Taxation – Federal Income Tax – Consequences to Seller and Buyer of Covenant Not to Compete

The owners of the entire capital stock of a newspaper business received an offer of $1,000,000 for their stock and a covenant not to compete with buyers for ten years. After the offer was accepted and the contract of sale drawn up, buyer asked for a clause in the contract evaluating the covenant not to compete at $50 a share and the stock at $150 a share in order to help him taxwise. The clause was accepted with little discussion. The sellers reported the entire proceeds of the sale on their income tax returns as long term capital gain, but the Commissioner ruled that $50 per share of the proceeds constituted consideration for the covenant not to compete and was taxable as ordinary income. The Tax Court held that since the covenant was treated as a separate item in the negotiations, the amount received for it was ordinary income. Clarence Clark Hamlin Trust, 19 T.C. 718 (1953). The buyer treated $50 per share of the amount paid as a capital expenditure for the covenant and deducted an amount representing amortization of the cost. In this case the Commissioner argued that the agreement not to compete was no more than an incident to the transfer of the good will of the business and had no separable value. The Tax Court held that the covenant had a separable value and was a depreciable capital asset. Gazette Telegraph Co., 19 T.C. 692 (1953).