April 2002

John McGill’s TAX Q&A

Q I practice with two other doctors, who are sole shareholders in our corporation. We are planning on buying out the oldest doctor in the group, having the corporation pay a relative small amount to redeem his stock, since this amount is nondeductible, and paying the remaining consideration to him in exchange for his agreement not to compete for a five-year period. Since our payments to the retiring doctor for his covenant not to compete are being made over a five-year period, and he is agreeing not to compete with us for a five-year period, can we deduct the payments made over the same time period, or must we use a 15-year write-off period as my accountant suggests?

A Your accountant is correct. The Tax Court recently held that under Section 197, a 15-year write-off period applies to a covenant not to compete entered into when a corporation redeems the stock of one of its owners. Even though payments are made over a five-year period, and the covenant not to compete covers a five-year term, the redemption constitutes the acquisition of an interest in a trade or business, and therefore Section 197 applies to require a 15-year write-off. See Frontier Chevrolet Co. vs. Commissioner, 116 TC 23 (5/15/01).

Q I own my office building, which is not fully depreciatedand too small for my current practice. Some time ago, I bought a commercial building lot in a more desirable part of town and would like to begin construction on a new office building. Can I avoid capital gains taxes on the sale of my current office building, as long as I reinvest the proceeds within six months into the new office building?

A Possibly. The Internal Revenue Service recently issued Revenue Procedures 2000-37, allowing so-called “reverse” tax-free exchanges when the new office building is purchased prior to the sale of the old one. However, strict conformity with the IRS requirements is necessary in order to qualify for tax-free treatment.

In DeCleene vs. Commissioner, 115 TC 457 (11/17/00), the taxpayer tried to set up a reverse tax-free exchange. In this case, he had the party interested in acquiring his office building purchase the land from him and owned it while a new building was being constructed on it, which was financed by the taxpayer. Once completed, the buyer then exchanged the recently completed building to the taxpayer in exchange for the property that he wanted.

In this situation, the Tax Court held that there was a taxable sale of the property, and not a like-kind exchange, because the buyer never acquired the benefits and burdens of ownership of the replacement property since there was an agreement between the parties that the two properties would be of equal value. sMr. McGill, MBA, CPA, JD, is a tax attorney with McGill and Hassan, P.A., a legal firm in Charlotte, N.C., that specializes in financial issues. He formerly worked with the Office of Chief Counsel, the legal branch of the Internal Revenue Service in Washington, D.C.