Reargued December 20, 1966.
Staley, Chief Judge, and McLaughlin, Kalodner, Hastie, Smith, Freedman and Seitz, Circuit Judges. Staley, Chief Judge (dissenting).
This is the decision on various petitions of the Commissioner of Internal Revenue to review a decision of the Tax Court of the United States determining the tax treatment of certain payments which were recited in certain covenants not to compete to be the consideration for such covenants. That court decided that the amount explicitly allocated as payment for each selling stockholder's covenant not to compete should not, for tax purposes, be treated as having been received for such covenants. The correctness of this ruling under the particular facts is of ever-increasing concern because of the frequent use of such covenants in connection with the sales of businesses.
The taxpayers*fn1 were stockholders in Butler County Loan Company ("Loan"), which was engaged in the small loan business and, through a subsidiary, in the consumer finance and discount business in Butler, Pennsylvania. The husband of taxpayer, Helen Sherman, had been its successful manager until his death in 1958. Thereafter, one Shukis was brought in to run the business and was given an option to buy 100 shares of the Loan's stock. He later exercised an option to buy 10 shares.
In 1959, the stockholders decided to solicit offers to purchase what was then a declining business. On November 2, 1959, Thrift Investment Corporation ("Thrift") offered in writing to buy all the common stock of Loan for $374 per share and "our usual non-compete agreement in the Butler area". The amount of Thrift's offer was higher than it would otherwise have been because Thrift "passed on" to the selling stockholders part of the favorable tax benefits which it inferred would accrue to it because the amount paid over and above the actual value of the stock was amortizable.*fn2
All the stockholders but Shukis accepted Thrift's offer. He notified Thrift that he was exercising his option to buy 90 additional shares. He apparently was willing to sell only if he was treated as holding 100 shares.
On the same day that it heard from Shukis, November 5, 1959, Thrift forwarded to the President of Loan copies of the proposed agreement of purchase and copies of the non-competition agreement. The proposed covenant not to compete restrained the stockholders from engaging in the small loan business around Butler, Pennsylvania for approximately six years. However, it permitted them to own stock of any small loan corporation. The agreement contained a blank, which was presumably to be filled in later, representing that part of the total consideration which was to be allocated to the covenant not to compete.
Because of Shukis' action, a dispute arose between him and the other stockholders. Nevertheless, the settlement was fixed for November 16, 1959. At that time all the stockholders were present along with representatives of Thrift. All the stockholders except Shukis had one attorney. He had his own counsel present.
Thrift made it clear, of course, that the stockholder dispute would not cause it to increase the offering price for all outstanding shares. Thus, the cost of issuing any additional shares to Shukis would have to be shouldered by the other stockholders. Protracted negotiations took place that day between Shukis and the other stockholders. They finally reached a settlement. Thrift thereupon completed the agreements with Shukis and then with the other stockholders, the taxpayers herein.
Thrift allocated $152 per share to the covenant not to compete and $222 to the contract for the sale of stock. These figures were inserted in the documents. Some question was then raised by the taxpayers as to the tax treatment they would receive on the $152 per share allocated to the covenant. As found by the Tax Court, the Thrift officials explained that the allocations were to Thrift's tax advantage but they did not tell the stockholders that they (the stockholders) would receive capital gains treatment. Nor did Thrift make any attempt to explain to the stockholders that such amounts would be taxable to them as ordinary income. After a brief discussion with their own attorney concerning the allocation, the stockholders here involved, on the advice of their own counsel, signed the documents. Each payment check from Thrift contained the notation that it represented the con sideration for both the sale of the stock and the agreement not to compete.
Each taxpayer reported the entire amount received by him as proceeds from the sale of capital assets.*fn3 The Commissioner disallowed that portion which corresponded to the consideration recited in the covenant not to compete and issued a notice of deficiency. The taxpayers then petitioned for a redetermination of the deficiency. The Tax Court ruled in favor of the taxpayers on the present issue, 44 Tax Court 549 (1965), thus permitting the consideration allocated to the covenants to be taxed at capital gains rates rather than as ordinary income. It found in effect that the taxpayers produced strong proof that the covenants were not realistically bargained for by the parties and that the amounts allocated thereto by Thrift were in reality that part of the purchase price of the stock which represented a premium on corporate receivables.
The Commissioner filed these petitions for review and this is the decision thereon.
The Commissioner argues here, as he did before the Tax Court, that where the parties to a transaction involving the sale of a business have entered into a written agreement spelling out the precise amount to be paid for a covenant not to compete, they should not then be permitted, for tax purposes, to attack such provision except in cases of fraud, duress or undue influence.
The taxpayers counter by saying that such an approach would dignify form at the expense of substance and that the substance of this transaction, as found by the Tax Court, shows that the amounts allocated in the agreements for the covenants had no independent basis in fact or arguable relationship with business reality.
We address ourselves to the soundness of the rule contended for by the Commissioner because we are satisfied that if it is basically not acceptable then the factual findings of the Tax Court would compel us to affirm its decision in favor of these taxpayers. We say this because we think we could not, on this record, disturb the Tax Court's findings that the covenants were not fully restrictive in view of the wording and also because these particular stockholders were not realistically in a position to compete. In contrast, if the Commissioner's proposed rule is accepted, the factual findings of the Tax Court would require us to reverse its decision. This is so because after Thrift first evidenced its intention to make an allocation to the covenants not to compete the taxpayers had almost two weeks in which to investigate the tax consequences. Nevertheless, they entered into the agreement on the advice of their own counsel. The present record does not reveal that the taxpayers lacked a full understanding of the terms of the agreement or that the purchaser engaged in fraud, duress, or undue influence. We do not understand either the Tax Court or the dissent to view the facts any differently.
We note at the outset that it is almost as important to delineate some of the matters which are not before us as it is to determine the applicable legal principle. First, since we are dealing with an issue as to the applicability of the correct legal principle, we are not concerned with the "clearly erroneous" rule. Compare Commissioner of Internal Revenue v. Duberstein, 363 U.S. 278, 80 S. Ct. 1190, 4 L. Ed. 2d 1218 (1960). " [The] question here is not one of 'fact,' but consists rather of the legal standard required to be applied to the undisputed facts of the case." United States v. General Motors Corp., 384 U.S. 127, 141, 86 S. Ct. 1321, 1328, 16 L. Ed. 2d 415 (1966).
Next, we are not here involved with a situation where the Commissioner is attacking the transaction in the form selected by the parties, e.g., Schulz v. C.I.R., 294 F.2d 52 (9th Cir. 1961). Where the Commissioner attacks the formal agreement the Court involved is required to examine the "substance" and not merely the "form" of the transaction. This is so for the very good reason that the legitimate operation of the tax laws is not to be frustrated by forced adherence to the mere form in which the parties may choose to reflect their transaction. Gregory v. Helvering, 293 U.S. 465, 55 S. Ct. 266, 79 L. Ed. 596 (1935); C.I.R. v. Court Holding Co., 324 U.S. 331, 65 S. Ct. 707, 89 L. Ed. 981 (1945). In contrast, the Commissioner here is attempting to hold a party to his agreement unless that party can show in effect that it is not truly the agreement of the parties. And to allow the Commissioner alone to pierce formal arrangements does not involve any disparity of treatment because taxpayers have it within their own control to choose in the first place whatever arrangements they care to make.
We turn, then, to a consideration of the principle advanced by the Commissioner. We begin by noting that the determination as to whether a covenant not to compete was actually executed is important, taxwise, both to the buyer and the seller. A tax challenge aside, the amount a buyer pays a seller for such a covenant, entered into in connection with a sale of a business, is ordinary income to the covenantor and an amortizable item for the covenantee. Ullman v. Commissioner of Internal Revenue, 264 F.2d 305 (2nd Cir. 1959). Indeed, the presumed tax consequences of the transaction may, as here, help to determine the total amount a purchaser is willing to pay for such a purchase. Therefore, to permit a party to an agreement fixing an explicit amount for the covenant not to compete to attack that provision for tax purposes, absent proof of the type which would negate it in an action between the parties, would be in effect to grant, at the instance of a party, a unilateral reformation of the contract with a resulting unjust enrichment. If allowed, such an attack would encourage parties unjustifiably to risk litigation after consummation of a transaction in order to avoid the tax consequences of their agreements. And to go behind the agreement at the behest of a party may also permit a party to an admittedly valid agreement to use the tax laws to obtain relief from an unfavorable agreement.
Of vital importance, such attacks would nullify the reasonably predictable tax consequences of the agreement to the other party thereto. Here the buyer would be forced to defend the agreement in order to amortize the amount allocated to the covenant. If unsuccessful, the buyer would lose a tax advantage it had paid the selling-taxpayers to acquire. In the ...