In Muskat v. Comm’r, 103 AFTR2d 2009-666 (1st Cir. 2009), the First Circuit Court of Appeals rejected taxpayer’s refund suit based on the taxpayer’s claim that payments contractually delineated as payments for taxpayer’s covenant not to compete and originally reported by the taxpayer as ordinary income, actually were payments for taxpayer’s personal goodwill, taxable as capital gain.
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Irwin Muskat (TP) was the CEO of JacPac Foods, Ltd., a family business. In 1993, an agreement was reached between JacPac and a subsidiary of Corporate Brand Foods America, Inc. (CBFA) for purchase of JacPac’s assets for approximately $45,000,000 plus assumption of JacPac’s liabilities. As part of the sale, TP entered into an employment agreement, a noncompetition agreement and a subscription agreement (under which he invested $2,000,000 in the purchaser). Under the noncompetition agreement, the purchaser agreed to pay TP $3,955,599 for a covenant not to compete over a 13 year period. The first installment of $1,000,000 was paid at closing with the remainder payable over the 13 years. These payments survived TP’s death.
TP received the first installment in 1998 and reported the payment as ordinary income on his 1998 federal income tax return and paid self-employment taxes on the income. In 2002 however, TP filed an amended return for 1998 reclassifying the $1,000,000 payment as capital gain and seeking a refund of $203,434, which included $21,479 of self-employment tax. After the IRS denied TP’s refund claim, he filed suit in the federal district court. The District Court denied TP’s refund claim on the ground that he failed to present strong proof that the parties intended the payment to be a payment for TP’s personal goodwill and denied TP’s self-employment tax claim on the ground that it lacked jurisdiction over that claim because that claim was not part of TP’s administrative refund claim. Initially, the court reaffirmed the application of the “strong proof” rule in the First Circuit. Under this rule, when parties to a transaction have executed a written contract providing for allocation of sums to particular items and one party thereafter seeks to alter the written allocation, for tax purposes, the proponent must present “strong proof” that, at the time of execution of the contract, the contracting parties actually intended the payments to be compensation for something else.
The court found that TP did not produce strong proof that the contracting parties intended the challenged payment to be compensation for TP’s personal goodwill. First, the court clarified that “strong proof” means that a taxpayer’s evidence must approach “clear and convincing” evidence required to reform a written contract on the ground of mutual mistake. The court found that the district court did not clearly err in holding that TP failed to adduce such strong proof. In this respect, the trial testimony revealed no discussion of TP’s personal goodwill during the negotiations and none of the transaction documents, including early drafts of those documents, mentioned TP’s personal goodwill. Further, the court found it significant that the noncompetition agreement referenced protection of JacPac’s goodwill (purchased by purchaser for $16,000,000, which made it extremely unlikely that the contracting parties intended the payments under the noncompetition agreement to serve as de facto compensation for TP’s personal goodwill.
The court rejected TP’s argument that survivability of the noncompetition payments mandated a conclusion that the payments were for something other than refraining from competition. The court stated that other courts have
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classified agreements that contain survivability provisions as valid noncompetition agreements for tax purposes.
The court also rejected TP’s argument that the terms of his employment and subscription agreement were so lucrative that they eliminated any realistic possibility that, at an advanced age, TP would compete with the purchaser. The court responded that proof that a written allocation does not have economic reality, does not in of itself, constitute strong proof that the parties intended some other allocation. Further, the court found that there was evidence that the noncompetition provisions were grounded in economic reality, including the fact that CBFA representatives testified that the noncompetition agreement was to prevent the possibility that TP would use his relationships with customers, suppliers and distributors to pursue competitive opportunities.
Finally, the court upheld the district court’s rejection of TP’s self-employment tax claim on the ground that it lacked subject matter jurisdiction over the claim. In this respect the court agreed that TP had substantially varied the legal theory and factual basis of his self-employment refund claim made to the IRS. TP’s refund claim to the IRS was based on the argument that he had incorrectly characterized the claim as ordinary income and not capital gain. However, at trial, TP shifted gears and argued that sums paid in consideration of a covenant not to compete are not deemed to have been earned in the conduct of a trade or business and, thus, are not subject to self-employment tax. The court concurred with the district court that the taxpayer’s refund claim filed with the IRS did not properly raise the revised self-employment tax claim and thus, was not within the subject matter jurisdiction of the court to address.
3. Tax Court Recharacterizes Payments for Personal Goodwill as Ordinary