stated term shorter than 15 years.
- Recovery Group treated the covenant as not subject to I.R.C. § 197 and amortized the covenant cost over its contractual term; the resulting deductions flowed through to shareholders.
- The IRS determined the covenant was a “section 197 intangible” under § 197(d)(1)(E) and required 15-year amortization under § 197(a), issuing deficiency notices to shareholders.
- The Tax Court upheld the IRS; the taxpayers appealed to the First Circuit.

## Issues

1. Whether a covenant not to compete entered into in connection with a corporation’s redemption of 23% of its stock is a “section 197 intangible” under I.R.C. § 197(d)(1)(E).
2. If the covenant is a § 197 intangible, whether it must be amortized ratably over the 15-year period in § 197(a) rather than over the covenant’s stated term.

## Decision

- The First Circuit affirmed the Tax Court.
- The court held the covenant not to compete was an amortizable § 197 intangible because it was entered into in connection with an acquisition (via redemption) of an interest in a trade or business.
- The court rejected a requirement that the acquired interest constitute a “substantial portion” of the corporation’s stock for § 197(d)(1)(E) to apply.
- The court held the covenant’s cost had to be amortized over 15 years under § 197(a), not over the covenant’s shorter contractual duration.

## Legal Principles

- Under I.R.C. § 197(d)(1)(E), “any” covenant not to compete entered into in connection with an acquisition (directly or indirectly) of “an interest in a trade or business or substantial portion thereof” can qualify as a § 197 intangible.
- The phrase “interest in a trade or business or substantial portion thereof” is disjunctive; an acquisition of an “interest” need not itself be “substantial” for § 197(d)(1)(E) to apply.
- Corporate stock represents an ownership interest in the corporation’s trade or business; a stock redemption can be treated as an acquisition of such an interest for § 197 purposes.
- If a covenant not to compete is an amortizable § 197 intangible, the amortization period is the uniform 15-year period specified by § 197(a), regardless of the covenant’s stated term.

## Conclusion

The court held that a noncompete obtained in connection with a minority stock redemption (23%) falls within § 197(d)(1)(E) and therefore must be amortized over the 15-year period required by § 197(a), sustaining the IRS’s deficiency determinations.


Recovery Grp., Inc. v. Comm'r, 652 F.3d 122 (1st Cir. 2011)