Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board
Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board
Chapter 15 Covenant Not to Compete A covenant not to compete between the seller of a business and the purchaser for a specified period after the sale may be valid under certain instances. However, this issue often arises in the auto dealership context as a form of disguising the full purchase price of the dealership or as a means to ensure the furtherance of the business goodwill built up over the years by the seller. If this is the case, the entire sum received by the seller represents the proceeds from the sale of the business, including goodwill, and the purchaser would not be entitled to amortize the corresponding amount paid out for this covenant. Resolution of this issue is laid out in the judicial test found in Forward Communications Corporation v. United States, 608 F.2d 485 (Ct. Cl. 1979). The following four tests may be applied to determine whether any part of the purchase price may be separately allocated to a covenant not to compete: 1. Whether the compensation for the covenant is separable from the price paid for the goodwill? 2. Whether either party is trying to repudiate an amount fixed by both parties as allocated to the covenant? 3. Where there is no precise allocation in the agreement, did both parties nevertheless intend that some portion of the price be allocated to the covenant? 4. Whether there was economic reality behind the covenant? a. Rev. Rul. 77-403 expands the economic reality analysis: Case Study 1) Whether in the absence of the covenant would the seller actually desire to compete with the purchaser? 2) The ability of the seller to actually compete effectively with the buyer. 3) The feasibility of the seller effectively competing with the buyer considering the business and market within the time and area specified in the covenant. Consider the following factual situation and the application of these principles to determine if the designated covenant not to compete being amortized by the dealership was nothing more than a non amortizable disguise of a portion of the sales price paid for the seller’s assets: Buyer was in the auto business for many years but was new to this area. Seller began his dealership in the same area over 30 years ago. Buyer and Seller entered into an agreement to purchase all of Seller’s assets and assume certain liabilities. 15-1
One of the assets specifically identified in the sales instrument was the purchase of goodwill, namely "all of seller’s goodwill, all of seller’s existing telephone numbers, all costs and sales records and data, customer lists, mailing lists, files, invoices, advertising material and methods, warranty records, licenses to conduct the business and any files required to be retained after the closing by law or regulation for a purchase price of $250,000." Subsequent to the agreement to purchase and concurrent with the closing of this transaction, Buyer and Seller enter into a Covenant Not to Compete and Consulting Agreement. The agreement was for 5 years and covered a 50 mile radius from the site of dealership. Seller was to receive $300,000 each year for 5 years on the anniversary date of the closing of this sale. As a consultant, Seller agreed to provide the Buyer with "technical assistance, advice, and consulting with respect to the management and operation of the dealership, business principles employed, introduction to key executives of the dealership and outside the dealership, analysis of market employee relations, and other matters pertaining to the profitable operation of the business for 5 years from the date of the closing of this sale." The agreement further stated that if seller died or was to become incapable of performing these consulting duties during the term of the agreement for any reason he shall be deemed to have earned the full amount of compensation payable to him under the terms of this agreement. Facts brought out during the examination: Seller did provide management of the dealership with advice on how to market in this particular area. He provided advice on competitors in this market. He provided through his presence and advice for a smooth transition at the time of purchase. There was no appraisal of the covenant not to compete. Its valuation was based on assumptions that seller would take 5 percent of the dealer’s business if he competed and this would be more than $1,500,000 for the 5 years after the sale. Buyer had no objective criteria on which to base such an opinion. The covenant was separately negotiated by the buyer and seller. Seller was 69 years old and in poor health. The Buyer approached the Seller who had no intention to stay in business and compete. Buyer was aware of Sellers intentions. The net worth of the dealership per financial statements just prior to the sales closure was $6,000,000. The sales price was stated in the closing memorandum to be $7,750,000. Applying the principles found in Forward Communications Corporation: 1. Whether the compensation paid for the covenant is separable from the price paid for the goodwill? The presence of separate goodwill existed in this transaction as shown by the inclusion of 15-2
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Chapter 15<br />
Covenant Not to Compete<br />
A covenant not to compete between the seller of a business and the purchaser for a specified<br />
period after the sale may be valid under certain instances. However, this issue often arises in the<br />
auto dealership context as a form of disguising the full purchase price of the dealership or as a<br />
means to ensure the furtherance of the business goodwill built up over the years by the seller. If<br />
this is the case, the entire sum received by the seller represents the proceeds from the sale of the<br />
business, including goodwill, and the purchaser would not be entitled to amortize the<br />
corresponding amount paid out for this covenant.<br />
Resolution of this issue is laid out in the judicial test found in Forward Communications<br />
Corporation v. United States, 608 F.2d 485 (Ct. Cl. 1979). The following four tests may be<br />
applied to determine whether any part of the purchase price may be separately allocated to a<br />
covenant not to compete:<br />
1. Whether the compensation for the covenant is separable from the price paid for the goodwill?<br />
2. Whether either party is trying to repudiate an amount fixed by both parties as allocated to the<br />
covenant?<br />
3. Where there is no precise allocation in the agreement, did both parties nevertheless intend that<br />
some portion of the price be allocated to the covenant?<br />
4. Whether there was economic reality behind the covenant?<br />
a. Rev. Rul. 77-403 expands the economic reality analysis:<br />
Case Study<br />
1) Whether in the absence of the covenant would the seller actually desire to compete<br />
with the purchaser?<br />
2) The ability of the seller to actually compete effectively with the buyer.<br />
3) The feasibility of the seller effectively competing with the buyer considering the<br />
business and market within the time and area specified in the covenant.<br />
Consider the following factual situation and the application of these principles to determine if the<br />
designated covenant not to compete being amortized by the dealership was nothing more than a<br />
non amortizable disguise of a portion of the sales price paid for the seller’s assets:<br />
Buyer was in the auto business for many years but was new to this area. Seller began his<br />
dealership in the same area over 30 years ago. Buyer and Seller entered into an agreement to<br />
purchase all of Seller’s assets and assume certain liabilities.<br />
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